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Bank of England delivers a further poisoned chalice to UK pensions

Nick Woodward, Head of Liability Driven Investments (LDI)

12 August 2016

In a not so surprising move, the Pension Protection Fund, the government mandated pension scheme lifeboat fund, published record UK deficit levels on the back of Brexit. However, the findings of August’s inflation report were much more surprising. The report acknowledged the negative impact of low yields on pension scheme deficits and that driving much of the deficit widening of late has been the fall in yields. However, the report concluded that even though lower yields pose potential risks to pension schemes, the effects appear to be relatively limited! The report infers that the requirement of financial stimulus for economic growth, as provided by low yields, far outweighs the funding need of UK pension schemes.

The report’s primary argument for this is that by pushing yields lower through the extended Quantitative Easing (QE) programme, pension schemes will be able to bank significant gains made on their gilt (fixed and index-linked) investments. By selling these gilts, schemes would be able invest the proceeds in ways to stimulate growth that benefit the wider economy. This argument, however, neglects the reasons why schemes hold these assets in the first place.

As schemes have increasingly become aware of the unrewarded interest rate and inflation risks embedded in scheme liabilities, many Trustees have considered some form of LDI strategy using long dated government bonds as a key hedging instrument. The key aim with LDI is to hold assets which move in line with liability movements. Whilst it may appear good news that these hedging assets have increased in value to historic highs (yields fallen to historic lows), this increase in value offsets (although not completely unless the scheme is fully hedged) a corresponding increase in the value of a scheme’s liabilities. Furthermore, assessing the available returns in other asset classes, schemes may be forgiven in choosing to retain their holding of these bonds. 

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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.