In the post-Brexit period, I have listened to no fewer than three investment consultants advocating the immediate hedging of interest rate risk in our pension scheme “as the deficit is likely to blossom in the event of further quantitative easing”, which has now come to pass.
The scheme has total liabilities amounting to £3,476 million, the sum of the present best estimates of all future pension payments. The scheme has assets amounting to £2,087 million at current market values. These assets need to earn 3.77% p.a. to be sufficient to meet the pension liabilities
The present value of the liabilities is £2,610 million using a discount rate of 2.0% p.a. The scheme is 80% funded on this basis. Should discount rates decline to 1.0% p.a., the present value of liabilities would increase to £2,997million, and the reported funding ratio, with no change in asset values, would fall to 69.7%. According to these consultants, this should be cause for alarm and action.
Now, the portfolio of assets is already invested and produces a 4.02% income yield. As this is greater than the required yield (3.77%), the scheme is sufficiently well funded to meet its obligations on time and in full, notwithstanding the meaningless deficit reported (20%). In fact, the scheme will throw up a surplus of £367 million after pensions have been paid.
The important point here is that the discount rate applied to liabilities is immaterial; the rate of return required to meet liabilities is independent of that discount rate. This rate is determined fully by the projected pension payments and today’s asset values
There is a further dimension to this issue, that of cash flow sufficiency. Even though the income yield is higher than the required rate of return, this scheme has cash flow shortages over most of its life. This ranges from 15% of the required pension payments in the current year to 64% in 2043, with investment cash flows exceeding pension payable from 2055 onwards. The scheme will need to liquidate assets. This cash flow deficit is largest in 2026, at £73.5 million. The value of the fund and the relative importance of liquidations are shown in figure 1
Figure 1: Value of fund and liquidation requirements
By contrast, a scheme which is cash flow positive, through contributions or the income yield of assets, faces the prospect of lower total re
turns when the available investments are higher in price and power in yield. This is the well-known convexity effect in bond markets, where the interim reinvestment rates determine the achieved return, and are responsible for departures from the gross redemption yield.
Few schemes now face this latter situation; the majority are cash-flow negative. These schemes will actually gain from further rounds of quantitative easing to the extent that this succeeds in raising prices since they have a need to liquidate.
The reported deficits may increase but actions based upon these are misplaced; an act of self-harm.