The Bank of England (BoE) has hiked its policy rate by 50bps to 2.25%, prioritising the fight against inflation over support for growth in its domestic economy. This interest rate increase has hit levels not seen since the end of 2008 but in line with a majority of economists’ consensus.
This latest hike should push UK pension fund trustees to understand how such an environment could impact the ability of sponsoring employers funding their defined benefit (DB) schemes.
Rising long-term rates are generally good news for pension scheme funding levels – a 2.7% rise in long-term government bond yields since December 2021 has reduced the liabilities of UK DB schemes by £750bn (€840bn), according to XPS Pensions Group. But they will impact businesses differently depending on their debt structure and how exposed they are to interest rate fluctuations.
For schemes less than 100% hedged to interest rates, the wider rise in yields that is being seen in the market will be positive for funding levels. But the challenge that is almost overshadowing this improvement for many schemes is the balancing act required between managing risk and sticking to strategy, and maintaining hedging positions.
With asset allocations for some pension funds drifting 5-10% off benchmark, trustees are faced with the choice of running an unbalanced risk profile, selling illiquid assets at a lower-than-market value, or accepting interest rate and inflation risk will increase in their portfolios.
Any adverse impacts on covenant support available to a pension fund could have significant consequences for an employer’s ability to provide financial support to its scheme.
Trustees should aim to understand their sponsors’ financial position and structure, particularly in light of the Pensions Scheme Act 2021, as the Pensions Regulator expects trustees to have full visibility of changes to the security of their pension schemes.
Looking ahead, although the BoE has not yet joined the ‘75bp club’ – which includes the US Federal Reserve and the European Central Bank – the trajectory of UK monetary policy remains in line with the similarly tighter policy settings being put in place by most major central banks.
Venilia Amorim, Editor, IPE.com