XPS Pensions Group DB:UK Tracker - Pension scheme funding levels improve by £34bn despite inflation reaching its highest level in over a decade

  • XPS’s DB:UK funding tracker reveals that scheme deficits against long-term funding targets fell by £34bn over the month to 30 September 2021.
  • August saw the highest annual increase in prices since 2012 and over the last month, long term inflation expectations rose a further 0.14% adding c.£58bn to the value of UK pension scheme liabilities.
  • However, gilt yields rising by 0.36% has ensured that overall deficits fell by £34bn over the month.
  • Employers and trustees should review the hedging strategies in place on their schemes in the context of rising inflation expectations.

Deficits of UK pension schemes against long-term funding targets have reduced by around £34bn over the month to 30 September 2021, analysis from XPS’s DB:UK funding tracker has revealed. Based on assets of £1,844bn and liabilities of £2,130bn, the average funding level of UK pension schemes on a long-term target basis was 87% as of 30 September 2021.

DB:UK tracks the funding position of UK defined benefit (DB) pension schemes on a long-term target basis and allows real time monitoring of changes and analysis of the reasons behind any movement.

Drivers of the trend

UK prices1 rose by 3.2% over the year to 31 August 2021, representing the highest annual increase in prices since 2012. The Bank of England’s Monetary Policy Committee projects that inflation will continue to rise to 4% in Q4 2021.

For pension schemes, a concern is that the long-term inflation expectations are also rising, leading to increasing member benefits and pension liabilities. Over September, long-term inflation expectations have risen by 0.14% and the impact on individual schemes will vary considerably. Highly hedged schemes will be largely protected, while the funding position of schemes with limited inflation protection will worsen considerably. With many pension schemes in an improved situation thanks to recent strong growth market performance, schemes should therefore review the inflation exposure in place. The impact of rising inflation on growth assets is more unclear.

Felix Currell, Senior Consultant said “How long supply-side challenges in the global economy – examples recently in HGV driver shortages and rising energy prices – persist and the impact of further stimulus in the US will be key factors in the ongoing performance of equity markets. Pension schemes will be concerned about the ability of markets to keep pace if inflation reaches very high levels, particularly if interest rates are raised early to combat prevailing inflationary fears. Pension schemes should be exploring how they can adjust their portfolios to hedge against inflation risk. In addition, schemes may also want to consider how to protect their growth portfolios, such as by incorporating more real assets with contractual inflation-linkage.”

The market has reacted to the accelerated inflation expectations and the prospect of higher interest rates with long-term gilt yields having risen by 0.36% over September 2021. The combined effect is that overall deficits of UK pension schemes have reduced by £34bn over the month.

Change in position

The chart below breaks down the reduction to UK pension scheme deficits into its component parts, with the main contributors being the rises to inflation and gilt yields with a c.£58bn increase and c.£146bn reduction to the value placed on UK scheme liabilities respectively.

Charlotte Jones, Senior Consultant, said: “At the moment the changes in market conditions have slightly shortened our expectation of when schemes will meet their long-term funding targets. Whilst any rise in inflation will increase the value of the liabilities, most schemes will be protected from extreme rises in inflation as it is likely that any scheme benefits linked to inflation will be capped at certain levels.”