With gilt yields
more than tripling this year, what steps could you be taking?
5 March 2021
Gilt yields have more than tripled since the start of the year with, at the time of writing, a 10-year gilt now yielding 0.9% pa. It may not sound like a lot, but in the world of pensions it’s a huge deal.
In January alone, UK pension schemes saw their pension deficits fall by more than £20bn, and we expect the February improvement will be significantly larger.
Gilt yields skirted around record lows in 2020, even turning negative in the summer (ie paying the government to lend it money!). However, against a backdrop of rallying equity markets, a strong vaccine rollout and rising inflation expectations, yields have surged in the past couple of months.
Many pension schemes (and likely yours as well) now find themselves in a much healthier place than at the start of the year.
We all know markets can be volatile and unpredictable (perhaps more so than usual with COVID-19 lurking in the shadows). So, what can sponsors do to capitalise on this good experience or reduce the risk of losing the good progress?
Three simple steps
- Find out what the latest position is – the trustees should have this available at the click of a button if you don’t.
- Consider making de-risking proposals to the trustees – We think its pays to be proactive on this. As the sponsor, you are ultimately underwriting the investment risk being taken by your scheme, and why underwrite more risk than you need to? See more on this below.
- Think about your contribution schedule - does it still have a basis in reality? This is a contentious topic at the best of times, and there are lots of differing options. Could your contributions be replaced with contingent support, reducing the risk overpaying and finding yourself with a trapped surplus? Find out more how contingent funding solutions can help.
What are the options for de-risking?
Each scheme and its de-risking pathway are unique, but I’ve listed a few thoughts below that are relevant in most cases. Which of these options is right for your scheme will of course depend on your circumstances and will need careful consideration.
Hedging: Increasing hedging ratios is the obvious way to capture improvements in gilt yields. Many schemes stop at hedging 100% of assets, but why not hedge more and stop the value of any deficit (and hence contribution schedule) from going back up?
Equities: Selling equities is an obvious choice. However, it’s not your only one. I like the idea of purchasing equity protection – protecting against market falls but keeping some upside on the table. From a sponsor perspective, this keeps equities in the investment strategy and reduces the time and headache associated with re-risking if needed in the future (see David's blog on equity protection).
Credit: De-risking out of equities into credit is a well-trodden path for pension schemes. But credit spreads are narrow, and there are question marks around lending to companies for long periods of time whilst getting a minimal pick-up over gilts. In the current environment we have a bias for strategies that lend money for shorter periods (you can always lend it out for longer periods if conditions improve) (See Andy’s blog on short-dated credit) and lending to those issuers less exposed to climate transition risks (see Jacob’s blog on corporate bond investing).
Now is a good time to click that button, find out your scheme’s latest position and consider whether to take the opportunity of rising gilt yields and improved funding positions to both de-risk the investment strategy and re-assess how you fund your scheme.