State Street Global Advisors' Ben Clissold looks at the potential impact of 'Operation Twist' on UK defined benefit schemes.
After a prolonged period of central banks holding short-dated interest rates at record lows and a couple of rounds of quantitative easing (QE), the US Federal Reserve has decided to move on to 'Operation Twist'. The basic premise is to reduce long-dated bond yields by buying $400bn (€296bn) of long-dated Treasuries (maturities 6-30 years) and selling $400bn of short-dated Treasuries (three years or less). The market effect has been dramatic in the US, with long-dated bond yields - and hence swap yields - tumbling from more than 4% at the start of July to 2.75% in late September. UK investors have also felt the affect, as long-dated bond yields followed the US lead and fell by 0.75% over the period.
Because long-dated gilt yields are used to value pension scheme liabilities, a move of this size for an average UK pension scheme will have had a dramatic affect on funding levels. As a rough guide, an average UK define benefit pension scheme has a 20-year duration to its liabilities. As a consequence, a 0.75% move in interest rates entails a 15% increase in liabilities and hence a reduction in funding level.
This change in funding level will hopefully have been partially offset by pension scheme bond holdings or swaps used for liability-driven investment. Also a reduction of 0.3% in long-dated inflation expectations will also have helped. At an overall scheme level, without taking into account losses on equity holdings, an average pension scheme's funding level may have deteriorated 5-10% depending on asset allocation and how sensitive its liabilities are to inflation.
The minutes from the latest Bank of England MPC meeting show that further forms of economic stimulus were discussed, with quantitative easing still being seen as the best solution if necessary. Although the vote was still 8-1 against further QE, if at some point in the future additional QE was needed, some members of the MPC would potentially be in favour of a US-style 'twist' to further lower long-dated bond yields. The knock-on effect to pension schemes would be a further worsening of their funding positions and more worries for members about their pensions.
Ben Clissold is senior LDI portfolio manager at State Street Global Advisors' Multi-Asset Class Solutions Group