Rising gilt yields amid interest rate increase 'good news’ for scheme sponsors

The Bank of England’s (BoE) decision to increase the base rate from 0.75 per cent to 1 per cent is likely to be good news for pension scheme sponsors and defined benefit (DB) schemes that are not fully hedged, if gilt yields continue to rise in line with interest rates, according to industry experts.

The BoE announced yesterday (5 May) that it would increase the base rate further to help cope with rising inflation.

XPS Pensions Group noted that, with liabilities of UK schemes having already reduced by £420bn since the first base rate increase in December, a further rise will likely be good news for sponsors if gilt yields continue to track upwards in line with interest rates.

Its DB:UK Funding Watch found that a 0.25 per cent rise could translate into an additional £100bn in savings for pension schemes if long-term gilt yields also increase as a result.

However, this movement in liabilities is based on gilt yield movement only and makes no allowance for changes to inflation or the market value of assets, or allow for any offsetting reduction in the value of hedged assets.

“Despite the UK currently experiencing the highest levels of inflation for over 30 years, with interest rates rising and long-term expectations of inflation now stabilising, pension schemes which are not fully hedged will be better funded than they were at this time last year,” commented XPS Pensions Group actuary, Tom Birkin.

“Given the cost of living crisis facing pensioners and with caps on pension increases already limiting pension income, pension scheme trustees may come under increasing pressure to pass on some of these funding improvements to their members by providing discretionary increases to members’ pensions above inflation caps.”

Hymans Robertson co-head of DB investment, Elaine Torry, agreed, noting that although the impact of any short-term interest rate was unlikely to alter funding levels, the concurrent risk in gilt yields “cannot be ignored” by these schemes.

“The significant, c0.9 per cent rise in gilt yields that has been experienced since the start of the year, will be causing a greater impact,” she continued.

“This increase in medium and longer dated gilt yields could see liability values reduce by c15 per cent leading to an average duration, £100m scheme facing a reduction in liabilities of c£15m as a result.

“For those DB schemes that are not fully hedged against interest rate movements, this gilt yield rise could prove a much welcome tailwind for funding and present an opportunity to reduce risk and lock in funding gains. We would urge trustees to consider whether this movement is an opportunity to take further steps towards shoring up the funding position and protecting their members benefits.”

Broadstone technical director, David Brooks, warned that while any underhedged position may be proving a “positive contributor” to funding levels, this was not something for trustees to be complacent about and should be a position taken consciously.

“The statement from the BoE that inflation will reach 10 per cent in Q4 this year, nearly 1.5 per cent higher than the Office for Budget Responsibility predicted, will be concerning,” he said.

“However, this may encourage schemes, particularly those that are now better funded, to consider de-risking their positions. At the very least they should be reassessing whether their liability hedging programmes remain in line with their intended targets given the significant moves in both interest rates and inflation.

“Trustees and sponsors should also watch carefully the impact of interest rate hikes, both in the UK and elsewhere, on the wider economy as this may yet depress the recovery from the Covid-19 pandemic.”

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