Record pension deficits could balloon by a further £30bn after interest rate cut
Today’s interest rate cut could see the deficits of beleaguered pension schemes rise by another £30bn according to experts.
"The Bank of England’s decision today is painful for pension schemes," said Charles Cowling of the JLT Employer Benefit Index, which announced record deficits earlier this week.
Read more: Pension deficit headache for British companies
Matt Saunders of Gocompare warned: “With enormous pension deficits of an estimated £900bn, this cut will impact both returns on existing pension incomes and future pension returns."
Pain
The negative sentiment was shared by Tom Selby of AJ Bell who added that the rate cut increases the chance of companies needing to provide cash top-ups to the schemes: “Today’s rate cut piles further pain onto scheme sponsors.
“A lower base rate will place further downward pressure on gilt yields, which have already plummeted in the wake of the Brexit vote."
Gilt – or British government bond – yields are the key reference point used by actuaries in calculating defined benefit pension schemes' liabilities – in other words, what they must pay to pensioners during their retirement.
Broadly speaking, the lower the yield, the higher the liability – so as gilt yields fall, liabilities increase thereby broadening the gap between them and the pool of assets that have been paid into the scheme by employees during their working life.
In the wake of the announcement by governor Mark Carney, gilt yields fell. Some of the interest rate cut was already factored into the yield pricing. But the decision confirmed what the market already anticipated and Cowling estimated that today's fall would lead to the record-level deficits widening by a further £30bn.
Annuity levels have steadily fallen as yields decline (Source: Hargreaves Lansdown)
Priced in?
However, it remains a matter of debate how much the interest rate cut was already priced into bond markets.
“For pension schemes, gilt yields have already baked in the broader, adverse impact on scheme funding following the referendum vote. The impact of today’s decision will likely be more muted on the liability side," said Alex Hutton-Mills of Lincoln Pensions.
JLT’s Cowling agreed: “With the latest survey of British business activity showing the sharpest fall in at least 20 years, markets had largely factored it into prices.
“However, we have now seen long-term interest rates fall markedly in the last few weeks, with 10 year government bond yields now well below one per cent. This has caused pension scheme deficits to soar from already record highs to levels which for some could be catastrophic."
Cash top-ups
Notwithstanding how much deficits are likely to rise, experts reiterated that companies and pension scheme trustees need to address the situation and find a way to plug the gap.
“Trustees should ensure they have a good understanding of the longer term impact of lower gilt yields,” said Hutton-Mills
Read more: Further evidence that pension deficits jump in July
“Pension schemes with actuarial valuations in 2016 will have to have some difficult negotiations with the sponsor as bigger pension deficits will inevitably lead to calls for a hike in employer contributions,” added Cowling.
Concerns were summed up by Sorca Kelly-Scholte of JP Morgan: “The Bank of England today delivered what may feel like the thousandth cut to beleaguered UK pension schemes, and no doubt we will see more headlines about ballooning deficits as a direct fallout.”