Interest rate increases and defined benefit pension schemes

While Defined Contribution (DC) pension savers have likely seen a drop in the value of their pensions over the last 18 months, Defined Benefit (DB) pension schemes have had an altogether different experience. I know it seems counter intuitive that poor investment performance leads to a strengthening position of a DB scheme so I will do my best to explain the anomaly in this article.

In its simplest form a DB scheme is valued based on the assets it holds and the liabilities it has accrued i.e. the funds it is due to pay to the scheme members. The valuation of liabilities is heavily dependent on what is happening in the bond market, effectively the calculation looks to see how much funds will be required to purchase an income stream (bonds) that will allow the scheme to pay its members in retirement.

So, what has actually happened to DB schemes over the last year and a half? In an effort to combat out of control inflation Central Banks quickly began to rise interest rates, this rising interest rate environment led to a subsequent increase in bond yields. After a decade of interest rates hovering around 0, and even going into negative territory, we have seen an increase of 4.00% in the European Central Bank’s interest rates since the first rate hike in 2022. These rate hikes have resulted in a huge reduction in pension scheme liabilities which has more than offset the fall in pension scheme assets.

It is very important to note that this net gain is a ‘paper’ gain only. The key question is whether these higher yields will persist as inflation looks like it may be starting to come under control. If we see yield decreases this will lead to an increase in DB schemes liabilities.

The big question for trustees and sponsors is how they can turn this notional gain into a real gain. Every DB pension scheme that I am involved with is actively discussing, if not in the process of moving to, matching assets. Matching assets means changing the mix of investments the scheme holds to match the schemes liabilities i.e. buying bonds that have similar duration to that of the schemes liabilities. Some better funded schemes are moving to near 100% matching while other less well funded schemes are moving a significant portion of their assets into matching bonds. It is also possible to commence the process of a buy-in, this involves purchasing bonds that will match the benefits currently in payment which removes investment risk for this cohort of scheme members.

A small number of deferred schemes are choosing to move into wind-up, however this is very complex and takes significant consideration. In general, it is the employer that makes the decision to wind up a pension scheme. If the scheme is in surplus, winding it up will have a notional negative effect on the company’s financial position as the surplus will be removed from the company accounts. This may be slowing down the process.

While I am on the subject of wind-ups, it is interesting to have heard representatives of the Pensions Authority begin to encourage DB schemes to think about the “end game”. There is no doubt that this is an exciting time to be involved in the management of DB pension schemes, hopefully the next 18 months will be as kind as the last 18.

Author: Eoin Hassett, Trustee Services Director, ITC Group.