UK’s defined benefit (DB) pension schemes are at their healthiest since before the start of the COVID-19 pandemic, as of Q3 2021, according to Legal & General Investment Management (LGIM).

The firm’s DB Health Tracker – a monitor of the current health of UK DB pension schemes – found that the average DB scheme can expect to fund 98.3% of accrued pension benefits as of 30 September 2021.

According to the tracker, that is a rise of 0.1 percentage points from the figure of 98.2% recorded three months before on 30 June 2021.

DB pension schemes’ health had been gradually improving since March 2020, when it had dropped as low as 91.4% as a result of the immediate impact of the pandemic on financial markets, LGIM stated.

However, while these figures suggest that the health of UK DB schemes has been improving since the initial spread of COVID-19, LGIM said these figures may yet still understate the negative impact of the pandemic, “due to weakening covenants from pension scheme sponsors, which many schemes have endured”.

John Southall, head of solutions research at LGIM, said: “Inflation expectations rose to their highest levels since 2008 with the bond markets implying a substantial risk that the rise in inflation may be more than transitory.”

He said that this has made it more challenging for DB schemes to meet their unhedged inflation-linked liabilities.

However, he noted, a relatively modest – but still substantial – rise in nominal interest rates, combined with respectable growth asset performance, meant that overall LGIM’s Expected Proportion of Benefits Met (EPBM) measure still managed to post a small gain.

Christopher Jeffery, head of rates and inflation strategy at LGIM, said that yields on short-maturity government debt around have risen sharply globally since the end of the second quarter, as markets prepared for the turn in the monetary policy cycle.

“That same dynamic has played out in the UK with increasing focus on when, not and if, the Bank of England raises interest rates. However, long maturity bond yields have confounded widespread expectations of a material sell-off,” he said.

At the end of the third quarter, 30-year gilt yields were only marginally higher than in Q2 and that was before the sharp falls in recent weeks triggered by the reduction in government bond supply and the Bank of England’s “wait and see” decision in November, he said.

He added: “Yet again, the rumours of the death of the gilt market have been greatly exaggerated.”

Pay more attention to inflation

Additionally, Consultancy LCP is calling for UK DB schemes to pay more attention to optimising their strategy for hedging against inflation as inflation rates become more volatile.

According to new analysis from LCP, included in the firm’s latest corporate report, for some schemes inflation hedging may be incomplete, leading to unexpected bills when inflation rises.

But LCP also pointed out that schemes that have taken inflation risk seriously in the past could now find themselves over-hedged and could also look to make adjustments.

In terms of schemes being under-hedged, LCP analysis showed that the impact of surging inflation has already added around £15bn (€17.5bn) to UK DB pension costs. And a further £35bn could be added to pension costs if the rise in inflation proves to be more than a temporary phenomenon, the firm stated.

Phil Cuddeford, lead author of the report and partner at LCP, said: “The resurgence of inflation could lead to big bills for many companies, especially where their pension scheme had not taken steps to protect against rising inflation.

“Even if you think you have the right protections in place things can change quickly in either direction – up or down.”

He said that reviewing hedging strategies is a must and this could also free up risk budgets to invest in more return-seeking assets such as equities, private credit and property.

LCP highlighted that even schemes that believe are fully hedged could still be vulnerable to an upswing in inflation. This is because it is common in DB schemes for this to mean hedging 100% of funded liabilities but not the deficit.

This would mean, LCP said, that a scheme that is 85% funded and 100% hedged on assets could see their recovery plan contributions increase by around 20% or more if inflation rises by 1%.

On the other hand, for schemes that were previously completely hedged against inflation, the inflation hedge ratio may have drifted upwards to 110-120% because of higher inflation and caps on inflation-linked pension increases.

Schemes in this position should consider rebalancing their hedging approach and selling some inflation-linked assets, the consultancy noted.

LCP is urging schemes to review their hedging strategy to avoid the risks of under or over hedging against inflation.

Deeper analysis by LCP on the impact of inflation is featured in this blog.

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