(November 12, 2013) — Sponsors of UK pension funds have a 25% chance of being forced to find another £253 billion in additional contributions, according to analysis from Fathom Consulting and Pension Insurance Corporation.
Government policy aimed at protecting household savings could force employers to contribute another £253 billion to their pensions over the next 20 years.
That is one of three scenarios facing UK pension funds, depending on the UK’s growth rate, the monetary policy committee’s actions and consequently what happens to inflation.
UK pension funds are significantly under-hedged against inflation, meaning additional contributions from employers depend on this potential risk—as well as how the Bank of England and market rates react to it.
Under the worst case scenario, believed by Fathom Consulting Director Danny Gabay to have a 25% chance of occurring, the current financial repression situation will continue and the UK’s monetary policy committee will take action to offset any over-spill from the US Federal Reserve’s tapering exercise.
In this example, the Bank of England could even extend quantitative easing (QE) further, in an effort to keep index-linked yields below zero. Economic growth will continue to be meagre, and interest rates will remain on hold.
Fathom Consulting—which worked with Pension Insurance Corporation on a report into the impact of three UK growth scenarios corporate pension funds—claimed the vast majority of that £253 billion would have to be found in the next 10 years. In addition, around 25% of companies would become insolvent before their pension funds reached a fully funded status.
“This is the worst case scenario,” said Gabay, “that we have another six years like the last six years.
“Pension funds have already had £135 billion pumped into them just to stand still. At the heart of the problem is that we still haven’t fixed the banks. Banks that are stuffed with assets don’t lend to newer, riskier businesses. We’ve seen a million jobs created in the UK to create an output of nothing.”
Gabay also highlighted that the UK had fallen the farthest of all of the OECD’s major countries in terms of growth rate, and was now on the path to have the same trend of growth as Japan. Only Italy ranked lower.
This scenario is a far cry from the Bank of England’s own estimates of where the UK economy will go. The central bank believes the UK currently has a considerable degree of spare capacity, and that the UK’s growth rate will improve to pre-crisis levels without any upward pressure on inflation.
Fathom Consulting and Pension Insurance Corporation refer to this as the “rapid re-normalisation” scenario, which Gabay believes has a 35% chance of occurring. Here, the conventional and index-link yields would return to normal levels, helping to move defined benefit funds back into fully funded status as soon as the end of next year. The over-supply will lead to greater demand, helping the UK to increase growth output.
The most likely scenario, with a 40% likelihood according to Gabay, was the second scenario, labelled “supply pessimists”. Poor productivity levels as evidenced in the UK today will continue. There is currently a 15 percentage point gap in productivity between the US and the UK, caused by the structural damage done to the UK economy being unrepaired as a result of government policy, Gabay said.
In this scenario, even if a modest pickup in inflation occurred, the Bank of England would resist a rise in interest rates. Nor would it tighten monetary policy, in order to avoid volatility in output. Yields would ultimately drift higher, but it would take far longer than the Bank of England’s “rapid normalisation” example.
The UK regulator requires the funding scenario to be reassessed every three years. If it is under target, the plan sponsor is required to put in additional contributions. If it is over target, the pension fund is encouraged to de-risk their strategy.
Under the “rapid normalisation” scenario, virtually no pension fund sponsors would be required to put in extra capital at each triennial evaluation, taking for the purposes of the report’s model that all pension funds started with an 80% funding ratio.
In the “supply pessimists” scenario—the one Pension Insurance Corporation and Fathom Consulting believe most likely—employers will have to hand over £26.2 billion on aggregate to shore up the deficit within the 10 years required by the Pensions Regulator.
But under the worst case scenario, £252.8 billion would have to be found to help pension funds reach being 100% in that decade-long window.
Asked how he would change the situation Gabay—himself a former employee of the Bank of England—said he would drop the government’s Help to Buy scheme (which he referred to as “Help to Buy an Election”) as it was artificially stimulating demand in the housing sector. He would also prevent any further rounds of QE.
The issue facing pension funds is how they position their investments for any of these scenarios. In particular, a rise in inflation would prove extremely problematic, given UK funds are under-hedged today.
As Mark Gull, head of asset liability management at Pension Insurance Corporation, noted: “There are around £1.2 trillion liabilities in the corporate pension market, but the index-linked gilt market is just a third of that.”
The full report can be read here.
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