How should DB schemes react after interest rate rise?

The Bank of England’s Monetary Policy Committee, headed up by Mark Carney, raised rates for the first time in over a decade earlier this month, reversing what was widely seen as an emergency cut in 2016.

The move, which raised the base rate to 0.5%, has pushed up mortgage rates but had little impact on bond yields, with a muted reaction so far from investors in fixed income, likely because it was so well flagged in advance.

In the world of defined benefit (DB) pension schemes, the rate rise has been seen as broadly positive. “The rate rise will be welcomed by many pension schemes, and we hope it will not have to be reversed in early course,” David Weeks, co-Chair of the Association of Member Nominated Trustees (AMNT) said following the move by the Bank’s Monetary Policy Committee.

Hargreaves Lansdown’s Senior Pension Analyst Nathan Long added gilt yields had already provided a boost to schemes throughout the year: “As gilt yields have risen of late (prior to the base rate hike), the cost for schemes of buying guaranteed income has reduced and so too have the assumed liabilities. The latest data from the Pension Protection Fund showed that by September the aggregate funding position of these schemes was 90.6%, compared to only 79.8% a year earlier.”

But caution – and hedging liabilities where possible – should remain the watchwords for schemes, according to experts. Barbara Saunders, Managing Director, Solutions, at P-Solve says a single rate rise – even if followed by a few more – will fall short of providing a longer-term solution for DB schemes.

She notes gilt yields have already risen substantially off their lows in August 2016, and are unlikely to keep climbing with so many factors at play in the UK. “We don’t see gilt yields getting much higher and in fact, the guidance from the MPC of only two more rate hikes over the next three years disappointed the market, with yields actually falling since the base rate rise.

“Ultimately this rise is fairly insignificant as it only reverses the 0.25% rate cut that occurred after Brexit. Monetary policy is still very loose and we expect it to stay that way for a while given the uncertainty of Brexit looming.”

The remaining unknown is around sterling weakness, with the Bank potentially forced to shore up the pound at some stage via further rate hikes if Brexit hammers the currency.

However, putting that aside in the near term, Saunders said the key is to take the risk of a potential decline in yields (in the event of a Brexit-induced recession, for example, or a risk-off spell for the market) off the table and let other assets do the heavy lifting.

“Pension schemes can match liabilities using LDI and still earn return with their other assets. We would still advocate hedging at these levels as when equity markets turn, gilt yields could fall again as they are seen as a safe haven,” she said.

“Hedging now removes a risk that is unrewarded and hard to predict, and allows schemes to focus on taking risk where rewards are expected e.g. in equities and alternative asset classes.”