While many in the flnancial market welcomed the Bank of England’s relaunch of quantitative easing - or QE2 - committing a further £75bn (€86bn)to its asset repurchase facility, the timing of the announcement took everyone by surprise - including those in the pension industry, who immediately called for an “urgent” meeting with the regulator.
While the sustained acquisition of Gilts to introduce liquidity into the market is, in itself, not negative, the resulting falling yields on UK debt raises concerns for the country’s pension funds, most notably increasing already-rising liabilities following two months of market instability, triggered by renewed sovereign debt fears and concerns over the level of funding in European banks.
The Bank of England seemingly again neglected to consider the impact of its programme on a sector already suffering severely from the European sovereign debt crisis and declining stock markets. Consultancy Hymans Robertson says that a further 25 basis point drop in yields would increase pension liabilities of the FTSE 350 companies by £25bn.
Other commentators indicate that falling yields will wipe off any gains made by pension funds in the past two years. They are urging funds to lock into interest rate hedges at a time when the real yield has fallen so low that they are, in fact, negative. They argue that it is better to lock in at the current rate than wait for it to fall further.
At the end of September funding ratios had already dived to an all-year low. The Pension Protection Fund estimated a deficit of nearly £197bn in its monthly index, a 40% increase over the previous month. Funding across all schemes fell by six percentage points to 83%.
In all this, it is worth noting that assets had not drastically decreased over August, dropping by only £10bn, while liabilities had risen by £68bn month-on-month. The crucial figures will only become clear over the coming months, once the effects of the buyback have depressed gilt yields and likely driven up deficits further.
Fallout from QE2 will manifest itself in several ways, from the need to increase deficit reduction payments to a potential reassessment of investment strategies.
Companies already forced to commit to high recovery payments for their underfunded occupational schemes will see these increase as the gap widens, while pension fund managers will have to consider alternative ways of hedging against inflation if the already limited Gilt market shrinks further through the buyback.
Speaking to IPE, Aon Hewitt’s global head of asset allocation Colin Robertson suggested that despite falls in rental yield across the market, property would be an attractive alternative to the dwindling supply of fixed income, especially as many leases stipulated a rise with inflation.
However, he urged against exposure to the debt of core European countries, noting that especially German Bund yields would suffer from the country’s need to underwrite an expanded European Financial Stability Fund. This, combined with increased issuance of bonds, would likely trigger a fall in yields to a similarly undesirable level.
Among other proposals is increased exposure to infrastructure bonds. However, the market is still not sizeable in the UK and the Green Investment Bank has yet to launch.
A further asset class worth considering - housing associations - shares an attribute with infrastructure in that it is debatable whether to consider it fixed income or property .
Some companies, most notably consultancy Redington and fund manager M&G and Aviva, have been extolling the virtues of investment in social housing and housing associations for some time and in light of further austerity measures by the UK government, the affordable and social housing shortfall is expected to grow. The Scottish devolved government has also been looking to attract schemes into the market but with little visible success so far.
Pension funds have had the option to seek exposure to such asset classes for a number of years and it remains to be seen whether QE2 will encourage new investments where there was previously hesitation.
Regardless of outcome, it seems that pension funds have - despite their size, importance to the UK economy and its employees - have, once again, been overlooked and are likely to suffer a further blow after three years of upset.