Defined Benefit Pensions – What should you do?
Transfer values are correlated with real long-term interest rates which remain at historic low levels. This started in March 2009 when the Bank of England (BoE) cut interest rates to the lowest since the bank was founded (27th July 1694) from 1% to 0.5%. Simultaneously, they began pumping tens of billions of pounds into the UK economy through quantitative easing (QE). This super benign backdrop has continued pretty much unabated ever since, pumping up almost all asset prices to what many would consider dangerously and even artificially high levels. At the same time, the simultaneous inflation and wage growth, which were prophesised to be an outcome on this rising tide of QE, have mysteriously failed to materialise.
The fact that DB transfer values are high in this environment intuitively makes a lot of sense. Lower interest rates make it harder for companies operating DB schemes to meet their obligations, as the potential returns available from low risk investments has been reduced significantly. This can be seen most acutely in the yields available from those traditionally regarded as lower risk securities, such as government issued UK 10- Year Gilts. Basically, asset prices have risen and therefore the corresponding yield has fallen and this can be seen in the chart below (Fig1).
With these lower prospective returns, many schemes sit on record deficits, frequently after having reduced their equity levels over the last few years most often for reasons around supposed de-risking. Over the same period, potential liabilities have increased in line with longer life expectancies due to medical advances and reduced tobacco consumption. These record high transfer value multiples, are encouraging members to leave the schemes in record numbers, and lock-in some of these eye watering valuations which few members anticipated ever reaching the current levels. The concept of ‘free money’ has probably never been discussed so often as in the context of the valuations.
(Fig 1) 10-year UK 10 Year Gilt yield
Where will transfer values go from here?
As mentioned earlier, a key point to remember is that the UK (in line with the US and most of Europe) has had circa eight years of exceptionally loose monetary policy. The situation does however look as though it might be changing. The Bank of England is no longer looking to increase QE and there is now as much talk of raising interest rates as there is about lowering them. They may of course continue with their current strategy, and Mark Carney has a history of changing his mind. But currently in the UK, and often more globally, central banks are now focusing in on increasing interest rates, unwinding QE and even unwinding their respective bloated balance sheets. This might indicate it is unlikely that DB valuations are going to increase much higher unless some other factor comes to the fore.
So, if they are not going up, are they likely to go down? The short answer is that nobody can say with certainty, but it’s our belief that the demise of the thirty plus year bond bull market might be overstated. Therefore values could remain at relatively high levels for quite some time yet. We remain unconvinced of the central banks’ ability to ‘normalise’ rates let alone start unwinding the balance sheets. Sticking to the UK, the economy is not in the rudest health with many risks to the downside and we could yet see further yield compression. After all there are a wealth of investors, (pension providers most prominently), that are desperate to buy long dated gilts at a higher yield. If, for example, yields push upwards in the event of an interest rate hike or a reduction in the amount of bonds purchased (through QE) the yield will likely be driven down again by investor demand.
This effect of central banks pushing for rising inflation and interest rates alongside strong investor demand for Gilts has caused something of a cap and collar for gilts with the yield fluctuating between 1% and 1.5% per year to date and this is a situation we could envisage enduring for some time yet.
(Fig2) 1 Year UK 10 Year Gilt yield
Is now a good time to transfer?
It can therefore be argued that now is a very good time (subject to ‘best advice’) for members to be transferring out of their DB schemes and taking advantage of high transfer values. But the decision is not without risks that are almost impossible to overstate. We would caution that despite the immediate and well publicised advantages of DB transfers, the new chosen investment destination is just as, if not even more, important.
It is the same central bank fuelled QE which has been largely responsible for the inflated transfer values that has led to the very high prices of equities, bonds and property funds that many people are now transferring into. So what happens when loose monetary policy is taken away? Getting this decision wrong either via a lack of understanding of the associated risks of the investment, or just unfortunate market timing, could mean the gains made in the transfer value are lost via the subsequent investment.
The last major market crash was back in 2008 and people often have short memories. The risk return profile of the current equity bond and property markets is relatively poor when compared to history and we are running our most conservative allocations in nearly a decade. Cash is consistently maligned and rarely figures prominently in many clients’ portfolios. A legitimate fear maybe that some clients and advisers are not sufficiently aware of just how far valuations have come and the potential correlation of assets that make up a supposed diversified portfolio.
To summarise, we feel that potentially too much emphasis is being placed on the elevated valuation part of the equation and insufficient on the risks of the investments chosen as the replacement.
We regularly meet with our clients to discuss their options and review the investment strategy. It is only by this method that any potential market movements that effect our clients that we can be sure the right advice at the right time to the right person can be guaranteed.
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