Govt mini-Budget announcements set to drive down DB pension deficits

Industry experts have said that the high levels of government borrowing announced in the mini-Budget could drive up interest rates and reduce defined benefit (DB) pension deficits, although corporation tax changes could impact sponsoring employer contributions.

LCP partner, Jon Forsyth, pointed out that the interest rate on 20-year UK gilts rose to just over 3.8 per cent before the Chancellor stood up, increasing further to around 4 per cent amid market reaction to the statement.

Coming on top of earlier rises in long-term interest rates, Forsyth suggested that these increases will reinforce the trend of more schemes being in surplus and more schemes being in a position to consider buying out some or all of their liabilities.

“The vast majority of DB schemes will find themselves in a better funding position this year than last, and today’s announcements are likely to reinforce that trend," Forsyth stated.

"If long-term interest rates continue to rise, deficits will tend to fall, and for some schemes this could bring forward the potential to buy out or buy in some of their liabilities."

Indeed, Barnett Waddingham partner, Ian Mills, said that the Chancellor's announcement has already had a "seismic effect" on gilt markets, suggesting that the market has "reacted with what could best be described as an allergic reaction", with

"The effect of these rising gilt yields will be significant – DB pension scheme liabilities will have fallen sharply in just a couple of days, perhaps by as much as 10 per cent for some schemes," he continued.

"Many schemes will find that their funding positions have improved sharply, particularly those that have not fully hedged their interest rate and inflation risks with LDI."

Mills suggested that this environment may present opportunities to de-risk, encouraging trustees to review their funding positions in the next few days and assess the implications for their own specific circumstances.

However, he clarified that while the falls in DB pension liabilities may be good news for some scheme’s solvency positions, they will cause "significant challenges", especially for schemes with LDI portfolios.

"DB schemes using LDI will come under pressure, especially if the rise in yields is sustained," he continued.

"The rise in gilt yields will likely cause schemes to have to recapitalise hedges – some will be able to do so from cash reserves but others will find they are forced to sell other assets.

"Some schemes could even be forced to unwind hedges exposing them to the risk of reversals in yields. Schemes using LDI should immediately review whether their collateral buffers remain adequate, and consider taking remedial action if not. Waiting to receive a collateral call that you cannot meet is not a good idea."

In addition to causing problems in meeting LDI collateral calls, the rise in yields could disturb the ongoing viability of the whole strategy, according to Mills, who urged these schemes to "immediately review their illiquid asset programmes to ensure they remain suitably robust to the possibility of further rises in gilt yields".

Forsyth also noted that the impact of other Budget measures, such as the scrapping of the Corporation Tax increases, will have a "less clear-cut impact", as companies will get less tax relief than expected, which could affect the timing of DB contributions.

This was echoed by Cardano Advisory managing director, Alex Hutton-Mills, who warned that while reduction in corporation tax will be welcomed by sponsors struggling with supply chain issues, soaring energy costs and spiralling wage demands, it could prompt concerns over future financing costs for DB sponsors.

“It won’t help those already operating at a loss and is likely to lead to a stronger monetary response in November, raising financing costs for many DB scheme sponsors," he explained.

"The silver lining will be falling pension deficits, so we expect some sponsors to need to engage with trustees to preserve funding slated for schemes that may no longer need it, to better preserve or deploy that "marginal pound" over the challenging months ahead.”

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