Over Halloween, the PPF 7800 Index funding level creeped and crawled marginally higher, from 90.6% at end September to 91.2% at end October 2017. The frightening prospect facing pension funds is that it’s going to take more than central bank hocus pocus to make things much better. Indeed, those hoping that the decision by the Bank of England to increase interest rates at the start of November, for the first time in over a decade, would improve matters were in for more of a trick than a treat – yield levels are broadly unchanged following the announcement. The bigger moves for UK yields came in September, when the Bank signalled a potential interest rate rise; by November markets had already discounted the announcement.
The recent rate rise only takes yields back to where they were prior to the Brexit vote last year. September‘s signposting by the Bank, which came as a surprise to many, was consistent with our view that UK interest rates will be higher than the market is expecting in around 5 years’ time. Earlier this summer, we suggested pension funds consider modestly lowering their target hedge ratios in line with this, to benefit more from the anticipated upside to funding levels with rates rising. This is because we saw less downside risk to UK real rates than we saw in the immediate aftermath of the Brexit vote last year, not least due to international factors such as a firmer footing to global growth.
Brexit is likely to continue to loom large, however, and give Bank of England policy makers plenty to consider. Indeed, the rate rise needs to be viewed in the broader context - despite the modestly higher yields we anticipate, UK rates will continue to be very low by historical standards in the coming years, we believe. As such, pension funds should not get carried away. While we still think that interest rates will be higher in 5 years’ time, hedge ratios should still be materially higher than the industry averages. An uncertain political environment given the Brexit negotiations means that interest rate shocks are always possible, even if they are not our core view. As such, pension funds should position for further upside to rates in the coming years, but it needs to be a scaled position – or else they may be confronted by an unwelcome fright.”
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