Find out why low interest rates are a threat to your UK pension

DB members: It’s time to take an interest in interest rates 

The Pensions Regulator identifies three main risks that all defined benefit pension schemes and their members need to be wary of. Those are; funding, investment performance, and employee covenant. 

The management of these three risks are grouped together and defined as ‘integrated risk management‘.

This article will focus on the investment performance aspect of the integrated risk management, specifically interest rates. 

Why are interest rates such an important consideration for DB pension schemes? 

Interest rates are essential for defined benefit pensions. Their importance simply cannot be understated.

Here’s why… 

Defined benefit pension schemes promise to pay members an income for life in retirement. That income is drawn from the scheme’s assets.

For the scheme to provide an income to members, they need to be able to grow their assets each year to meet their liabilities.

Historically, high-interest rates and the fact most retirees rarely lived long into their retirement, meant schemes were able to meet their liabilities without too much difficulty.

So, what’s changed? 

  • People are living longer, prolonging the period in which schemes need to provide an income for members.

In 1980, life expectancy in the UK was 73

In 2020, life expectancy in the UK has risen to 81

Sources include: World Bank

For schemes, this poses in many cases a requirement for an extra 8 years of funding.  

  •  Schemes are receiving a lower return on their assets – notably government bonds.

The importance of interest rates 

Pension schemes have a considerable reliance on government bonds.

Key fact: Government bonds produce a yield based on interest rates set by the Bank of England.

According to the pension protection fund’s purple book, pension scheme reliance on government bonds has increased significantly between 2006-2019.

                                                   

In 2006 pension schemes held 28% of their assets in bonds 

 

In 2019 that figure had risen to 63%. 

Interest rates are rock bottom 

Interest rates have been steadily falling since their peak in 1989, where interest rates were 13.75%. 

In 2006, rates had dropped to 5%, and now as of March 19th, 2020 rates are an abysmal 0.10%.

UK Interest Rates 1960-2020

Above we see the long-term decline of interest rates, which results in a decline in gilt yields being offered by the UK government.

Key fact: When a government needs cash, it issues bonds, this is also known as government borrowing. 

This equates to approximately 63% of defined benefit assets being held in bonds that are producing ever-decreasing yields. As bonds mature regularly, pension schemes are required to purchase new bonds, of which the return is worsening.

For pension schemes, this poses a significant problem, in terms of them being able to meet their liabilities. Schemes have, what could be considered, an over-reliance on low-yielding government bonds.

Schemes are restricted by the UK Pensions Regulator in terms of which assets they can invest in. These restrictions are in place to ensure schemes do not take on too much risk, however, with gilt yields falling year-on-year, schemes will find it increasingly difficult to achieve a return on their assets.

Certain schemes have already failed to meet their liabilities for various reasons and had their assets and liabilities transferred to the Pensions Protection Fund (PPF). Once a scheme enters into the PPF, members may lose certain benefits as explored below.

The Pension Protection Fund Cap 

When a scheme passes into the PPF, members may lose certain benefits. If a member has not yet taken benefit from their DB pension at the time when the scheme enters the Pension Protection Fund, the total amount of compensation they can receive each year is capped at a certain level.

From 1 April 2020, the cap at age 65 has been set at £41,461. This is an increase of 3.6% from the 2019/20 cap which was £40,020.

Whilst this cap does not impact the majority of DB scheme holders, those expecting an income in retirement above that level may be affected, should their scheme fall into difficulty.

It should be noted most schemes are not under risk of falling into the PPF, however, we advise all members of DB schemes to learn about their pension and their rights by regularly reviewing it.

Learn more about your pension 

deVere offers a pension review service, whereby DB scheme members can receive a statement about their pension, along with guidance on their options. Click here to learn more. 

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