The Fed is raising rates but the Bank of England is waiting. Rate hikes are not worrying DB managers but they’re a considerably bigger deal for DC savers, says Michelle McGagh
The first US rate rise in a decade may have left pension funds unfazed but experts are looking ahead to the third and fourth rounds of increases that will drive investment and liability changes.
On 16 December the Federal Reserve announced the first interest rate rise since 2006, increasing it from zero to 0.25 per cent. The move was welcomed by markets although it was not unexpected as a tightening of monetary policy in the US had been heavily signposted.
Where North America leads, the UK usually follows with a three- to six-month lag. However, a delay of at least 12 months is expected before a rise is seen here as the UK economy slows. Bank of England governor Mark Carney has made clear that a rate rise in the UK is unlikely this year.
While US rates do not have a direct impact on UK pensions funds, there is a correlation between UK and US rates and consequently UK interest rates and gilt yields. Defined benefit pension schemes are directly affected by long-term gilt yields but Punter Southall principal Adam Gillespie says gilt yields are “not the same thing as [UK] base rates and US rates, although there is a correlation”.
He continues: “What we have seen over the past 10 years is real pain for DB schemes because of falling gilt yields. Most people will be thinking that the Fed raising rates is good news but it does not mean liabilities will fall,” he says.
“What has happened to gilt yields since the Fed’s announcement? The answer is not a lot.”
Unexpected events
With markets already pricing in interest rate rises at some point in the not-so-near future, DB pension liabilities are not greatly affected by a 25 basis point increase and Gillespie says liabilities are impacted only when markets do something unexpected.
“Liabilities do not necessarily go up because bond yields fall. And liabilities do not necessarily fall because yields go up,” he says.
“US and UK markets are pricing in rises in bond yield and the yield only changes if there is a surprise – either good or bad. If what happens in the market is different from what has been priced in, then gilts change.
“The bond market is pricing in yields to rise and a pension scheme only gets good news if bond yields rise at a faster rate or land at a higher rate than expected.”
Just a 1 per cent shift in gilt yields has a major impact on DB liabilities; 20-year gilt yields have fallen from 3.5 per cent to 2.5 per cent in just two years, equalling “as much as a 20 per cent increase in liabilities”, says Gillespie.
The lag in impact of US rate rises means DB pension funds should sit tight for now.
“The investment advice for DB schemes is the same as five years ago: dynamic asset allocation and diversification of growth assets, protect against liability risk of falling interest rates and inflation with increased liability hedging,” says Gillespie.
However, investors should be prepared for gilt yields to increase further down the line when the impact of later Fed rate rises feeds through to the UK.
“What might drive rate rises in the UK is not the first or even second Fed rate rise but the third or fourth, which may happen before the end of the year,” says Gillespie.
Even with ongoing rate rises in the US, both DB and defined contribution funds should acknowledge the abnormal interest rate cycle the UK is in.
Economic circumstances
Smith & Williamson chief investment strategist Philip Lawlor says DC funds, in particular, have to take into account the unusual economic circumstances.
“Historically, the interest rate cycle tightens because the economy is doing well and you have a strong cyclical bias towards the stockmarkets because they are enjoying strong performance,” he says.
“But we are in a different interest rate cycle this time around…because the rates we have now are abnormally low and increases are not based on the economy ripping away.”
Lawlor says the UK is in “uncharted territory” and therefore interest rates are likely to stay low for longer.
“This is an unprecedented scenario. We will probably tighten rates to under half the historic average over two or three years,” says Lawlor.
As and when interest rates increase, Lawlor expects DC funds to shift away from stocks that are sensitive to rate rises and bond yields, such as telecoms and utilities.
Standard Life Investments investment director David Bint says an interest rate rise, and subsequent gilt yield increase, will have differing consequences for DC pension investors depending on where they are in the investment cycle. For those in the accumulation phase, rising interest rates are “not consistent with improving equity returns so, for those in the early stages of saving, higher interest rates are not positive”, he says.
However, for those at the point of retirement who are looking for income, rising interest rates and bond yields make it easier to derive the income needed, he says.
Over-reaction
Regardless of the investment stage, Bint believes it would be “an over-reaction to think that, because US rates have gone up by 25bps, pension funds should change their investment strategy”.
He adds: “I would prefer pension funds to have a broadly diversified investment strategy to start with so that the impact of one event can be moderated and the portfolio is able to see through the changes.”
In the short term there is little concern about interest rate rises dramatically impacting pension funds but there is a wider fear that a Fed rate hike would precipitate a bond bubble burst, the impact of which should not be ignored, especially by DC schemes.
Punter Southall DC scheme corporate advice specialist Neil Latham says: “Pensions are long-term investments and concerns about a bond bubble may be a relatively short-term investment consideration.
“The difficulty is that, if DC members lose too much money because of inappropriate investments, it may take them many years to recover.”
If interest rates rise, bond yields will increase and bond and gilt prices will fall. While this is of less concern to DB schemes, now that DC investors no longer save with the aim of buying an annuity, the falls in bond prices can hit hard.
“This is less important for a DB scheme as the income from the bonds is what the trustees will use to meet their pension payment liabilities. These are fixed income products, so the trustees have already secured this cashflow when they bought the bonds,” says Latham.
“But for DC investors who are no longer trying to hedge annuity rates, a fall in bond values will reduce their investment pot. A smaller pot can only support a lower income in retirement.
“Smaller pots also mean less monetary return when investments grow… making the recovery from the loss even harder to achieve.”
For this reason, Latham thinks DC funds should be cautious of buying long-term fixed interest investments “in a world where they are currently expensive”.
Due to these risks, target-date funds are expected to rebalance to “avoid the excessive volatility that bonds may now suffer” and reduce the level of longer-duration fixed-term investments they hold.
The increased volatility coupled with retirees moving towards drawdown and away from annuities following pension freedom makes a compelling case for changing investment strategy.
“Both TDFs and lifestyle profiles will have to make changes in the pre-retirement phase as the final objective has changed. Evidence is gathering for a broad shift away from annuity purchase to taking cash or income via drawdown,” says Latham.
Annuities need a shot in the arm
Annuity rates fell by an average 5.6 per cent in 2015. With no rate rise imminent, the direction of travel is unlikely to change any time soon.
Standard Life’s David Bint says people fall into different categories when asked why they do not want to purchase an annuity, and cost is just one factor.
“Whether annuities become attractive again or not depends on the reason why people do not want to buy them,” he says.
“Will long term rates go up sufficiently to make people believe annuities are fair value? I would question that. But the other aspect of annuities that makes them unattractive is the lack of flexibility, and that is separate from the price.”
However, Latham believes annuities have the ability to get more popular as they become better value and as retirees better under-stand the danger of running out of money in retirement.
“If new long-term bonds are issued with better yields, annuity rates could improve,” he says. “Any improvement is counter-balanced by general ongoing improvements in longevity, which will make annuities more expensive to buy.”