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Impact of Bank of England decision on pension schemes

Nick Woodward, Head of Liability Driven Investments (LDI)

5 August 2016

Yesterday (4 August) saw the Monetary Policy Committee (MPC), having agreed unanimously,  cut official interest rates to a new record low of 0.25% from 0.50%, the first rate change since March 2009. In a bigger-than-expected package of measures designed to stave off a post-Brexit recession, the Bank of England (BoE) also:

- Extended the current quantitative easing (QE) program (government bond buy-back programme) by an additional £60bn over the next six months raising this to £435bn in total

- Introduced a corporate bond purchase programme to the sum of £10bn in the next 18 months; and

- Made available up to £100bn of new funding to banks to help them pass on cheaper borrowing costs.

Reacting to early economic indicators suggesting the economy had slowed since the June referendum, the Bank signalled further cuts were possible, dependent upon the economic fallout from Brexit becoming clearer. Although Carney said he was strongly opposed to negative interest rates, MPC minutes revealed that if economic news proved consistent with the Bank’s forecasts, the majority of the 9 MPC members expected to support a further interest rate cut, potentially taking official borrowing costs to as low as 0.10%. In a letter to Mark Carney, Philip Hammond, the Chancellor of the Exchequer, hinted that further action by the Treasury was expected in the Autumn Statement.

With interest rates falling more than 0.1% for maturities of 5 years and over following the announcement, the main losers appear to be both savers and pension schemes. Savers will be hit by continuing low rates for their bank balances and pension schemes will be impacted through their growing deficits. Movements on the announcement of the referendum saw combined UK deficits increase to an estimated £935bn (Hymans Roberston). Yesterday's fall of 0.1%, whilst increasing the value of the bond assets, would also increase the value of liabilities. Given that the majority of UK schemes are in deficit and relatively few are fully hedged against interest rate movements, this market fall would have increased deficits significantly. 

We estimate that taking a typical representative scheme as a proxy for the combined UK pensions market, deficits would have risen by over c.£50bn.

Whilst gilts and index-linked gilts are highly sought after in LDI programs given their matching characteristics to liability risks, the introduction of QE in 2009 is driving interest rates lower. QE was designed to kick start the economy by providing lower borrowing costs for companies and households.  However, the BoE and pension schemes, as two significant buyers of these bonds, have entered into a bidding war, thereby driving yields lower further or, at least, maintaining their historic lows. It appears the BoE has created a cyclical problem with no natural end, supporting the ever increasing deficits which in turn prompt more schemes to de-risk.

The irony is that whilst in June, ministers discussed the finances of BHS and the impact on the BHS pension schemes with Sir Philip Green, yesterday’s announcement has made the (pension) problem that much more significant. Frank Field made the comparison between Sir Philip and Robert Maxwell. If this is the case, who does Mark Carney compare to?

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.