The impact of rising gilt yields on pensions

However, more recent events both globally and domestically have seen a very sharp reversal in UK government gilt yields, following the Russian invasion of Ukraine in February 2022, which brought about high global inflation and the ill-fated September 2022 "mini" Budget from former prime minister Liz Truss.

In October 2022, UK government gilt yields briefly reached highs of around 5 per cent — not seen since before the banking crisis in 2008.

UK gilt yields have partially fallen since the highs of October 2022 and have now appeared to stabilised around 3.5 per cent to 4.0 per cent, which is the level they were at 10 years ago.  

UK government gilt yields are around 2 percentage points higher than they were this time last year. So, what does this rise in UK government gilt yields over such a short term mean for the UK pension sector in 2023 and beyond?

DB pension schemes

Defined benefit schemes pay a pension to members based on their service and salary while in the scheme. Contributions are paid by members and the scheme’s sponsoring employer, which are invested in one common fund that is used to pay members’ pensions when they reach retirement.

The calculation to place a value on the DB pension built up by members is complicated and based on a number of assumptions. The value is generally highly correlated to UK government gilt yields. When UK government gilt yields are low, the value placed on the DB pension promised to members is high and vice versa. 

Until recently, UK government gilt yields had been falling. In March 2020, UK government gilt yields were at record lows and had fallen by as much as 4 per cent since the global banking crisis. 

While a 4 per cent fall does not sound a lot, as a rule of thumb, a 1 per cent fall in UK government gilt yields can increase DB pension liabilities by around 20 per cent. So, the impact of falling UK government gilt yields by around 4 per cent over the past 10 years or so has had an immense impact on UK DB pension schemes.

A higher value in DB pension scheme liabilities generally results in an increase in the deficit in those pension schemes, which has to be met by additional contribution from the sponsoring employers of those schemes.

This additional financial burden on employers has meant that many have now closed these schemes to new employees (only 10 per cent remain open to new employees) or closed to all employees (53 per cent of DB schemes are now closed to all employees). 

These ‘gold standard’ pension schemes as seen in the eyes of the members have been replaced by less generous defined contribution arrangements, which provide more certainty for the employer over the contributions that they pay as all the financial and longevity risks for future service are taken on by the employee. 

In the worst cases, for a few financially distressed employers, the additional burden of these pension contributions has been the final straw that has driven them into insolvency.

Now fast-forward to late 2022 and the fallout from the "mini" Budget. 

The fiscal statement was not well received by the UK’s financial markets and their reaction to this caused a fire sale of UK government gilts. This caused the value of UK government gilts to significantly fall in value and so significantly increased UK government gilt yields. 

There were worrying headlines in the press about DB schemes being in trouble, not being able to pay collateral calls on their liability-driven investments. 

In my opinion these articles were exaggerated and while there were some underlining issues for many DB schemes, even though the value of their assets had fallen (as many hold UK government gilts and LDI), the value of their DB liabilities had fallen even further and therefore their funding positions significantly strengthened. 

If UK government gilt yields remain at their current levels, the next time a DB pension scheme carries out its triennial valuation, which is the formal financial health check of DB schemes, sponsoring employers in many cases should see a vast improvement in their funding levels of their DB schemes, with deficits reduced or even eliminated.

The likelihood of this is that sponsoring employers can potentially reduce the deficit contributions that they pay to their schemes or even not pay any at all.

This also means DB pension schemes can derisk their investments as there is no requirement to chase additional returns, which in turn is good news for the security of members’ benefits. 

In addition, with the freed up cash employers can invest more into their business, which should be a shot in the arm for the struggling UK economy. 

A further outcome is that sponsoring employers could be able to pass their DB pension scheme obligations to insurance companies (known as buyout) sooner than expected. 

When this transaction is made, it removes all the employers’ involvement in terms of costs and management time and the financial and longevity risks, and uncertainties of the sponsoring employers are passed to the insurance company.

In most cases it should also enhance the security to DB members of receiving their full entitlement now and in the future.

The scale of improvements will of course depend on funding and investment strategies of each scheme, but a number of DB schemes are already carrying out the required preliminary work to do this and we expect a huge increase in the number of DB buyout transactions over the next 12 to 24 months. 

DC pension schemes

As we have seen, a rise in UK government gilt yields means that the value of UK government gilts falls. This will have had a negative impact on the value of the DC funds of individuals who invest in these types of assets.  

However, exposure to these types of investments in DC funds is generally low, so most members in DC pension schemes should not see too much of an impact. Even if they do, for most pensions are generally a long-term investment and so will have time to recover.

For those DC members nearing retirement though, the amount held in UK government gilts is generally higher than members further away from retirement and these members are more likely to have seen more of a drop in the value of their DC pension scheme investments.

However, the fall in UK government gilt values will lead to improved annuity rates and so those about to retire and purchase an annuity (pension) may find that they can achieve a higher pension than they would have otherwise. 

As a reminder, annuities can be bought by DC members from the age of 55 and provide a guaranteed income for life. Recipients use their DC fund to buy the annuity at a one-off rate based on current gilt yields, which is then not impacted by future changes to interest rates.

Annuities had been on a gradual decline in popularity due to low income rates, as a consequence of falling UK government gilt yields. 

This decline was compounded by the DC pension freedoms introduced in 2015, which meant those aged over 55 could withdraw all their pension pot as a lump sum with 25 per cent tax-free and the remainder subject to their normal rates of income tax, or use pension drawdown and the flexibilities that this offered.

When UK government gilt yields were at one of their lows in early 2021, £100,000 could purchase a guaranteed level income of around £3,800 a year at age 65 with a two-thirds pension for a spouse.

With the rise in UK government gilt yields, we are now seeing an increase in the annuity rates offered by the UK pension market and £100,000 could purchase a guaranteed level income of around £6,000 a year at age 65, which is a whopping 60 per cent increase since early 2021.

It is not surprising that finance and insurance companies have reported a resurgence of interest in annuities with people viewing them as a steady option for retirement.

At Quantum, we have seen an increase in the uptake of annuities for our DC members and have signed off more annuity advice letters in the past six months than we have over the past few years.

Maybe not all the increase in annuities is solely due to the increase in UK government gilt yields. People want a more secure, guaranteed level of income than drawdown provides. Furthermore, people who started drawdown years ago are that bit older now and want to buy annuities because their income requirements have changed.

While annuities offer simplicity and a guaranteed income that will not run out, they are restrictive. What we will most probably see is individuals combining an annuity with another method such as drawdown, rather than completely on its own.

Individuals can buy an annuity to ensure a regular guaranteed income to pay the bills, but maintain a drawdown for bigger, sporadic purchases.

What about index-linked annuities that offer some protection against rising costs? It is unclear at present whether we will see an increase in index-linked annuities as they will likely go up in cost relative to level annuities, given where inflation is at the moment. 

What next for 2023?

Surprisingly, 2022 turned out to be a very good year for DB pension schemes with many starting 2023 in a very healthy financial position.

Many of these DB schemes in 2023 will be actively planning their journey to get to their endgame objective, which complements The Pensions Regulator’s new funding code that is expected to come into force at the end of 2023.

Buyout will be the main endgame solution for most DB schemes, but one issue is whether the insurance industry has the capacity and resources to take on all of this business from these DB schemes and also the surge in individual annuities from DC members over such a short timeframe.

One thing for sure, I expect 2023 will be a record year in relation to pension buyout/annuity business for insurance companies. 

Stuart Price is a partner and actuary at Quantum Advisory

This article was originally published on FTAdviser.com