LONDON (Reuters) - Record low gilt yields following Britain’s vote to leave the European Union are deepening UK pension deficits, worsening a headache for domestic companies which may be called upon to help fill the gap.
Several years of ultra-low British interest rates had already pushed gilt yields to record depths ahead of last Thursday’s vote and a subsequent rush to investor safe havens has only made matters worse.
“The bottom line is that market conditions were very difficult, and they have got more difficult,” said Charles Cowling, director at JLT Employee Benefits.
Defined benefit, or final salary, pension schemes pledge a fixed income to pensioners and then try to match that liability by buying safe-and-steady assets such as government bonds.
Measly returns and the fact that more retired people are living for longer are adding to the pressure on pension schemes.
The obvious solutions for the schemes, which operate at arms’ length from companies, are to try to find better investment opportunities or to ask companies for increased contributions.
As British firms struggle to plan for an uncertain future in the wake of the Brexit vote, hefty pension deficits can reduce their scope to borrow money, curb their ability to invest and act as barrier to mergers and acquisitions.
Problems at two high-profile companies — retailer BHS and Tata Steel’s British business — have illustrated the risk of allowing those deficits to yawn.
The combined deficit of UK schemes hit a record 935 billion pounds ($1.26 trillion) on Monday, consultants Hymans Robertson said, a 13 percent rise from before the vote, while liabilities hit a record 2.3 trillion pounds.
If a business collapses, payments to pensioners are taken on by the Pension Protection Fund which is funded by an annual levy on company schemes and generally cuts payouts by at least 10 percent.
Pension valuations were a worry before the Brexit vote and so firms are required to assess them regularly, usually once every three years.
For the one-third of companies who did that on March 31 this year, using the 20-year gilt yield as a rule of thumb to measure valuations, yields had fallen 60 basis points from three years ago. That highlights the need to protect against such a fall through mechanisms such as interest rate derivatives.
“Schemes which have built up reasonable hedging levels will be well-protected,” said Patrick Bloomfield, partner at Hymans Robertson.
“Starting to hedge now is looking more and more expensive.”
Other ways to reduce the risk include securing pensions against property or more exotic company assets.
Milk processor Dairy Crest in 2013, for example, tied pension payments to part of its cheddar cheese stock, while Diageo has used whisky as backing for its pension fund.
Companies who want to offload some or all of the risk of their pension schemes can also do so through buying a so-called ‘bulk annuity’ from an insurance company, but the wider the deficit, the higher the cost of striking such a deal.
Bulk annuity sales have slowed this year as yields have fallen and following the introduction of new European capital rules for the insurance industry. Around 8 billion pounds in bulk annuities were sold last year.
Timing is everything, however.
“There’s a view that pensions buy-outs are expensive, but it’s about whether they are fair value,” said Darren Redmayne, managing director at adviser Lincoln Pensions, adding that some companies “would be wishing they had done one last week”.
($1 = 0.7439 pounds)
Editing by Simon Jessop and Keith Weir