Approaching pension pressures

The majority of UK defined benefit (DB) pension schemes are currently in deficit, which means they do not have enough assets to cover existing and future pension payouts, otherwise referred to as liabilities.

The value of a pension scheme’s liabilities are estimated based on a number of assumptions – inflation, interest rates, how long people are expected to live – and are closely linked to government bond yields.

The current yields on government bonds are extremely low, which means they are considered to be very expensive, and this in turn is putting pressure on pension schemes in a number of ways.

The value of liabilities are linked to the value of government bonds, so when bonds become as expensive as they currently are, the estimated value of a pension scheme’s liabilities increase. This means that even if a scheme’s assets did not change in value, a pension scheme’s deficit would increase as a result.

Pension schemes that already have a significant allocation to government bonds are in a better position, having a larger proportion of assets which move in line with their liabilities.  This is known as hedging. For those pension schemes that do not currently hold much in government bonds, it has now become very expensive to hedge any proportion of assets at all.

If trustees were to hedge today by buying government bonds and held them to maturity, the yields received would be very low and are not likely to exceed current or expected future inflation. This means that pension schemes may actually be eroding the long-term value of a portion of their assets.#

As most pension schemes also need to hedge their inflation exposure, the increased demand for inflation-linked bonds has made them more expensive. Uncertainty surrounding expected inflation levels in the future has exacerbated this even further.

Schemes are now seeking to structure their asset portfolios to generate cash flows that more closely reflect the profile of their liabilities

In addition, trustees are tackling how to make sure they have enough cash flow to pay out existing pensioner liabilities. As pension schemes mature, the proportion of cash required to pay pensioners will also increase, as more members migrate from active (paying in) to retired (paying out). More schemes are reaching the point when pension payments exceed contributions and they become cash-flow negative.

Pension schemes have three ways to meet their cash flows: sponsor contributions; disinvesting assets; or income from invested assets.

In an environment where interest rates and government bond yields are low, pension schemes have been looking at private assets. With private assets – asset-backed securities, private lending, real estate debt, infrastructure debt or property – it is possible to find sources of reliable income that offer a higher interest rate in exchange for tying up assets for longer.

Pension schemes have the added benefit of long-term investment horizons, so are in an ideal position to invest in these assets to receive higher returns. Private assets can also offer better protection to investors in the form of security and covenants.

These sorts of portfolios have had two main objectives to provide a return higher than the equivalent government or corporate bond, and generate stable, predictable and high-quality cash flows that can be used to deliver pensioner benefits.

There are a range of assets available that pension schemes can access on a standalone basis or as a multi-asset approach. Schemes are now seeking to structure their asset portfolios to generate cash flows that more closely reflect the profile of their liabilities, while at the same time diversifying away from the volatility and uncertainty of more traditional asset classes.

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The views expressed in this document should not be taken as a recommendation, advice or forecast. Issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK, and provides ISAs and other investment products. The company’s registered office is Laurence Pountney Hill, London, EC4R 0HH. Registered in England No 90776