How will the rate rise affect DB pension funds?

Many defined benefit (DB) pension schemes have come under pressure from ultra-low gilt yields since the financial crisis, as a result of extreme monetary policy.

So the Bank of England's (BoE) announcement on 2 November that its Monetary Policy Committee (MPC) had voted to raise the base rate by 25 basis points (bps) to 0.50% for the first time in 10 years has been widely welcomed.

Governor Mark Carney has stressed the "gradual pace" of future interest rate increases, with the central bank's forecasts based on two more hikes over the next three years.

Slowly as she goes

This "baby steps" move towards normalisation should be welcomed by those who believe that asset prices have been distorted by an over-extension of quantitative easing (QE) over the last few years, says Hermes Investment Management group chief economist Neil Williams.

"The $15trn (£11.4trn) of liquidity poured in by the big four central banks (including the BoE) since the end of the last recession has now started to contribute to the problem rather than the solution. This is partly because it's distorted financial markets and asset prices, and caused extra tensions on pension funds because of ultra-low yields.

"This tightening cycle is very different to any in our lives, which is because of increased balance sheets that banks have held during QE, they now have skin in the game. If they take us off guard by for example hiking rates too aggressively, they will inevitably feel some of that pain themselves. So it's in their own interests to continue on this gradual slow baby steps path towards nudging rates higher."

Schroders senior European economist Azad Zangana adds that Carney's expectation of two more rate rises over the next three years is "very limited" and "we've never really seen such a slow pace of rate rises probably anywhere in the world".

Last week's move also only brings the base rate back to where it was last August when the central bank cut it by 25 bps to 0.25% in response to the EU referendum result. 

This ‘slowly as she goes' approach combined with strong communication with the markets ahead of action may however mean limited reprieve for DB schemes that have seen funding deficits increase on the back of low yields.

Scheme funding levels are affected by what happens to long-term yields and also whether there are more rises in the base rate and if those surpass what the markets expect.

Punter Southall's investment consultant Nick Harvey says: "Whether it's largely symbolic or good news for pension schemes will depend on what happens to long-term gilt yields, which won't necessarily react in the same way as there are different drivers."

This is because there will continue to be high demand for long-term gilts from investors such as insurers and pension funds to match their liabilities, which will help keep prices high and yields low.

Lincoln Pensions managing director Alex Hutton-Mills adds that the central bank's move will only "marginally improve" the funding position of some schemes, as it has been expected and priced in for some time. "Any improvement in funding will be modest as many schemes still contain significant levels of investment risk."

Nothing is certain

Interestingly, the markets seem to have moved away from the BoE's own guidance, as since the announcement they are now pricing in the next rate rise for Q1 2019 rather than Q3/Q4 2018, and the second one not until 2021.

"The market has looked at the current conditions and the statement provided to them, and concluded the BoE wouldn't be able to follow through with the guidance," says Zangana.

As a result, some of the pension schemes hoping for more hawkish guidance decided this was not going to come so they went in and bought bonds, which depressed the yield curve in the 24 hours following the MPC's announcement, he adds.

"If the BoE does decide it wants push the market higher, you would expect yields to rise a bit further from here but not dramatically so. I'd say on the 10-year gilt yield there could maybe another 10 to 15 bps at most, so nothing too dramatic, but there's probably a bit of upside left for pension funds hoping to get a better yield."

Hermes' Williams suggests in tandem with nudging rates up slowly, the BoE could tighten by effectively doing nothing and allowing the balance sheet to gradually wind down. "This could be done by following the US Federal Reserve in stopping the reinvestment of gilts that mature on its own balance sheet, which may exert some gentle upward pressure on gilt yields, while at the same time allowing them to peak out at a far lower bank rate than we're used to."

There is of course the possibility the bank has gotten the timing wrong. The economy's outlook is very uncertain especially due to lowered growth expectations and Brexit, which could scupper its planned rate rises.

Zangana explains: "It has assumed a range of Brexit outcomes based on several scenarios and it hopes for a smooth transition to one of those scenarios. If, for example, we move towards a no-deal scenario, which it has excluded from its  analysis, it may end up cutting rates again or at least not raising rates for a while."

Conversely, if the UK ends up with a favourable Brexit scenario, this could prompt the BoE to speed up the rate rise process.

How to react?

Faced with continued uncertainty about the future path of interest rates and Brexit, how should schemes react?

Harvey believes it is still very valid to take a significant proportion of interest rate risk off the table through hedging as rates both short and long term are incredibly difficult to predict.

"There is so much unpredictability out there," he says. "No one can say with certainty whether this rate rise is just a reversal of the rate cut we had in August 2016, in which case we're just back to where we were for most of the decade, or whether we've turned a bit of a corner and rates will rise from here."

Hutton-Mills says schemes should focus on managing risk and think about the sponsor covenant. He is concerned about the impact of the interest rate rise on sponsors' business models (as it rate rises hurt unhedged borrowers), as well as the Brexit uncertainty.  

"Because there are still factors like Brexit uncertainty over the hill, the sponsor covenant for some schemes is still very uncertain, so trustees need to keep an eye on how businesses will develop and how they're thinking about investment decisions in the context of the current environment."

At any rate, the path towards normalisation will only be slow and steady, which will mean little nirvana for DB schemes in the short term. Schemes should tread with caution as the BoE's plans could be scuppered by the lurking uncertainty of Brexit.