The Struggle To Overcome Pension Deficits (3 min read)

Pity those poor pension fund trustees. This past week has seen the 10y gilt yield drop to around the 70bp level, its lowest since the end of Q3, 2016. Falling yields, the discount rate for a defined benefit pension fund’s liabilities, typically drives an expansion in the deficit. Some relief may come from the equity rally, but this most recent shift lower in yields must have left UK pension trustees feeling much like Sisyphus who, according to Greek mythology, would heave a large boulder up a hill, only to see it roll back down just before he could reach the summit.

Still Pension Deficits, Despite Contributions

In the same way, every time the sector gets within touching distance of balancing their assets and liabilities, a rally in the bond market seems to undermine the hard work that went in to try to get there. Years of contributions from scheme sponsors coupled with strong asset growth have failed to deliver a surplus. On the Pension Protection Fund’s (PPF) section 179 (s179) valuation basis, deficits widened back out to £70bn in May from close to flat the month before, despite an all-time high in asset values.

This will be a source of significant frustration for those schemes that have dipped back into deficit, not least because the decline in yields is being driven by offshore factors – namely the decline in Euro rates. Perhaps more telling is that the PPF numbers also show that 3,382 of the 5,450 defined benefit schemes are in a deficit to the tune of £200bn in total (Chart 1). In short, a majority of pension schemes are still struggling to close the deficit despite it being over twelve years since the Pension Protection Fund, and the levy to finance it, were set up.

De-risking Likely to Continue to Support Longer Dated Gilts

The blowout in deficits in the aftermath of the EU referendum encouraged many funds to seek to better hedge their liabilities. This has clearly had a beneficial effect as the current deficit is nowhere near as wide as the £400bn-plus deficit recorded in August 2016 when the BoE cut policy rates. This latest shift lower in rates is likely to re-sharpen the focus on de-risking. Moving to full buyout is expensive, but is the only real way that companies can be certain that the deficit issue has been ‘solved’.

Attempts by the sector to get this metaphorical boulder to the top of the hill suggest that the backdrop for the long end of the UK curve looks favourable:

1) Pressure pushing pension schemes towards buyout hints that demand for long gilts will remain strong.

2) Shorter term, summer flows typically see the longer end of the curve outperform.

3) Spreads, such as 10-30y, are directional (Chart 2) and the recent rally in 10y has left the 10-30y slope looking a little steep from a historical context (black dot). Spreads out of 10y should flatten if bonds are unable to sustain current low-yield levels and so are a way of positioning bearishly.

One note of caution, the Debt Management Office is clearly looking to capitalise on summer demand for duration and has a 30y auction scheduled for August as well as an ultra-long (+35y) syndication in September. So, there could be some supply pressures.

Defensive Trustees

In conclusion, there will be intense frustration at the most recent rewidening of the pensions gap, and it looks like the current rates environment will keep deficit reduction at the forefront of discussions between trustees and scheme sponsors. There are some indications that the health of the sector is improving. But locally, fears over BoE rate cuts and Brexit, and globally, concerns over growth, weak inflation and the restarting of asset purchases by central banks are likely to sustain the pressure to hedge liabilities. Presumably, Sisyphus is still rolling his boulder – let’s hope that the pension sector does not take quite as long to finally get its books in order.

Chart 1: Historical s179 Deficit (Surplus) for Schemes in Deficit (Surplus)

Chart 1

Source: UK Pension Protection Fund

Chart 2: UK Gilt 10-30y Spread Still Driven by Front End Pricing


Source: Macro Hive,

Jason has been a sell-side rates strategist for over 20 years. During his career, he has predominantly focused on the UK, but he also looks at markets from a global perspective. He can be reached here.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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