Two former senior Bank of England staff have warned a major shortfall in index-linked bond issuance will pose huge challenges to UK pensions’ funding levels in the next 40 years.
Danny Gabay and Andrew Brigden of Fathom Consulting used current economic forecasts from the Office for Budget Responsibility (OBR) to map out the implications for defined benefit (DB) scheme funding, in a report titled ‘Who carries the risk?’ sponsored by Pension Corporation. They estimated that demand for index-linked gilts—a key asset for liability-matching strategies—would outstrip supply by as much as £500 billion ($784 billion) over the next 10 years.
Gabay, director at Fathom, said this gave rise to “a simple, but very real, question: who is going to carry the risk of inflation being higher than currently expected?”
“Should UK plc be forced to put even more into DB schemes, putting further downward pressure on investment, risking more corporate failures, and perhaps leaving scheme members exposed?” Gabay asked. “Or should the government pick up this burden?”
If the Debt Management Office—which oversees the issuance of UK government bonds—was to take on responsibility for the problem, Fathom estimated it would need to increase the amount of index-linked gilts in circulation from its current level of roughly 25% of the UK’s debt to nearer 75%. Gabay said the UK government was unlikely to support such a move as it was in the process of reducing overall debt levels.
.jpg "Forecast supply and demand for index-linked gilts")
The majority of DB pensions in the UK are set to be fully funded within two years under the OBR’s assumptions, Fathom said. If UK government bond yields rise to 5% in just over 10 years, as the OBR predicts, liabilities will fall in line with rising yields, Gabay and Brigden said.
“The UK’s DB pension crisis will be over by the end of the decade—if the OBR is correct,” Brigden stated. “But if the OBR is right then there is going to be a huge demand for index-linked gilts. One headache is just being replaced by another.”
Improved funding positions would also lead to a higher number of pensions seeking full buyout. However, the current size and predicted issuance of inflation-linked bonds meant it would become increasingly difficult for funds to hedge inflation.
Mark Gull, head of fixed income at Pension Corporation, said there were “other options” for pension funds seeking inflation-tracking assets, but cast doubts on the capacity of asset classes such as infrastructure to take up the slack.
“I would love to say more infrastructure projects are coming along but the size of these is pretty small in the context of the index-linked gilt market,” Gull said.
David Collinson, head of strategy at Pension Corporation, said this could lead to more pensions offering members the option of switching to a higher fixed pension in place of an inflation-linked annual uplift—effectively transferring inflation risk to the members. This strategy was used by TRW as part of its £2.5 billion de-risking project with Legal & General, completed last month.
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