With long gilt yields hovering just above 2%pa, many pension scheme deficits will be looking rather unpleasant.
Since the beginning of 2014, yields have tumbled by over 1.5%pa – that could easily mean a 25% increase in the liabilities of a typical defined benefit (DB) pension scheme. Typical risk asset returns have been moderate at best – UK equities, for example have returned 1.2% over 2014. Some pension schemes may have been able to hedge some or all of their long-term interest rate risk – either by investing in bonds, or using ‘Liability Driven Investments’ (LDI) to match scheme assets with liabilities. But many schemes will not be completely hedged in this way, and will now be suffering from significantly increased deficits – on pretty much any calculation basis.
Looking forward, the prognosis is bleak. With the European Central Bank beginning its own Quantitative Easing programme, there doesn’t seem any immediate prospect of higher yields – indeed, some commentators, think that yields could fall still further.
What should DB scheme trustees do? Fortunately, most only need to get out of bed and worry about how to fund deficits every three years, so many may well pull the covers over their eyes and keep their fingers crossed that, by the time the next valuation comes around, the position is a little better. But those with valuations now are faced with the unpleasant prospect of asking sponsors for more cash. Some sponsors may be able to find a few extra pennies, whilst for others deficit funding may be driven primarily by affordability - in which case there’s probably no chance of extra cash no matter what the actuary says.
Of course, schemes that hedged their interest rate risk a few years ago will be feeling very smug indeed. But hindsight is a wonderful thing.
John Broome Saunders