QE’s unintended consequences: Pension deficits to hit balance sheets

QE is having some serious unintended consequences, increasing pension scheme deficits and hitting company finances. Driven by liquidity and deflation fears, UK government stock, gilts, beat shares and most other asset classes in 2014. Long dated gilts gained over 20%. The trend has even accelerated already this year. Yet many UK pension funds, endowments and managed funds simply do not own enough of them. Already Tesco and BT have warned of bigger pension scheme deficits, which will need increased sponsor funding.

Active investment managers rarely give much thought to gilts – they are not an investment that adds much business value. The fees are in equities; even in their fixed income investments, managers tend to bet against the government. If yield can be picked-up on corporate debt or infrastructure funds, clients are happy. Or, at least they were until a strong gilt performance in 2014 left many active mixed funds trailing, and clients feeling they had missed out. Most funds were underweight gilts or had insufficient duration.

The embarrassment of wealth managers was matched by pension fund managers. Pension fund deficits in defined benefit schemes are now widening as gilt yields collapse. Many pension schemes simply do not hold enough long term index linked or conventional gilts to secure their obligations to future pensioners. Essentially, long term liabilities are discounted by expected investment returns, and balloon as yields disappear.

Managers thought their anti-gilt stance was rational. Many entered 2014 believing a rise in UK interest rates was just months away, with the Bank of England talking of the risk of inflation. Such low gilt yields left little net income for investors, after paying expenses and management fees. So, being underweight in gilts was an easy decision. But to almost everyone’s surprise yields fell further, delivering strong gains for gilts. And, despite low inflation, UK index linked gilts also performed well. While there were some gains from higher yielding bonds too, these involve credit risks and lower liquidity.

Half of the corporate UK’s defined benefit pension scheme liabilities are not fully hedged, leaving a lot of exposure to the yield collapse. Company or employee contributions will need to fill the gap if other assets do not offset this underperformance. At low levels of yields, small changes can make a huge impact on the size of liabilities. One estimate is that liabilities jumped 25% in 2014, with a further rise already this year, as gilts strengthen on the ECB decision. Few assets can keep pace with that.

European QE may force more money into UK gilts, given how low returns are in Europe. The belief that low inflation could persist, or even turn into deflation, is pushing many investors further out in gilt duration. British investors tend to focus on the risks of the General Election, and declare the gilt moves as madness. But it is hard to see ourselves as others do. European investors may simply be looking for a safe haven with a yield pick-up, faced with charges to make deposits in other currencies, such as Swiss Francs. British investors may simply not recognise how attractive government securities are, in a nation with strong growth, rule of law and a history of democracy. The bears of UK government stock may be victims of the very British bias of self-doubt.

This month, a bond issued by Nestle has moved to trade at a negative yield, the first corporate bond maturing in over one year to do so. In future, securing yield with low credit and currency risk could prove very difficult. 20-year gilt yields of 2% could prove a bargain if this psychology persists.

Consensus is that buying long dated gilts is a mug’s game, given the potential for inflation and capital loss. But, a repeat of 2014’s remarkable gilt performance could have serious consequences for many listed companies, as well as pensioners. Some of the companies that have maintained defined benefit schemes, such as Tesco, are least able now to afford the additional contributions. Companies with pension schemes that have actuarial reviews to the end of 2014 may surprise in their forthcoming annual reports.

UK plc will have to pay for the mismatch in pension schemes, and the impact of QE. This may surprise investors and the Bank of England; printing money was meant to stimulate Britain’s businesses, not burden them with more debt and switch money out of equities. Investors might note that the Bank of England’s own £3bn pension fund is invested entirely in bonds, with more than 83% in gilts.

Why are investment managers and pension scheme actuaries so slow to recognise what QE is doing? Perhaps because long gilt yields are now in unchartered territory, and fund managers tend not to be incentivised to hold gilts. The collapse in yields matters for pension funds, endowments and wealth managers alike. Investors need to suspend their disbelief and look more rationally at how to deal with disinflation.

A version of this article was published as in the Behavioural Finance Series in Citywire on February 5 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. At the time of writing my employer’s clients had interests in UK government stock.

Image credit; Picture of a gilded frame ready to be burnished with an agate tool.Juangonzalez64 04:28, 16 December 2006 (UTC) Public domain.http://commons.m.wikimedia.org/wiki/File:Gilded_frame_being_burnished_wit

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