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Higher government bond yields: good news for DB pension sponsors at last?

Higher government bond yields: good news for DB pension sponsors at last?

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When I started out in the pensions industry, one of my first jobs was to keep track of government bond or ‘gilt’ yields. These yields were of particular interest to trustees and sponsors of defined benefit pension schemes, as they had a material impact on the funding position of their schemes.

This is because the financial strength of the UK government means that gilt yields are seen as a proxy for the expected return of a ‘risk-free’ asset, which most scheme actuaries use to determine how much money needs to be set aside to fund their pension schemes (the ‘liabilities’). If gilt yields go up, then the liabilities go down, and – more commonly – vice versa.

At that time when I started my pensions career, most schemes were fully exposed to movements in yields (this was before widespread ‘interest rate hedging’). It was also before ‘funding trackers’ were common, so a change in gilt yields was usually significant and unexpected news.

When we did contact clients with a liability estimate, it tended to be bad news. Back in 2008, a 20-year gilt yield was around 4.5% p.a.. Despite a chorus of advisers preaching over many years that these would eventually ‘revert to a higher long-term mean,’ they fell steadily, reaching a low of around 0.7% p.a. towards the end of 2020, before settling at around 1% p.a..

In isolation, falls of this size could double the liabilities of a typical pension scheme. Sponsors have borne the brunt of this, needing to pay higher and higher contributions over the years, just to keep their pension scheme funded. Many have seen funding positions deteriorate, in spite of substantial contributions being paid.

In the context of these prolonged falls, I had to make doubly sure that I believed the market data from the start of this year. Government bond yields have risen consistently over 2022, with the 20-year gilt yield rising from 1% p.a. at the start of December 2021 to 2.1% p.a. today, generally following the increases in the Bank of England base rate. In isolation, that could represent a 24% liability reduction for a typical scheme.

So, is this now finally cause for celebration? Well, that depends. Since 2008, many pension schemes have hedged away a substantial proportion of their interest rate risk, such that changes in interest rate are less of a concern. This is great for reducing downside risk, but also means that schemes do not benefit from the upside. In addition, some of this improvement may have been offset by high inflation levels and volatile equity investments.

Nonetheless, most schemes retain exposure to at least some interest rate risk and in general, funding levels are expected to have improved significantly since the start of the year. It is therefore vital that sponsors and trustees obtain an updated funding position and continue to monitor it regularly, as improved funding positions can present a unique opportunity to reduce costs in future. In some cases, assets can be de-risked to ‘lock in’ favourable positions. Those schemes who are targeting long term buyout will find they are even closer now than previously anticipated, particularly as widening credit spreads will improve insurer pricing.

So perhaps finally, some good news for pension scheme sponsors… with a caveat. With a more prudent funding regime on the way, any funding benefits may only be realised by those schemes who act quickly! It is essential that sponsors consider their end game and their journey towards it, and engage early with trustees to ensure that the improvements in the funding position can be locked in to avoid future increases in funding contributions.