The UK’s defined benefit pension deficit could grow by hundreds of billions of pounds if the Bank of England opts to cut interest rates in response to Brexit, Hymans Robertson has warned.
The actuarial consultancy firm estimated post-Brexit the DB deficit stood at £900bn. Its head of corporate consulting, Jon Hatchett, told FTAdviser that a 25 basis point cut to interest rates, assuming it flowed on to bond yields, could push the deficit above £1trn.
“If the Bank of England initiated action that led to bond yields going down by 0.25 per cent, then that would cause UK pension liabilities to increase by 5 per cent, or £100bn.
“The market seems to expect such a scenario, with UK 10-year gilt yields having dropped to the lowest level in history, suggesting expectations of further cuts to interest rates and more quantitative easing,” he said.
Bank of England governor Mark Carney has said he was ready to pump £250bn into the economy and would “consider any additional policy responses” to Britain’s decision to leave the EU.
Minutes from this month’s Monetary Policy Committee meeting gave a strong hint interest rates - currently at a record low 0.5 per cent - would be cut at its August meeting.
Immediately after the referedum vote, the swaps market put the chances of a rate cut in July at 50 per cent, and 80 per cent by the end of the year. There was also a 15 per cent chance Britain would follow Japan and the Eurozone into negative interest rate territory.
Mr Hatchett stressed DB scheme liabilities are at the mercy of the long-dated bond market, but he pointed out that longer-dated bonds are less closely linked to the base rate.
“Whilst the Bank of England has a strong level of influence over short-dated rates, the long end is governed more by longer-term structural views and institutional demand and supply,” he said.
Even without a rate cut or quantitative easing, the uncertainty following the referendum had increased demand for fixed income, pushing up prices and consequently pushing down yields.
The impact of this on DB schemes was “by no means uniform” Mr Hatchett stated, noting much would depend on the hedging strategies individual schemes put in place before the vote.
“While liabilities will have increased across the board, those that fully hedged against interest rates and inflation would have seen their assets increase broadly by the same amount as their liabilities. At the other end of the spectrum, those who had no hedging in place against interest rate and inflation will have seen a hit to their funding levels.
“Whether they have hedged or not, schemes might still have suffered further if they were invested in equities and corporate bonds.”
A sharp fall in the pound meant schemes invested in overseas shares without currency hedging would have fared much better than those invested in sterling-denominated shares, he added.
However, Mark Dowsey, a senior consultant at Willis Towers Watson, said there may be a silver lining for DB schemes paying into the Pension Protection Fund levy.
Currently, if a scheme falls into the PPF, new retirees receive only 90 per cent of what they were promised. But speaking before the referendum, Mr Dowsey said the EU could rule against such a significant cut to retirement benefits.
“There is concern in some quarters that the Court of Justice of the EU might deem the levels of compensation inadequate. Any decision to increase compensation would likely lead to an increase in levies.
“Brexit would reduce this risk as UK legislation would no longer fall within the gambit of the CJEU,” he said.
james.fernyhough@ft.com
