WHY A RATE RISE DOES NOT GUARANTEE LOWER LIABILITIES

“Carney tells UK to prepare for rate rises”Financial Times, June 2014.

The general consensus is that the Bank of England (BoE) will increase base rates early in 2015 (or maybe even sooner). This is an increase in interest rates, which is good for Defined Benefit (DB) pension funds right? Not necessarily. A rise in the base rate is not a guarantee that the value of pension fund liabilities will fall.
 
Why are interest rates important for DB pension funds?

DB pension funds have to make pension payments to their members in the future, these are known as the fund’s liabilities. The chart below shows a “typical” cash flow profile of a DB pension fund.
 

Nick-Graph-1-(1).JPG

 
The size of these cash flows are dependent on: inflation, employees’ wage increases and how long the members live but not interest rates. (Click here for more on how inflation and mortality affect liabilities)

So, why do interest rates matter?

In order to assess a DB pension fund’s ability to pay its liabilities we discount the value of the cash flows to a “present value”. This is simply the amount of assets that the fund would need today to pay all their pension liabilities, assuming they earn a return on their assets equal to the discount rate used.
 
Below are some examples of how the discount rate that is used affects the present value of the liabilities (using our generic liabilities from before):


Nick-Figure-2.JPG

 
As you can see, changes to the discount rate have a big impact. As the discount rate rises the present value of the liabilities falls. As the liability value falls, the funding level (size of assets relative to the present value of liabilities) increases.

In practice, discount rates that are used are based on interest rates, usually gilt yields (the return offered by UK government bonds) for UK DB pension funds. This intuitively makes sense as it is the “risk-free” return that the fund could make on its assets between now and when the pensions are paid.
 
Back to the BoE and base rates…

So as interest rates rise, liabilities will decrease in value, then why might a rise in BoE base rates not be good news?

Liabilities are very long dated so the key factor is not today’s short-term interest rates (as dictated by the BoE) but long term interest rates which already allow for the base rate to be increased over time.

There are times when an increase in short-term rates (due to an increase in BoE base rate) actually leads to long-term rates falling as the market begins pricing the next rate CUT cycle into long-term rates. The following chart shows this happening in two of the last three recent rate hike periods – 1999-2000 and 2003-4.

Nick-Figure-3.JPG

To demonstrate the impact of changes in short term rates (BoE base rate) and long term interest rates (30 year gilt yield) on the present value of our generic liabilities, we can use a model which simplifies the impact of these rates changing. The table below shows the results:

  Current Short Term Rate: Rise
Long Term Rate: Rise
Short Term Rate: Rise
Long Term Rate: Unchanged
 Short Term Rate: Rise
Long Term Rate: Fall
Short Term Rate (%) 0.5% 1.5% 1.5% 1.5%
Long Term Rate (%) 3.5% 4.5% 3.5% 3.0%
Present Value of Liabilities (£m) 1,000 833 975 1,063

 
As you can see, when both short-term rates and long-term rates increase the present value of the liabilities falls significantly (by 17% from £1,000m to £833m). However, an increase in just short-term rates has a much smaller impact (-2.5%). If an increase in short-term rates led to a drop in long-term rates, which has been the case in recent years, the present value of liabilities will rise by 6.3%.

What does this mean for DB pension fund trustees?

Yes BoE base rates will rise at some point but this may not have a material impact on your liabilities – it is the long-term rates that matter. An increase in short-term rates will not necessarily lead to an increase in long-term rates, which have a greater effect on liability values.

In addition, it is not just about whether rates rise or not, it is also about how they move against what the market is expecting – the market has incorrectly priced in higher rates which have not materialised on several occasions during this economic recovery. (Click here for more information on why rate expectations matter and how well the market has predicted rate hikes)

Despite an expectation of rates rising in the future, it remains as important as ever to understand and manage your interest rate risk. Relying on higher rates to improve your funding level sounds like a good idea, unless the near future mimics the recent past.

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

Author: Nick Lewis

Nick joined Redington's Investment Consulting team in April 2014. Nick was previously part of the Investment Consultancy team at Aon Hewitt working with a range of clients on investment strategy and risk management. Nick is a CFA charterholder and previously studied Economics and Maths at Bristol University.