The Bank of England recently doubled its base rate to 0.5%, with almost half the Monetary Policy Committee in favour of a higher increase. What does the rise in rates mean for pension funds? 

 

The Bank’s Monetary Policy Committee aims to keep inflation at 2%, but the latest figures have shown the consumer price index reaching 5.4% over 12 months in December, and further increases are anticipated. 

Against this backdrop, the Bank has started to edge away from its record low 0.1% base rate, first to 0.25% last year, and now to 0.5%. 

 

 

With defined benefit funds being exposed to gilt yields both on the asset and the liability side, what does this mean for them? Nigel Sillis, client portfolio manager at investment firm Cardano, noted that gilt yields have been rising for some time now, in reaction to the market pricing in higher base rates and multiple increases in 2022. 

  

Therefore, “this week’s Bank of England announcement, albeit accompanied by hawkish split voting, validated market expectations”, Sillis said, adding that the most recent rise in yields started in early December and has been “quite orderly”. 

 

While all other things being equal, a rise in gilt yields would normally act to reduce a pension scheme’s liability value through a higher discount rate, “all other things are not equal”, he warned. Rising inflation, as we are seeing it at the moment, increases pension scheme liabilities. “We are not clearly out of having the toxic mix of relatively low gilt yields and relatively high inflation,” he said. 

 

So what can pension funds do in this environment? Cardano advocates a fully hedged approach to liability management, believing that there is no good reason to have open interest rate and inflation exposure. Sillis said that “this is as true now as it has ever been”, with considerable uncertainties around inflation and gilt yields.  

  

He also advises schemes that are closing funding gaps with investments in growth assets to check in with their investment consultants, to understand if they have the right tools to deal with increased volatility, whether investments are sufficiently diversified and if an increasingly inflationary environment can be successfully navigated. Schemes that rely too narrowly on UK-centric or equity market assets could find “deficiencies in their current approach”, he added. 

 

 

Growth assets rely in there being growth, but higher rates, coupled with a 54% increase in the energy price cap in April and a national insurance hike of 1.25% may well put a dampener on that. 

 

Jamie Niven, senior fund manager at Candriam, said the increase and, alongside it, the MPC's unanimous decision to reduce the stock of UK government bond purchases by no longer reinvesting maturing assets, came as little surprise, but “the decision of four voters to dissent in favour of a 50bps hike was unexpected”. 

 

Niven said further MPC actions will be influenced by the consumer and wider economy’s reaction to the tighter conditions.  

 

“We anticipate a further two hikes in the coming months to 1%, followed by a pause and the active selling down of balance sheet assets,” he said, adding that “the reaction today, pricing in faster and more hikes this year, seems premature”. 

 

 

Much of the economic outlook depends on how wealthy consumers feel. The combination of price hikes, tax hikes and higher interest rates on loans does not bode well on that front. 

 

Prakash Chandramohan, strategic policy director at The Investing and Saving Alliance, is expecting consumers to tighten their belts in response to higher mortgage repayments, energy price rises and higher NICs. He said financial services firms must ensure people don’t disengage with their long-term financial priorities because of short-term pressures. “A starting point for any firm would be to communicate proactively with its customer base, especially to assist its vulnerable customers, during what is clearly set to be a difficult year,” he said. 

 

Research by provider Aegon found that over a quarter (27%) of adults are concerned about the impact rising interest rates will have on repaying short-term loans, and more than a third (35%) are apprehensive about higher mortgage payments. 

 

Pensions director Steven Cameron said the rate rise, if it is passed on to cash savers, will be little consolation, as an extra 0.25% interest on £10,000 of savings will provide £25 a year, nowhere near enough to pay for a £693 energy bill increase an average household faces. “Borrowers face an even gloomier future with further interest rate hikes likely this year making it increasingly more expensive to borrow money and pay off debt,” he added.