Experts warn schemes of recession and inflation risks after BoE rate rise

On August 4, the Monetary Policy Committee voted 8-1 in favour of a 0.5 per cent increase to its base rate. But given that the central bank’s rate hike was widely anticipated, the decision was already priced into markets. 

Hymans Robertson senior investment consultant Ben Farmer observed that it was therefore unlikely that there will be significant movements in gilt yields off the back of today's announcement. 

This means defined benefit pension funding levels, which have risen in recent months on the back of rising gilt yields, are unlikely to be too affected by the latest rate hike. 

For those with higher levels of hedging and leveraged LDI solutions, further rising yields could pose a different challenge, with the need to meet additional capital calls on hedging portfolios

Ben Farmer, Hymans Robertson

“It also means that schemes that have hedging strategies in place are likely to have a respite from the challenging collateral calls they had to face earlier this year when the central bank started raising rates,” said Farmer.

Inflation may hit 13 per cent

One part of the central bank’s announcement that may worry pension schemes is its prediction that inflation will rise from 9.4 per cent in June to 13 per cent in Q4 2022, along with its warning that the UK economy will move into a recession this year. 

Investment experts and economists have queried whether the BoE will be able to control inflation and slow the economy, and to what extent the market believes it can do this successfully.

“If the market believes that the Bank of England has inflation under control then we could see a reversal to recent trends, with longer-term gilt yields and inflation expectations falling,” Farmer said. 

“If, however, the markets believe the interest rate rises currently priced in are insufficient, and that inflation will continue to surprise on the upside, we could see further increases in gilt yields.”

Higher-for-longer inflation will create more challenges for pension funds. This will have implications for their funding and investment strategies, strategic journey planning, and various aspects of member benefit calculations, said LCP partner Jonathan Camfield. 

High inflation can be beneficial for some pension schemes, however, especially where they cap the increases, according to Barnett Waddingham partner and senior investment consultant, Ian Mills. These schemes may find that their inflation-linked assets outperform and their funding positions improve accordingly, he said. 

Further rises in gilt yields to control inflation could lead to big reductions in pension liability values, which could raise the potential of locking in funding gains by reducing investment risk, for example by increasing hedging. 

“For those with higher levels of hedging and leveraged LDI solutions, further rising yields could pose a different challenge, with the need to meet additional capital calls on hedging portfolios,” said Farmer. “This could either be done by selling non-hedging assets or reducing hedging if there is insufficient liquidity in the scheme.” 

Farmer suggested trustees should speak to their advisers to determine whether the recent market moves present an opportunity to take more investment risk off the table, or consider reviewing their hedging solution. 

He also warned that a lot of private sector schemes have high-quality, short-duration, asset-backed securities or secured finance assets in their collateral waterfall accounts.  

“The outlook for them will deteriorate if the Bank of England central projections are borne into practice, so it would be worth trustees asking for peace of mind or checking with their collateral managers or ABS managers to understand any potential impact from that,” he said.

How to react to recession fears

Alongside its rate rise announcement, the BoE warned that the UK could fall into recession this year amid rising energy costs. It expects the economy to shrink in the final three months of this year and continue contracting until the end of 2023.

Cartwright investment consultant and head of digital assets, Glenn Cameron, noted the possibility that central banks may engineer a soft landing and avoid inducing a recession, or that the recession is shallow and short lived. But he warned a “fairly deep and protracted recession could be in the cards”.

Recession fears will likely drive longer-dated interest rates lower as the market prices in future central bank cuts, which means trustees should be considering how to lock in recent funding improvements by reducing risk within their portfolios, he said. 

There will be pockets of opportunities for those that have the risk appetite, he added. As such, trustees should know how much risk they are currently taking, and whether they have room to take advantage of potential opportunities.

“They should also consider their scheme’s net cash flow position, and whether they are in a position where they will not be a forced seller of risk assets to fund outflows,” he added.

Another consideration is whether the scheme’s employer covenant will be impacted by a recession.

Farmer pointed out that a recession will spell bad news for domestically focused UK companies. However, constituents in the FTSE 100 or FTSE 250 have more internationally diverse revenues, and so are less sensitive to headwinds and tailwinds in the UK economy than their smaller counterparts.

Impact on members 

The increase in inflation expectations to 13 per cent will have an impact not only on schemes but also on their members who are facing a cost-of-living crisis.

Mills said: “Members of some pension schemes who thought they had an index-linked income may be surprised to discover that their increases are limited, with 5 per cent being a typical cap. Effectively, these people could be in for an 8 per cent cut in their incomes, in real terms. This could add to the cost-of-living crisis.”

He added that many pension trustees will be having to deal with the question of doing what is right. 

“They will be seeing their pensioners struggle to make ends meet, and so calls for one-off discretionary increases in pension payments will become louder and louder.”