The Bank of England's 'forward guidance' policy
BlackRock's John Dewey explores what the Bank of England's 'forward guidance' means for UK pension funds.
The aggregate deficit of more than 6,000 schemes in the UK fell to £115.7bn (€135bn) at the end of July, according to this week's figures from the Pension Protection Fund. A key driver of the fall has been the welcome increase in longer-term bond yields, while liabilities have not been fully hedged. This is a positive step, but pension scheme deficits remain at substantial levels.
For pension schemes in the UK, growth assets such as equities have been inflated due to the Bank of England's policy of buying government bonds and keeping interest-rate expectations low. While this seems like good news, falling real interest rates on unhedged liabilities have offset this move.
The Bank of England's 'Forward Guidance' has also changed the landscape for pension schemes in that interest rates will remain unchanged until unemployment falls to 7% or below from its current 7.8%. It also indicates inflation expectations of up to 2.5% will not warrant higher rates.
For pension schemes significantly under-hedged, the guidance weakens the case for delaying hedging programmes. The Bank of England has articulated its objective and methods to keep interest rates lower than what markets are pricing. Waiting to hedge interest rates or setting high trigger levels is only beneficial if interest rates rise faster than is already priced in the market. The announcement of forward guidance is designed to avoid this scenario – hence, there is less incentive for taking a concentrated bet on rising interest rates.
Schemes should also be aware that forward guidance is built on a premise that markets sometimes struggle to interpret monetary policy and may overreact. Pension schemes should ensure the necessary steps have been taken and infrastructure is in place to take advantage of such overreaction if and when it occurs. Unemployment statistics have taken on a more important role than ever before, and are notoriously difficult to predict and understand. In addition, if forward guidance is less effective than desired, additional stimulatory measures such as further QE could lead to lower interest rates. These factors may create further surprises.
If forward guidance is successful in keeping short-term interest rates lower for longer, it should continue to support equity performance in the short term. As such, unless schemes have a desire to reduce overall risk, the improving economic outlook and supportive conditions suggest interest-rate hedging should be done without reducing growth assets – for example, by using derivatives or by adjusting fixed income portfolios.
Increased inflation expectations can have a profound impact on pension funds' asset allocation. While the Bank of England remains vigilant against inflation running out of control, it is not just large inflation changes that are significant. Small but sustained increases in expectations are also of great relevance. For instance, schemes could be faced with cash-flow challenges as a result of having to pay out higher benefits to members.
Furthermore, the effective nature of large tranches of liabilities could change. Certain Limited Price Indexation (LPI) pension increases, such as LPI (0,2.5) or LPI (0,3) could effectively become considerably more akin to fixed liabilities in such a scenario, which would influence the desired real/fixed asset split in the asset portfolio. Schemes should consider the impact of this and identify investments that offer inflation protection.
John Dewey is managing director of client strategy at BlackRock