The Effect of Expected Interest Rate Increases on Defined Benefit Pension Transfer Values
After the Brexit vote in 2016, the Bank of England reduced its benchmark Bank Rate to 0.25%. This was decided upon by the Monetary Policy Committee (MPC) to limit the risk of the recession resulting from the decision to leave the EU.
On the 2nd November 2017, we witnessed the first Bank Rate increase in a decade, indicating the start of a gradual tightening process on monetary policy. The rate increase followed an extended period of high inflation due to a weak sterling and high energy prices. This is extremely welcome news for savers and puts slightly more pressure on borrowers.
Financial markets predict a rise to just above 1% over the next three years, with roughly a 50-50 chance that the MPC will vote to increase the bank rate to 0.75% in May. Gertjan Vlieghe, an external MPC member, thought that this was an underestimate and predicted that the rates would rise above 2% in the same period.
With regards to defined benefit pensions, the increasing interest rates will have an impact in a variety of different ways.
First of all, it will affect the price of gilts. Investing in gilts is often a default investment for pension scheme members that are approaching retirement. These funds are attractive due to their relatively low risk. However, with increasing interest rates, demand for gilts declines. This is because their pay-out may not beat rates found in a savings account and is not good news for pensions that are invested in gilts, as their value will fall. Make sure that you understand where your pension is invested so that you don’t fall into this trap.
In addition to this, increasing interest rates would likely lead to lower pension scheme deficits. Nevertheless, any improvement in funding will have a negligible effect on the deficit as many schemes still contain significant levels of investment risk. An explanation of the defined benefit scheme deficits can be found here.
Due to these large liabilities resulting from the extended period of low-interest rates, defined benefit pension schemes have been offering transfer values that are 30 or 40 times their projected pension income.
However, these offers are likely to be short-lived as they will fall as interest rates rise. Those that are considering their options may wish to take impartial advice on the points for and against a transfer as a matter of urgency.