Rising interest rates prompt employer pension funding concerns

Pension scheme trustees have been urged to consider how a high interest rate environment could impact the ability of sponsoring employers to fund defined benefit (DB) schemes, and to “lock in” recent gains, following the Bank of England's latest interest rate increase.

The Bank of England confirmed a further rise in interest rates today (22 September), from 1.75 per cent to 2.25 per cent, marking the highest rate since 2008.

According to XPS, the increase has pushed UK pension schemes into surplus, based on a long-term target basis of gilts +0.5 per cent, with the rising interest rates prompting an improvement in pension scheme funding positions.

“A rise of at least 0.5 per cent was already anticipated by investment markets, with a c2.7 per cent rise in long-term government bond yields since December 2021 reducing liabilities of UK DB pension schemes by £750bn, nearly 35 per cent," XPS Pensions Group senior consultant, Charlotte Jones, explained.

“The energy cap should lead to prices rising less quickly than previously feared, but with the future far from certain, pension scheme trustees should strongly consider taking measures to lock in some of these gains by reducing levels of risk in their investment strategies or securing members’ benefits with an insurance company”.

However, LCP clarified that while rising long-term rates are generally good news for scheme funding levels, they will impact upon businesses differently depending on their debt structure and how exposed they are to interest rate fluctuations.

In light of this, it warned that any adverse impacts on covenant support available to the scheme could have “significant” consequences on an employer’s ability to provide financial support to its scheme.

In addition to this, LCP explained that any required changes in the security provided to lenders could also impact a pension scheme’s insolvency recovery.

LCP has therefore encouraged trustees to understand their sponsor’s financial position and structure, particularly in light of the Pensions Scheme Act 2021, as schemes could face civil or financial penalties if they fail to meet the regulator's expectations for trustees to have full visibility of changes to the security of the pension scheme.

“In this high interest rate environment trustees need to really understand the finances of the sponsoring employer,” added LCP partner, Fran Bailey, explained. “Engagement is key to this.

"Processes should be in place to ensure that any changes in a sponsor’s financing profile are communicated in a timely manner, and that sufficient information is shared to allow the covenant impact of these to be assessed. This will help them to protect both the scheme and themselves.”

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