UK pension managers under strain
Crash in global bond yields is widening funding gaps even as BOE expands its bond-buying programme in an attempt to ward off a Brexit-induced slump
London
PENSIONS are looking like an economic time bomb for Britain, disrupting the plans of future retirees and today's investors as the nation tries to defuse it.
While deficits in defined-benefit retirement plans have ballooned to records, the task of covering future liabilities - which already exceed the UK's US$2.1 trillion of sovereign debt - is straining pension managers.
That is because the crash in global bond yields is widening funding gaps. In the UK, the situation is worsening as the Bank of England (BOE) expands its bond-buying programme in an attempt to ward off a Brexit-induced slump. Entering the gilt market has helped push long-dated yields to record lows this month, crimping pensions' future income.
"The current contradiction is that the BOE is driving down bond rates to support the economy," said Michael Wray, head of investment strategy at Kempen Fiduciary Management in London. "But the use of long-term gilt yields to value pension deficits means companies will, over time, be forced to put more money into their pension plans rather than using it to grow their business or pay dividends to shareholders. These contributions will not support the UK economy."
The sheer size of the task has begun to transfix fund managers. Pension-industry estimates of defined-benefit retirement liabilities run from about £1.5 trillion (S$2.7 trillion) to more than £2.3 trillion.
Consultants and investors are proposing measures to ease the strain - from issuing more gilts to adjusting how future liabilities are calculated. Changes to the supply of bonds, or to how they are used as a benchmark, may affect prices in the US$2.1 trillion gilt market.
The risk is that company-funded pensions may generate a vicious circle, whereby falling bond yields push up funding shortfalls, forcing managers to inject more cash into the plans. That is money which cannot be used to fuel business or staff expansions, so growth is blunted, boosting calls for even more monetary easing.
Without a fix, Britain's youngest workers may have to rely much more on their own savings for retirement - or keep working.
Some options that pension experts suggest might help include adjusting the discount rate. Pension funds invest to meet estimated future liabilities - to make monthly payments to retirees. To determine how much to stash away, managers discount their future cash flows. While there are few hard and fast rules on this, defined-benefit retirement plans tend to use liquid and low-risk assets as benchmarks. For many, long-dated gilts tick all the boxes.
With yields falling since the UK voted to leave the European Union in June, some managers suggest moving away from linkage with government bonds or changing how these liabilities are valued, especially if done in conjunction with other prudent measures.
Yields dropped an average of 0.8 percentage point on gilts due in 15 years and longer, according to a Bank of America Merrill Lynch index.
While plans use different discount rates depending on their circumstances, increasing the current level by setting a fixed rate of 4 per cent, for example, would decrease deficits by around £750 billion, from an estimated £1 trillion total, Kempen's Mr Wray estimated.
Mark Dowding, a partner and a money manager at BlueBay Asset Management in London, recommended setting a minimum rate for calculation equal to the BOE inflation target, currently at 2 per cent.
Setting a higher rate may backfire given that Britain may be in a low-yield environment for a long time, said Alan Baker, a partner and UK defined-benefit risk lead at the Mercer consulting firm in London. He suggested that pension managers and trustees look into other options such as linking plans to corporate bond yields instead.
"For some of the schemes we are advising, where they are heavily invested in corporate bonds, especially if they are using a buy and hold strategy, we think setting a discount rate that is linked to those bonds or credit spreads is a legitimate approach," Mr Baker said. "It is not a wide-spread approach, but we've seeing more schemes considering it. We should not make assumptions about future yields."
If low yields reflect how gilt demand outpacing supply, then why does the government not borrow more? That is how Patrick Bloomfield, a partner at consultancy Hymans Robertson, sees it. He said that the size of the gilt market, at about £1.6 trillion, should be more in line with pension liabilities, which he estimated at £2.4 trillion. "There is not enough money in the scheme and the type of discount rate used is neither here nor there. The issue at the moment is chronic illiquidity in gilts - an undersupply of gilts compared with the amount in demand," he said.
Daniela Russell, a portfolio construction associate in London at Legal & General Group plc, shared a similar view on supply. "And that may happen soon, with the UK government already implying that fiscal policy will be looser versus its 2016 forecasts," she said. "This is among ways to potentially ease the burden. The funding needs are likely to rise, and we are likely to see increased gilts sales in the coming years." BLOOMBERG
