By Mark Gull
More than £180bn poured out of UK plc and into UK defined benefit (DB) pension schemes between the start of quantitative easing (QE) in early 2009 and March this year, as corporates struggled to close deficits, according to data from the Pension Protection Fund’s latest Purple Book. Yet the size of the hole the sponsors of pension schemes were trying to fill actually grew. In March 2009, there was an aggregate deficit of £571bn in the UK’s corporate DB pension schemes. In March this year this figure was in excess of £700bn.
But the recent positive economic news and the end of the QE programme has allowed yields to rise from their historic lows, and helped to close deficits somewhat. What’s more, many UK economic indicators are blinking green and the economy seems to be gaining some momentum. Most recently, the European Commission doubled its UK economic growth forecast for 2013/14. It believes that growth in the UK will be stronger than in Germany. Sponsors can actually dare to hope that there might be some respite at the next round of triennial valuations.
But if this is just demand-led recovery, with GDP boosted by asset buying on the back of cheap borrowing, and should estimates of spare capacity be over optimistic or productive investment fail to grow to meet this demand, there is a risk that higher inflation will follow. This would be damaging for pension schemes.
The vast majority of DB scheme liabilities are currently index-linked, and that proportion is set to rise over time. If inflation goes up real (inflation adjusted) yields are likely to fall and this will push liabilities higher and deficits wider.
UK pension schemes are vulnerable to unexpected increases in inflation because they are chronically under-hedged; index- linked gilts make up less than a fifth of the assets of DB pension schemes. So the outlook for scheme funding depends crucially on the prospects for inflation, on actions taken by the Bank of England, and how market rates respond to both.
A new report, “What next for UK pension funds: Yield normalisation, or Financial Repression?”, looks at three possible economic scenarios and how they would impact the funding positions of UK pension schemes. In the most optimistic scenario, where the recent pick-up in growth is maintained, and the presence of spare capacity in the UK economy keeps a lid on inflation, there is a ‘rapid normalisation’ of real yields. In this environment, the typical scheme could be fully funded within a few years.
In the second scenario, ‘supply pessimists’, there has been lasting damage to UK productive potential as spare capacity is limited. The recent pick-up in demand feeds through quickly to higher inflation. But in spite of the increase in inflation, the Bank of England doesn’t raise interest rates. Conventional yields begin to drift higher, but real yields only move slowly so the normalisation process takes longer, meaning that there will be additional, but not onerous, deficit reduction commitments in the order of £26bn.
In the most pessimistic scenario, the Bank of England takes action to offset the spillover effects of higher bond yields in the US. It may even undertake additional QE in an effort to stop UK yield rises, if it is concerned about the UK economy’s ability to cope with these and achieve its “escape velocity”. It could keep index-linked yields below zero to support the UK economy. This scenario, ‘financial repression’, can be seen as just more of the same as we have had for the past four years. Unfortunately for the sponsors of UK DB schemes, this would mean additional contributions of around £250bn over the next decade.
Mark Gull is co-head of asset and liability management, Pension Insurance Corporation
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