Three charts that show how the coronavirus has hurt pension schemes
20-year duration UK gilt yields collapsed to a new all-time low of 0.5% on 9 March 2020. If that wasn’t bad enough, the market is holding out little prospect of yields rising much, even over very long time horizons. The 20-year duration yield is priced to be only 0.7% in 10 years time.
This is extraordinary. Prior to Friday 6 March, the 20-year yield had never fallen below 0.7%. Now the market is saying that it will struggle to even get back to that level. Ever again.
Chart 1 - Nominal gilt yields have fallen to rock bottom levels...and are expected to remain there
Source: Bank of England, Refinitiv, Schroders. Data as at 9 March 2020
It’s a similar story for index-linked gilts. 20-year duration real yields have fallen to -2.4% and in 10 years are only priced to rise to -1.9%.
Chart 2: The price of the 2068 index-linked gilt has soared
Source: Refinitiv, Schroders. Price rebased to 100 on 30 December 2019. Data as at 10:30 on 9 March 2020.
For pension funds that are unhedged, this is a very painful trade to be on the wrong side of.
Chart 3: A toxic combination of rising liabilities and falling assets
Returns 31 December 2019-9 March 2020
Source: Refinitiv, Schroders. * Liability proxy based on 80/20 split of index-linked gilts and fixed interest gilts. ** Hedge fund data only available to 29 February 2019, so does not reflect March’s market declines
On the face of it, it is hard to imagine a worse situation. Not since the financial crisis has there been such a savage increase in the value of liabilities, while values of growth assets, such as equities, have plummeted.
What it all means
The main mitigating factor is that the average pension fund now holds a far higher percentage of bonds and hedging assets than in 2008. According to the Pension Protection Fund’s 2019 Purple Book, average bond allocations have risen from below 30% in 2007 to 63% in 2019. However, even allowing for this, asset returns are unlikely to be much above zero in aggregate and could easily be negative. In contrast, liability valuations could see increases of close to 15%. It is not hard to envisage some schemes seeing their funding levels fall by 10% or more.
Furthermore it could push the most vulnerable into serious difficulties. There is a strong relationship between the allocation to bonds and funding level. While those with funding levels over 100% have average allocations to bonds of close to 70%, those with funding levels of less than 50% hold closer to 20% in bonds. They also tend to have much higher allocations to equities (around 40%, on average). The last few months could put the viability of some into question.
What are the consequences?
Most pension funds are likely to be in a far worse situation than contemplated a matter of weeks ago. Unless things improve dramatically, there are going to be some very difficult funding discussions in the coming months. Demands could increase for sponsors to pay in additional contributions. This could come at a time when sponsors are already under severe stress as a result of the coronavirus-induced economic slowdown. Dividends to shareholders could become vulnerable.
Those pension funds that have hedged their interest rate exposure will be incredibly grateful that they did so, but probably still wish they had done even more. For those who have not, there is no easy decision. Buying bonds when yields are at all-time lows is a bitter pill to swallow, especially if decisions were taken in the past to wait for yields to rise before buying. However, recent experience shows the danger of betting everything on yields rising.
The past decade is littered with failed predictions of this taking place.
Ask yourself a question – has there ever been a time when you thought bonds were attractively valued? If not, are you so sure there will be in future? There is nothing wrong with being positioned to benefit from yields rising. However, the logic is more questionable if that one view swamps all others.
So what is likely to happen to investment strategies? You might think that a downward shock to yields - as we have just experienced - would make bonds less appealing. However, recent analysis from the Bank of England shows that the reality is more complex. Most pension schemes are likely to have suffered a deterioration in their funding position during 2020. The less comfortable you are being exposed to the risk that you need to ask the sponsor to write a larger cheque (to help make up the larger shortfall), the more risk averse you're likely to become.
Hence, the Bank of England’s analysis found that there is an increased incentive to de-risk. Although you'd expect lower interest rates (more expensive bonds) to make bonds more unattractive to defined benefit pension funds, the opposite is true. They can become even more in demand. The weaker the sponsor covenant (the strength of the employer or other sponsor backing the pension scheme) and/or the larger the deficit, the more likely this is to happen.
Anyone expecting a big rotation out of bonds and into the stock market is sadly mistaken. A risk that cannot be ignored is that renewed pension fund buying adds even more downward pressure on yields. Like the pot at the end of a rainbow, anyone betting on yields rising significantly before thinking about hedging may find that elusive goal remains always just out of reach.
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