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IPE special report May 2018

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Rosy economic forecast has 'hidden sting in tail' for UK DB schemes

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Official forecasts for the UK economy suggest the country’s defined benefit (DB) pensions sector will be fully funded by the end of the decade.

But the same forecasts imply a £500bn (€634bn) cumulative shortfall in the supply of index-linked Gilts over the next decade, leaving pension schemes with a huge headache over how to lock-in those funding gains or pass the liabilities on to a specialist insurer.

The findings, presented in a report issued in partnership with buyout specialist Pensions Insurance Corporation, assume UK growth averages at 2.25%, inflation stays close to the Bank of England’s target of 2% and the UK achieves a primary budget surplus of 3% of GDP by fiscal year 2018-19 – as detailed in the Office of Budget Responsibility’s (OBR) 2014 Fiscal Sustainability Report.

Updated forecasts published in the chancellor of the Exchequer’s Autumn Statement on 3 December broadly agree with these assumptions, only pushing the return to primary surplus back by one year.

Feeding these assumptions into its Long-Horizon Asset Allocation model, Fathom forecasts that nominal Gilt yields would hit 4% by the end of this decade and 5% shortly thereafter.

The precipitous fall in the value of UK DB liabilities from their current total of around £1.5trn implies that the universe in aggregate would reach fully funded status before the end of the decade – with 50% at buyout funding level just two or three years later, according to economic consultancy Fathom.

Even by 2050, the forecast would be for no more than 5% of schemes to end up supported by the Pension Protection Fund (PPF).

At the launch of the research in London, Fathom’s chief economist Andrew Brigden said: “These forecasts imply that pension funds become fully funded very quickly, which will mean they will want to lock that in with purchases of index-linked Gilts. But the government, back into budget surplus, will be buying debt, not issuing more.”

Given the OBR forecasts, and assuming the UK Debt Management Office maintains index-linked issuance at its current share of 25% of the UK’s debt, Fathom calculates that the market value of all Gilts will begin to fall well within two years.

Factoring in demand from full-funded DB pension schemes, it further calculates that there will be a £500bn shortfall in index-linked Gilts over the next 10 years – a figure larger than the current value of outstanding issuance.

Danny Gabay, a director at Fathom, said: “If the OBR is right, pension funds will be in a lot of trouble, even though its forecasts look, on the face of it, to be great news for scheme funding levels.

“It struck us as such an incredibly rosy scenario and that there must be a catch. Well, this is the catch.”

David Collinson, head of strategy at Pension Insurance Corporation (PIC), added that this shortfall would also act as a limiting factor on the capacity that buyout specialists can offer the DB sector, as they will be unable to hedge the liabilities they assume and will face prohibitively high capital charges to hold alternative inflation-sensitive cash-flow assets – the supply of which would only make a small dent in the overall shortfall, in any case.

Launching the report, Fathom and PIC suggested there were only four options to deal with this problem.

Pension schemes could decide not to hedge liabilities and opt to take on inflation risk; the government could decide to issue more index-linked debt; pension schemes and buyout specialists could persuade members to exchange their inflation-linked pensions for higher but fixed-rate pensions; or the industry could dismiss the OBR forecasts as over-optimistic and instead model an environment in which bond yields remain lower.

But of course, the implications of the fourth option are arguably even worse than the Gilt shortfall implied by the official forecasts.

Fathom calculates that, if yields return only to 3% over the long term, 20% of UK DB schemes would end up going to the PPF, rather than the 5% currently assumed.

“You don’t have to believe in secular stagnation,” Gabay said, “to believe the PPF will have a much bigger role to play than currently implied in either the OBR or the PPF’s own forecasts.”

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