Actuaries have warned that the Bank of England's decision to hold down interest rates until the labour market picks up will keep up the pressure on UK defined benefit pension scheme liabilities.
Yesterday, new Bank of England governor Mark Carney issued 'forward guidance', making clear that he intended to leave interest rates at 0.5% until unemployment falls to at least 7% from its current level of 7.8%. He added that this did not mean that interest rates would be increased once unemployment reached that level, but that they would be reviewed.
Carney also said the Bank's Monetary Policy Committee would undertake further asset purchases - also known as quantitative easing - while the unemployment rate remains above 7% if it judged that additional monetary stimulus was needed.
Commenting on the announcement, Marian Elliott, head of trustee advisory services at actuarial firm Spence & Partners said keeping interest rates low would 'maintain the upward pressure on liability values of many UK DB schemes'.
She added: 'Maintaining QE for the short to medium term may well stem the recent rise in gilt yields, which had been good news for schemes as this lowered the current value placed on pension liabilities. Until the unemployment conditions are met and interest rates begin to rise again, we would not expect pension liabilities to reduce significantly on the back of rising gilt yields.'
Elliott observed that QE would have to be unwound at some point, something that was likely to create inflationary pressure over the medium term.
'Medium- and long-term inflation expectations have a greater impact on pension scheme liabilities than short-term inflation, as they affect the expected future increases due on pensions in payment and revaluation of pensions in deferment - in most cases causing the value placed on liabilities to increase.
Whilst the Monetary Policy Committee have said they will act should inflation expectations "no longer remain sufficiently well anchored", the Bank will be faced with competing pressures and something will have to give.'
There was, however, some comfort for pension schemes in the possibility of growing their assets. If the low interest rates succeeded in driving economic growth, then schemes' assets should also experience an uplift, said Elliott.
'Many schemes retain a significant exposure to real assets, so strong performance could offset some of the detrimental effect that low interest rates have on the liability side of the equation,' she said.
'In addition, a sustained recovery could result in a strengthening of the financial covenant available to schemes from their sponsoring employer.'
At Hymans Robertson, Graeme Johnston noted that interest rate and inflation risk were 'major considerations' for all DB pension schemes.
'Schemes need to decide whether their current assumptions about future interest rates and inflation are correct as they could be hurt significantly if they are proven to be wrong,' he said.
Danny Cox, head of financial planning at Hargreaves Lansdown, urged both savers and investors to ignore any short-term reaction to Carney's announcement and focus on long-term goals.
He noted that the markets were 'relatively unexcited' by the announcement, which was in line with expectations.
'We might see inflation expectations rise on the back of this news and bond yields may also increase moderately too, with an associated price fall. It seems unlikely at the moment we will see more QE in the UK in the short term. However, Carney is keeping this option open,' said Cox.
'Stock markets abhor both uncertainty and rising interest rates. This announcement should therefore be doubly positive for markets over the medium term - an improving economy plus the assurance that interest rates will remain low could be a very good environment for share prices.'
