UK consultants and asset managers have warned the pensions industry this morning to be on alert following last Friday’s replacement of Kwasi Kwarteng as chancellor of the exchequer with Jeremy Hunt, as the later this morning announced an almost complete u-turn on Kwarteng’s Growth Plan 2022, dubbed ’mini budget’.
The sudden and unprecedented rise in Gilt yields of three weeks ago, caused by the UK government’s massive fiscal stimulus announcement, tested the risk management strategies of UK defined benefit (DB) schemes.
However, the immediate impact of Hunt’s statement this morning has been to calm the Gilt market. The markets did anticipate a reversal of the mini budget but what the chancellor has announced was at the upper end of expectations.
“Today’s update from the chancellor should, to some extent, improve the market’s view as to credibility of the government’s fiscal plans, but political instability is not a favourable backdrop and Gilt market volatility may remain high,” said Chris Arcari, head of capital market at Hymans Robertson.
“We have seen 30-year yields down over 40bps and sterling up close to 1% versus dollar, although given the ever-changing market conditions we are cautious about the longer term comfort today’s statement will bring,” he continued.
The rolling back of unfunded tax cuts to stimulate an economy with already high inflation may take a degree of pressure off the Bank of England (BoE), but inflation at a headline and core level remain at extremely elevated levels, and labour markets are tight, he explained.
“Indeed, a scaling back of the energy support package may mean headline inflation rises more than recent forecasts suggest. As a result we still expect a series of large interest rate rises from the Bank of England in November and December, though this is at least fully priced in to the front of the gilt market already,” Arcari said.
“As we have previously said yields have risen, following global moves, to reflect fundamental developments in the wake of the pandemic and Russia’s invasion of Ukraine, but they have also faced upwards pressure from strong technical headwinds,” he said, adding that the chancellor’s announcements this morning should reduce some of this pressure, however, the near-term technical picture is not a positive one.
Even in its reduced form, the UK’s energy support package will require a large increase in Gilt issuance; the BoE are set to begin active gilt sales at the end of October; and, the de-leveraging of UK DB pension scheme’s interest-rate and inflation hedging programmes will weigh on gilt demand – even if yields stop rising, or fall, schemes are still in the process of de-leveraging as they, and their liability-driven investment (LDI) managers, adopt more prudent targets, Arcari said.
Adam Gillespie, investment partner at XPS Pensions Group, believes that the latest mini budget u-turn will hopefully end the “recent misadventure” in sterling bond markets, but he said the events of the last three weeks “have cast a long shadow over the pensions industry”.
“Initial market reaction to the latest announcement seems favourable overall, although it needs to be taken in context of the intra-day movements on Friday,” he said.
Whilst the pensions industry hopes this is an end to the large daily surges and market pull backs, Gillespie said the experience of the last three weeks will have had a detrimental impact on schemes in two ways:
- With the marked rise and fall of yields, any lost hedging could have led to a cost for affected schemes. Based on a round trip rise and fall in yields of 0.5%, every 10% reduction in hedging at the peak would result in a typical pension scheme’s funding level falling by 1%. Some schemes would have had their hedging reduced by more than 40%, meaning a 4% hit to their funding level based on the up and down movements witnessed over two trading days.
- Hedging is now more capital intensive. Since schemes typically first decide their return requirements before then considering how much they can hedge, the inescapable conclusion is that there will be lower hedging levels across the industry. This means schemes and companies being more exposed to uncertainty around funding pension deficits in the future than previously seen.
Gillespie added that It is important to position these movements against a backdrop of a 20% improvement in the very long-term funding of an average scheme, since the start of the year.
“What does this mean for pension schemes? It short, it gives them breathing space and more time. The immediate impact is to reduce the pressure to source further liquidity to meet collateral obligations,” said Bethany Payne, portfolio manager, global bonds, at Janus Henderson Investors.
“However, the sharp rise in gilt yields will have resulted in an improved funding position and a reduction in the expected time horizon to achieve the schemes’ long-term objective. This means trustees and their advisors will need to revisit their scheme’s asset allocations. The positive reaction to the chancellor’s statement means trustees now have more time to complete this exercise over the coming weeks,” she noted.
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