The following article was written by Tom Pilcher during his summer internship at Redington. Tom is a third year student of Economics and Accounting at Bristol University.
Since the Bank of England (BoE) started its quantitative easing (QE) scheme in late 2008, pension funds have suffered soaring deficits: according to the PPF7800 index, deficit figures ballooned from £194.5bn at the end of 2008 to £256.6bn in April 2013. There may be light at the end of the tunnel, however, as financial markets stir. Following recent stagnation, investors raised their expectations of interest rates, indicated by a recent spike in required returns on long bonds, the best indicator of interest rates’ future direction.
Since the start of the global financial crisis, central banks have turned to QE in order to help revive economic growth. The process of purchasing government bonds in order to rapidly inject liquidity into the private sector began in earnest in 2008, when the Fed bought $600bn in mortgage-backed securities. By June of this year, the Fed’s balance sheet had burgeoned to an astonishing $3.5tn. Similarly, the BoE has so far committed a total of £375bn to QE, but opted against further extending the programme to £400bn at Sir Mervyn King's final meeting as chairman last month. Central banks’ acquisition of these gilts relatively lowers their supply in the market, increasing prices and driving down yields.
These activities affect pension funds because their liabilities must be discounted at an appropriate interest rate to reflect the amount of assets needed to meet the future cash outflow. This is their worth today – the present value. In March 2009 just after the first round of QE took place, 15 year gilt yields stood at 4.26%, plummeting to just 2.06% in June 2012, and causing liability values to rise drastically and leaving pension schemes with worrying deficits. To add to pensioners’ woes, critics of the Bank's QE programme say it risks fuelling inflation, potentially slashing the real value of retirement incomes or inflating liabilities further.
The question on everyone’s mind is, what can trustees do to protect funding ratios from falling further? A sensible step could be to hedge your bets. Interest rate risk may be protected by matching asset interest rate sensitivity with that of the liability. As an example, let’s assume we start from a position of a 70% funding ratio, with liabilities worth £1bn and assets £700m. A fall of 1% in the discount rate has different effects on the deficit and funding ratio given different levels of hedging, as shown below:
Without a hedge, the result of a drop in interest rates is a growing deficit, which rises by £200m as the value of liabilities rise, but the value of assets does not change. When the hedge and funding ratios are equal, the funding ratio does not change since the value of assets rises proportionately to liabilities’ movement. Better still, a drop of 1% in rates has no impact on the size of the deficit under a 100% hedge, and the funding ratio actually improves by 5%. In practice, many pension funds who failed to hedge at least to their funding ratio witnessed deterioration to their financial position as central bankers undertook significant QE measures to tackle sharp economic contraction.
Now, the story is changing. While the BoE may remain in QE mode, news of the Fed’s planned ‘tapering
’ has of late caused bond yields to rise dramatically (as the prospect of potentially ‘loose money’ wanes) and global stock markets to take fright. A reversal of trend saw yields on 15-year gilts reaching 3% on the 26th
June, up from 2.06% in June 2012, translating to a fall in the value of liabilities.
To illustrate, let’s update our example, instead assuming a 1% rise in interest rates:
With no hedge, the value of assets does not fall (unlike liabilities) and so the funding ratio rises dramatically from 70% to 88%, contrasting to a fall of 7% if totally hedged. In a similar way to example 1, the funding ratio does not change when it equals the hedge ratio, but now the absolute value of the deficit has decreased.
If interest rates do pick up in line with the market’s current expectations, then, what then is the best response for pension fund trustees? While, theoretically, it may be tempting to rapidly un-hedge and capture the gain, this would be a significant gamble. Even though getting it right would be very rewarding, a future fall in rates could be disastrous, and may leave no possible hope of reaching full funding. Reducing interest rate risk (that is unrewarded) by hedging to the funding ratio should still be the name of the game. Combining return-seeking assets (earning a tangible premium) with interest rate and inflation hedging can offer stable returns that lead the way towards full funding.
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer