UK DB Funding Ratios: The Impact of the COVID-19 Pandemic - State Street Global Advisors

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Liability-Driven
Investing               UK DB Funding Ratios: The Impact
June 2021
                        of the COVID-19 Pandemic
                        Altaf Kassam, CFA
                        EMEA Head of Investment Strategy & Research
                        Daoyu Chen, CFA
                        Senior Investment Strategist

                        The UK has made great progress to overcome the
                        COVID-19 pandemic, but the fight is far from over.
                        Effective vaccines have given hope just as mutant
                        strains present new challenges. The first UK lockdown
                        in response to the pandemic began in March 2020. How
                        have UK Defined Benefit (DB) pension schemes fared
                        since then?

                        To answer that question, we examine the evolution of Section 179 (s179) funding levels from the
                        Pension Protection Fund (PPF). This looks at the universe of UK private DB schemes eligible for
                        entry into the PPF and is based upon compensation paid by the PPF, which may be lower than full
                        scheme benefits. To set the scene, at the end of 2019, the aggregate scheme funding ratio (the
                        ratio of a scheme’s total assets to liabilities) was 99.4%.

The Evolution of        Financial markets began to reflect concerns about the prospect of the global spread of Covid-19
Funding Levels During   as early as the second half of January 2020. This intensified in February and March as cases
                        surged globally and economies started to lock down.
the Pandemic
                        In the UK, expectations grew that the Bank of England’s Monetary Policy Committee (MPC)
                        would need to cut policy rates to mitigate the impact of the inevitable and catastrophic economic
                        downturn that would follow a pandemic-induced lockdown, which was ultimately announced on
                        23rd March. By the end of March 2020, the MPC had cut base rates twice, from 0.75% to 0.25%
                        and then to 0.1%, where it currently stands. The MPC also expanded asset purchases of UK gilts
                        and sterling non-financial investment-grade corporate bonds by £200 billion.

                        The result was that yields collapsed, along with equity markets. As shown in Figure 1, together,
                        these two developments were disastrous for UK DB pensions. With the present value of liabilities
                        rising and asset values falling, aggregate DB schemes’ deficits widened dramatically to lows of
                        92% by July 2020.
Figure 1
Evolution of PPF 7800 s179
Funding Ratio and Net Deficit
110     Percent                                                                                                                     (£Bn)   150

                                                                                                                                            100
105
                                                                                                                                            50

100
                                                                                                                                            0

                                                                                                                                            -50
 95

                                                                                                                                            -100
 90
                                                                                                                                            -150

 85                                                                                                                                         -200
          Jan                  May              Sep                 Jan         May               Sep              Jan             May
         2019                  2019            2019                2020         2020             2020             2021             2021

      Net Deficit (£Bn, RHS)          Funding Ratio

Source: PPF as of 31 May 2021.

                                         Since then, funding levels have steadily risen, accelerating through the first quarter of 2021 as
                                         vaccine optimism has taken hold. The latest reading from the PPF 7800 index shows funding
                                         levels back at 106% as at the end of May 2021, levels last seen in May 2008, just before the
                                         onset of the 2007–8 global financial crisis.

Delving Deeper:                          So, what has driven the renewed health of UK DB pension schemes? As we can see in Figure 2,
The Evolution of                         once the funding ratio dropped into the depths of the pandemic around end of February 2020,
                                         driven by ballooning liabilities, it then hovered around the 95% level for the rest of the year, as
Assets vs. Liabilities
                                         asset prices bounced back but liabilities also kept rising. The lift-off of the funding ratio from the
                                         end of 2020 to date has been driven by a precipitous fall (c. -12%) in liabilities, while assets have
                                         only fallen 2.5%.

Figure 2
Evolution of PPF 7800 s179
Funding Ratio vs. Aggregate
Assets and Liabilities
110     Percent                                                                                                                    (£Bn)    2,000

                                                                                                                                            1,950
105                                                                                                                                         1,900

                                                                                                                                            1,850
100
                                                                                                                                            1,800

                                                                                                                                            1,750
 95
                                                                                                                                            1,700

 90                                                                                                                                         1,650

                                                                                                                                            1,600

 85                                                                                                                                         1,550
          Dec  Jan  Feb  Mar  Apr  May  Jun  Jul  Aug  Sep  Oct  Nov  Dec  Jan  Feb  Mar  Apr May
         2019 2020 2020 2020 2020 2020 2020 2020 2020 2020 2020 2020 2020 2021 2021 2021 2021 2021

      Aggregate Assets (£Bn, RHS)           Aggregate Liabilities (£Bn, RHS)     Funding Ratio

Source: PPF as of 31 May 2021.

                                         UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                2
Figure 3 plots the recent evolution of funding ratios vs. the UK 20-year real yield. We see
                                        co-movement from the start of 2019 throughout the pandemic. However, over 2021 to May,
                                        we have seen scheme assets outperform liabilities by around 10%, providing a strong motivation
                                        for schemes to de-risk from their growth assets into their matching portfolios.1

                                        Despite this, it is clear that some of the interest rate and inflation risk from aggregate liabilities
                                        remains unhedged for UK DB schemes. Given the improvement in funding ratio, there is room
                                        for further de-risking in order to lock in the better funding levels and increase in yields from the
                                        pandemic lows.

Figure 3
Evolution of PPF 7800 s179
Funding Ratio and
20-year Real Gilt Yield

110     Percent                                                                                                                    Percent   -1.5

                                                                                                                                             -1.7
105

                                                                                                                                             -1.9
100
                                                                                                                                             -2.1
 95
                                                                                                                                             -2.3

 90
                                                                                                                                             -2.5

 85                                                                                                                                          -2.7
        Jan                   May             Sep              Jan               May               Sep               Jan               May
       2019                  2019            2019             2020              2020              2020              2021              2021

      20Y Real Yield (RHS)          Funding Ratio

Source: PPF as of 31 May 2021.

Liabilities: RPI and                    One endogenous event in the last year which had the potential to affect pension scheme
Negative Rates Focus                    liabilities was the outcome of the UK Retail Price Index (RPI) consultation, which sought to
                                        implement changes in the RPI2 methodology. Changes to the RPI methodology can directly
the Market’s Attention
                                        impact DB schemes on two fronts: changing the value of liabilities linked to RPI, as well as
                                        adversely impacting assets linked to RPI - such as index-linked gilts used to hedge those
                                        liabilities. The result of the consultation, announced on 25th November 2020 had two
                                        main elements:3

                                        • The RPI methodology will change starting from 2030.

                                        • The growth of RPI will be aligned with that of CPIH (Consumer Prices Index including owner
                                          occupiers’ housing costs) with no adjustment spread, or compensation to be offered to the
                                          holders of index-linked gilts.

                                        UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                3
Figure 4
Timeline of the Consultation on
the Reform to RPI, Overlaid on
RPI Swap Level
4.0    Percent
3.8                        Announcement
                                                                                                                Closure            Outcome
3.6                                                                                      Extension
                                                                             Launch
3.4
3.2
3.0
2.8
2.6
2.4
2.2
2.0
        Dec                 May                   Sep                  Jan                   May                   Sep                  Jan                     May
       2018                2019                  2019                 2020                  2020                  2020                 2021                    2021

      Events            10Y RPI Swap %              30Y RPI Swap %              50Y RPI Swap %

Source: Bloomberg, State Street Global Advisors Calculations based on A Response to the Consultation on the Reform to Retail Prices Index (RPI) Methodology.
Data as of as of 31 May 2021.

                                          Figure 4 shows market movements together with key events around the consultation period.

                                          More recently, inflation expectations have continued to move up as markets price in a post-
                                          lockdown bounce, materially increasing at the long end, and looking very rich considering the
                                          proposed RPI reform.

                                          The consultation outcome resulted in the removal of uncertainty, which we believe released pent-
                                          up demand for inflation hedging, leaving the long end of the inflation curve more expensive than
                                          previously. This pent-up demand has also been met with a lack of significant supply given the
                                          UK Treasury’s reluctance to increase its sensitivity to inflation, in contrast to the temptation for
                                          the Debt Management Office (DMO) to issue inflation-linked gilts at relatively attractive levels.

                                          One positive side effect of the ramp-up in UK inflation expectations has been the market’s
                                          dismissal of the possibility of negative policy rates in the UK. As the pandemic hit in 2020,
                                          investors began pricing in the expectation of negative rates in the near term, which enabled the
                                          DMO in May 2020 to issue its first ever negative-yielding nominal gilt, the July 2023 at -0.003%.

                                          The market’s suspicion was justified shortly afterwards as the Governor of the Bank of England
                                          acknowledged that the Bank was reviewing the option of negative policy rates. However, as
                                          vaccine optimism has surged, the market’s focus has shifted to possible future policy tightening,
                                          rather than loosening. At the same time, negative policy rates are set to become a feasible tool in
                                          the monetary policy toolkit in August 2021 or later. Whether they will be deployed as a policy tool
                                          will depend on the outlook for the UK economy and the merit of negative rates versus other tools
                                          available to the MPC at that point in time. For more information, please read our article.

                                          UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                               4
Assets:                                     The 2007–8 global financial crisis and its aftermath saw the US dollar (USD) gain a firm
Home Bias Remains                           ascendancy in the global currency pantheon, as well as an increasing weight for USD assets
                                            in global equity and fixed income benchmarks. Together, these trends provided a windfall for
                                            UK investors with overseas asset allocations, as an increasing part of their portfolios’ returns
                                            were flattered when measured in a weakening domestic currency.

                                            Whilst a domestic bias in the fixed income portfolio can be rationalised to hedge liabilities linked
                                            to domestic rates and inflation, it makes less sense in an equity portfolio. Nevertheless, the PPF
                                            data shows a persistent, albeit reducing, home bias4 in UK DB pension schemes’ equity holdings.

                                            As Figure 5 shows, the current average allocation of 13.3% within the total equity portion of
                                            investment portfolios still constitutes a large overweight to domestic equities given that the
                                            UK’s weight in global equity indices currently ranges from 3.5–4.5% (4.3% of MSCI World and
                                            3.8% of MSCI ACWI as of 31st May 2021; Source: Bloomberg).

Figure 5
Evolution of Home Bias
in Reporting PPF
Pension Schemes

2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010

       0             10              20              30              40             50              60              70              80              90     100
       % of Equity Portfolio in UK vs. Overseas Equities

     UK              Overseas

Source: PPF as of 31st March 2021.
Methodology note: Total equity includes “quoted UK”, “quoted overseas”, and “unquoted private”. To arrive at a conservative home bias estimate, we count
“unquoted private” as being non-UK.

                                            One often-cited reason for retaining an equity home bias is to reduce the effects of foreign
                                            currency fluctuations, but this bias has come at the expense of risk-adjusted returns. Figure 6
                                            below shows this by first plotting the returns for a GBP investor over increasing time horizons for
                                            investments in:

                                            1 UK equities

                                            2 World ex-UK equities

                                            3 World ex-UK equities hedged back to GBP

                                            UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                            5
Figure 6
Returns Over Increasing
Time Horizons to UK and
World ex-UK Equities
         Annualised Return (%)
 35

 30

 25

 20

 15

 10

  5

  0

  -5
                 1               2                3                5              10         15         20            25            30
         Time Horizon (Years)

       MSCI UK            MSCI World ex-UK (GBP)               MSCI World ex-UK GBP Hedged

Source: Bloomberg, State Street Global Advisors calculations as of 31 May 2021.

                                          Over each time horizon, UK equities have underperformed against overseas equities, to varying
                                          extents, but at all horizons by greater than 3.5% annualised, even over the last 30 years. Past
                                          performance is not an indication of future performance, and our own long-term asset class
                                          forecasts actually predict outperformance for UK equities over the medium term.

                                          However, historical results are clear on the long-term underperformance of UK equities, and
                                          also that currency hedging has had little effect on returns, discrediting the persistent equity
                                          home bias in UK DB pensions.

                                          What is also apparent is that recent GBP strength — reflecting renewed optimism in the
                                          UK economic recovery and the passing of Brexit — has seen hedged returns strongly
                                          outperform. State Street’s currency strategists continue to see ample upside in GBP, which
                                          leads us to recommend UK investors to continue hedging their overseas investments.

                                          At the same time, the volatility analysis in Figure 7 shows that while hedged indices have proved
                                          more volatile over the near term, the volatilities of the three investments are very comparable
                                          over longer horizons. In short, there is no return or risk justification for home bias, and the
                                          availability of currency-hedged overseas equity investments makes the transition to a hedged
                                          portfolio easy.

                                          UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                           6
Figure 7
Volatility Over Increasing
Time Horizons to UK and
World ex-UK Equities
        Annualised Volatility (%)
 25

 20

 15

 10

  5

  0
                1               2                 3                5              10         15         20            25            30
        Time Horizon (Years)

      MSCI UK             MSCI World ex-UK (GBP)               MSCI World ex-UK GBP Hedged

Source: Bloomberg, State Street Global Advisors calculations as of 31 May 2021.

Conclusion                                Since the UK’s first lockdown in March 2020, private sector UK DB funding levels have
                                          experienced great volatility, with most of the movement driven by changes in aggregate liabilities.
                                          Our observations of the evolution of funding ratios based on PPF data is suggestive of de-risking
                                          activity, and this corroborates what we have observed during our client engagements.

                                          However, we can infer from the breakdown of changes in aggregate assets vs. liabilities that there
                                          remain outstanding unhedged liabilities, and with funding ratios having improved recently, there
                                          is further room for schemes to de-risk from their growth assets into their matching portfolio in
                                          order to lock in the better funding levels and increase in yields. We stand ready to assist schemes
                                          in these endeavours.

                                          On the liabilities side, events that have focused the market’s attention have been the UK RPI
                                          consultation and the ability to use negative policy rates by the Bank of England. The outcome of
                                          the UK RPI consultation removed uncertainty, released pent-up demand for inflation hedging,
                                          and, given the lack of supply, left the long end of the inflation curve more expensive than before.

                                          Whilst the possibility of negative policy rates dragged expectations of rates lower during 2020,
                                          the market’s narrative has now squarely flipped to one of recovery and reflation. On the plus
                                          side, the resulting moves higher in yields have had a favourable impact on the valuation of
                                          scheme liabilities, but matching portfolio allocations have generally fallen in value, apart from
                                          inflation-linked gilts.

                                          In the growth portfolio, equities have rebounded strongly since the depths of the pandemic, but
                                          home bias remains a long-term drag on returns and a lack of currency hedging has been a near-
                                          term headwind. UK schemes should continue to reduce their home bias, while at the same time
                                          hedging the currency risk in their portfolios.

                                          UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                             7
Sources    Download the Purple Book 2020 (ppf.co.uk).

           Flows & Liquidity: Pension Funds’ High Incentive to De-risk. Tue Apr 20, 2021 (jpmorgan.com).

           Bank of England Paves Way for Negative Interest Rates | Interest Rates | The Guardian.

           State Street Global Advisors’ LDI Monthly Report.

Endnotes   1   Note that the PPF updated its valuation assumptions           3   For more information, please read our paper
               guidance for s179 valuations when calculating the PPF             ‘UK Responds on RPI Reform’.
               7800 liabilities. The impact of the change in the actuarial
               assumptions as at 31 May 2021 was an improvement              4   Home bias refers to the phenomenon of investors
               of the funding ratio by 2.8 percentage points and an              disproportionately allocating their investment portfolios
               increase of £46.5 billion in the aggregate funding                to domestic assets.
               position. See PPF 7800 Index for more details.

           2   The Retail Prices Index (RPI) is defined as an
               average measure of change in the prices of goods
               and services bought for the purpose of consumption
               by the vast majority of households in the UK.
               Source: RPI Data (dmo.gov.uk).

           UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                                     8
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                                                 UK DB Funding Ratios: The Impact of the COVID-19 Pandemic                                                                                                 9
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