The most frequently repeated mantra in pension land is probably that everything will be well once interest rates rise from their unprecedentedly/artificially/outrageously low levels. The value of liabilities will fall, funding positions will improve and the future will look a lot brighter for defined benefit schemes.
There are a number of reasons why this desired state of affairs may take longer to arrive than most people would like. Whilst it is clearly difficult to make market forecasts (after all if we were good at forecasting the markets we would all have different jobs…), it is important to be aware of the risks that can foil expectations of a better future.
Central banks to the rescue?
One thing financial markets await with bated breath is central banks hiking their benchmark rates. The trouble for a pension scheme relying on a rate rise to improve its funding position is that central bank policy rates will often only have a direct effect upon the short end of the interest rate curve (say tenors of 10 years and less). As most pension schemes will have liabilities whose average lifetime – as measured by their duration – is far in excess of 10 years, the impact of interest rates increasing at short-term tenors will, in a lot of cases, be small, even minuscule. Changes in 20- or 30-year interest rates are a lot more important for the vast majority of UK defined benefit schemes. (Click here for details of why long-term rates matter more for pension funds)
Pension schemes have to hope for central bank rates feeding into higher interest rates at longer term tenors. This would happen if investors think that higher rates at the short end offer a better risk/return balance and sell their long-term bonds, implying lower prices and therefore higher yields (as a bond’s price moves inversely to its yield). Additionally, higher central bank rates usually also imply that growth has recovered. This could lead to investors putting more money into growth assets, financed by divesting their long-term bonds (leading again to lower prices and higher yields).
Obviously, if this does not happen then long-term rates might remain at low levels despite a central bank ‘rate hike’.
The shackles of supply and demand
But even a successful central bank rate rise might offer little hope of deliverance. It is not inconceivable that demand for gilts remains high, implying high prices for longer-dated government bonds and therefore continually low bond rates.
First, the recent strong performance of equity markets has pushed up pension scheme funding levels significantly. Further improvements could mean that more and more of them hit de-risking triggers at which they will sell return-seeking assets and buy gilts (or similar instruments e.g. swaps). So, gilt rates may rise but only until de-risking triggers are hit.
Second – and this may sound surprising to UK pension schemes– gilts can actually offer relatively good value if you are an overseas investor. Bond rates are significantly lower in many parts of the developed world. French, Dutch and German government bonds offer significantly lower yields than UK gilts and have done so for most of the past year (and indeed before the 2008 financial crisis), as shown in the chart below.
The picture for longer dated government bonds with a maturity of 30 years is very similar.
I recently spoke to the manager of one large corporate pension scheme on the Continent who said that he was going to sell most of his French and German government bond holdings and invest in gilts instead because “they offer a lot more value”.
Consequently, demand for long-dated gilts – and therefore long-term UK interest rates – is also driven by monetary policy and investor expectations in other parts of the world. Financially, the UK is not an island. Especially in the Eurozone, monetary policy is expected to remain loose and demand for high-quality bonds is expected to remain high for quite some time to come due to, among other things, the overall lacklustre economic performance. This could drive Continental investors (and not just pension funds) towards buying UK gilts to earn some additional yield compared to their home-country government bonds.
In sum, there are market factors which could keep long-dated interest rates down for longer than you might expect. Pension schemes should therefore make sure that their interest rate exposure is the right size – so that the impact is bearable if rates fail to rise.