It is the most anticipated and heralded Central Bank decision in a generation. By the second week of November, the markets were pricing in a 66 per cent chance that the Federal Reserve would raise US base rates by a massive 0.25 per cent in December. This might seem trivial, but it is set to be the first rise since December 2008. A small rise, but after a long seven-year hiatus, it would be a highly significant event.
The probabilities started rising during November when a slew of better-than-expected economic data – along with unusually direct comments from senior figures at the Fed – seemed to be paving the way for the climatic moment. The rise was originally anticipated in September but the Fed backed off after the Chinese-led equity market crash at the end of August.
In the stars
Since then, markets have recovered, leading many commentators to conclude that the stars were at last aligning for the Fed. Importantly, 2016 is an election year in the US. On the few occasions when the Bank has raised rates in an election year the incumbent president has fared rather badly. Understandably, the pressure will be on from the White House to avoid any drama. December could be the Fed’s last chance to get the rate rise in for a whole year.
Why does any of this matter to UK retirement planners or their clients? There is an old saying in the bond markets that if a trader was offered one of two pieces of information to help predict future UK government bond prices – either future UK economic data or future US bond prices, the latter would win every time. Almost irrespective of what happens to the UK economy and inflation levels, or what the UK’s own central bank plans to do with base rates, UK government bonds (gilts) will be driven by their opposite numbers across the Atlantic. That means if US market rates rise, it is likely the UK’s will follow.
The gilt market is important for a number of reasons. Yields on gilts matter because they determine the Gad rates (Government Actuary’s Department) which in turn determine how much income a client could take in capped drawdown. Once upon a time (ie before April last year) this affected the vast majority of drawdown clients. Many clients have now moved over to the new flexible regime, short-circuiting the Gad limits. But many have remained in the old regime for tax and other reasons – and so Gad still applies to them. Gilt yields also set the prices for annuities.
A lower gilt yield means lower income (and a worse deal) on new annuity purchases. Again, under the new rules, sales of individual annuities have fallen, making this less significant. However, a third role that gilts play, which is now more important than ever before, is in setting transfer values for members leaving defined benefit (DB) occupational pension schemes.
Once in a blue moon
Once upon a time (before April last year) DB transfers were rarer than a smile on George Osborne’s baby-like face. These days transfer specialists are inundated with requests and DB schemes across the country are processing regular transfers as members are keen to access higher tax-free lump sums, better inheritance options and more control over their savings.
The key to these transfers is the transfer value itself. And the main determinant of the transfer value is gilt yields. Almost all DB pensions schemes calculate transfer values so that they are lower than the reserve amount the scheme expects the benefits to cost. They do this by using less prudent assumptions than they have used in regulatory scheme valuations. But they also, typically, use a reasonably up-to-date figure for gilt yields. The lower the number the higher the transfer value.
On some occasions this year transfer values have actually been higher than the scheme’s reserve amounts because yields had fallen so far below the level at the last valuation date for the scheme.
As Chart 1 shows, yields on 20-year gilts (which is the benchmark used by annuity providers and DB pension schemes alike) are much lower today than they were two years ago: 1 per cent lower, which means a rise in the cost (or transfer value) of a pension by about 20 per cent.
Change in trend
In November, however, that trend started to change. And what started it was movements in US Treasuries which had a knock-on effect on UK gilts. Chart 2 shows how 20-year UK gilt yields rose from 2.35 per cent at the beginning of October to 2.6 per cent at the beginning of November; a 25 basis point rise which would have caused transfer values to fall by about 5 per cent. It only takes a small change in yields to cause a large change in value, as Chart 3 illustrates.
What happens to gilt yields over the coming weeks or months is anyone’s guess. The chances are that if the Fed does raise rates in December, yields in the UK will rise and prices will fall. That will cause transfer values to fall. This could prove to be a temporary knee-jerk reaction. But it could also prompt the start of the gradual rise in long-term interest rates which many commentators have been predicting for years.
Transfer quotes last for three months, but members can normally only make one request a year. So it would be well worth an advisers’ time to find out how the transfer is calculated – in particular when the assumptions were last set.
If they are reviewed infrequently, and that last point was a relatively good day (gilt yields were lower than the current level), the adviser and client might consider this a relatively good opportunity. Of course for advisers trying to time annuity purchases the exact opposite is true. If gilt yields rise, their clients will benefit from higher levels of income.
Predicting the future is a near-impossible task when it comes to gilts. But if a scheme is using 12-month-old gilt yields to determine transfer values – and yields are now much higher than they were a year ago – clients may agree to seize the opportunity rather than wait. Carpe diem.
Bob Campion is head of institutional business at Charles Stanley Pan Asset Capital Management
