open navigation close navigation Menu
UK Defined Benefit Pensions No Longer In A ‘Black Hole,’ Thanks To Higher Corporate Bond Yield

UK Defined Benefit Pensions No Longer In A ‘Black Hole,’ Thanks To Higher Corporate Bond Yields

Thursday, 4 April 2024

It’s been a challenging few years for Defined Benefit (DB) pension schemes, which have suffered heavily from a convergence of demographic, economic and regulatory factors. The low-interest rate environment that followed the 2008 financial crisis further exacerbated matters, reducing returns on the fixed-income investments that pension funds had long relied on to match their long-term liabilities.

Although the number of DB schemes has dwindled in recent years, according to the Department for Work and Pensions (DWP), there are still around 5,000 DB schemes operating. These schemes have around £1.4tn in assets and are relied on by 10 million people for their retirement income. As recently as March 2022, DB schemes were in a collective deficit of £483.4bn. However, just one year later, that deficit had been turned into a £149.5bn surplus. According to PwC’s Low Reliance Index, the combined DB surplus increased to a record £390bn in February 2024. This means the majority of DB pension schemes have become ‘fully funded’ and are on track to meet their future obligations.

New rate environment benefits DB schemes

What’s behind the turnaround? Well, while rising UK interest rates since December 2021 have been a headache for mortgage holders, they have been welcomed by DB pension schemes, with higher rates lowering the cost of future pension outgoings. It’s also worth noting that schemes have been switching from lower-yielding government debt to higher-yielding corporate debt, both in order to pocket the higher yields available and to prepare DB pension schemes for sales to insurers.

This move up the risk/reward spectrum for pension schemes accelerated following the disastrous ‘mini’ budget of September 2022. In the aftermath, many schemes were forced to sell their government bond (gilt) holdings to meet cash calls from lenders. Now, many schemes have been choosing corporate debt over gilts because as well as offering higher yields than government bonds, corporate bonds offer greater protection from interest rate moves without schemes having to take on leverage. Also, under the IAS 19 (Employee Benefits) standard, companies are required to measure their DB pension liabilities at a present value. The discount rate used for this calculation is derived from the yields of AA+ corporate bonds.

Corporate bond holdings make DB schemes increasingly attractive

All of this means that selling DB pension schemes, as well as the underlying assets, to insurers is becoming a more realistic option for those companies still burdened with DB schemes. Corporate bonds are an important and desirable asset class for insurers, as they can use them as a match for their liabilities under solvency rules. Corporates are also more easily traded compared to harder-to-sell investments such as infrastructure or social housing, which make up a large share of insurers’ assets.

It's not surprising then, that insurers including Aviva, Legal & General and Standard Life are looking to arrange ‘buy-in’ and buyout transactions that transfer the pension scheme assets (or liabilities) to the acquirer. With surpluses now being reported, these schemes are looking increasingly appealing to acquirers. Legal & General has managed some of the UK's biggest pension scheme buy-ins in recent years, including a £4.8bn deal for Boots in 2023. In fact, the top five deals in the first half of 2023 were valued at £21.2bn. This trend is likely to continue in 2024 as bond yields have recovered and stabilised, according to a recent report from Bloomberg Intelligence.

As Kevin Ryan of Bloomberg Intelligence said, “It's clear that many companies view staff pensions as both a distraction and unwelcome liability, so we expect the trend to outsource the liability to continue… Many companies’ DB plans should begin to appear better funded, making these more attractive to the buy-in, buyout market. Still, challenges remain, with insurers uniquely qualified to manage them for pension fund clients.”

Higher average yields ‘the new normal’

The Bank of England has maintained Bank Rate at 5.25% since September 2023. Current market trends suggest that UK interest rates might gradually drop to just under 4% by the end of 2024 and then to around 3.4% over the next five years. Therefore, the ‘new normal’ for interest rates will still be significantly higher than the very low rates (below 1%) experienced over the past 15 years. This bodes well for future returns from corporate bonds, and the days of DB schemes struggling with a shortfall of funds may be over.

Find out more about how EQ Retirement Solutions is transforming the retirement and pensions markets with leading administration and technology solutions.