Fixing Pension Shortfalls in U.K. Means Disruption for InvestorsBy
More gilt issuance, new calculation methods being debated
BOE’s role sparks speculation about vicious circle in yield
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 U.K.’s $2.1 trillion of sovereign debt, is straining pension managers.
That’s because the crash in global bond yields is widening funding gaps. In the U.K., the situation is worsening as the Bank of England expands its bond-buying program 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 U.K. 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 pounds ($2 trillion) to more than 2.3 trillion pounds. 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’re used as a benchmark, may affect prices in the $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’s money which can’t 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.
Here are some options that pension experts suggest might help.
1) Adjust 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 U.K. 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 percent, for example, would decrease deficits by around 750 billion pounds, from an estimated 1 trillion pounds total, Kempen’s 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 percent.
Setting a higher rate may backfire given Britain may be in a low-yield environment for a long time, said Alan Baker, a partner and U.K. defined-benefit risk lead at the Mercer consulting firm in London. He suggested 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,” 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.”
2) Issue more gilts.
If low yields reflect how gilt demand outpacing supply, then why doesn’t the government borrow more? That’s how Patrick Bloomfield, a partner at consultancy Hymans Robertson, sees it. He said the size of the gilt market, at about 1.6 trillion pounds, should be more in line with pension liabilities, which he estimated at 2.4 trillion pounds.
“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.”
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 U.K. government already implying that fiscal policy will be looser versus its 2016 forecasts,” said Russell. “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.”
3) Adopt a U.S. model.
The U.K.’s Pension Protection Fund was set up to compensate members of defined-benefit pensions should their employers go bankrupt. As deficits widened, the PPF may need to adopt facets of its American counterpart, the Pension Benefit Guaranty Corp., to address the issue, according to Jonathan Tyce, a London-based senior industry analyst at Bloomberg Intelligence.
These include the ability to claim up to 30 percent of a business’ net worth and to proactively engage early with troubled employers directly, Tyce said.
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