In recent years, the volatility of pension fund deficits has been dampened by pension fund assets behaving more similarly to pension fund liabilities. This is partly because bonds make up a bigger share of assets than a decade ago, and partly because bonds and equities are moving more closely than before. Both factors have increased the correlation of assets with pension funds’ liabilities which tend to be intrinsically bond-like. This matters because the volatility of pension deficits can affect pension fund investment decisions. Given their size, changes in pension fund asset allocation can materially affect asset prices.
UK defined benefit pension funds are large institutional investors. They hold over £1.5 trillion of assets, so their investment decisions can have a material impact on asset prices. One important factor determining these investment decisions is how well funded the pension schemes are. In aggregate, UK defined benefit pension funds’ liabilities (as measured by the Pension Protection Fund) exceed their assets – they are in deficit (Figures 1 and 2):
Figure 1: UK defined benefit pension fund aggregate assets and liabilities
Figure 2: UK defined benefit pension fund aggregate assets minus liabilities
Pension funds (the trustees and/or sponsoring companies) don’t just care about the level of the deficit, they also care about how volatile deficits are. For example, more volatile deficits could mean more volatility in the contributions that companies need to pay to top up pension funds that are in deficit.
One measure of how volatile deficits are is their variance. This can be simply decomposed into three pieces: the variance of the assets, the variance of the liabilities and the covariance of assets and liabilities:
var(Deficit) = var(Liabilities – Assets)
= var(Liabilities) + var(Assets) – 2 x cov(Liabilities,Assets)
I’ve shown this decomposition below using a twelve month rolling window of monthly data (Figure 3):
Figure 3: Decomposition of the variance of UK defined benefit pension fund deficits
Source: Pension Protection Fund 7800 Index and author calculations. Y-axis units are thousands of £s squared.
The variance of the deficit (the black line) is moderately high at the moment, though it was more than twice as high in 2012 and 2015. But the decomposition shows us interesting offsetting effects behind the total variance:
- Long-term interest rates (e.g. gilt yields) are not just low, they have been very volatile over the past year or so, falling following the EU referendum and MPC policy package, before rising in the autumn amid changing perceptions of the UK’s future trading arrangements and the US presidential election. This has pushed up on the variance of liabilities (in red).
- On its own, this would push up on the variance of the deficit were it not for the fact that the covariance of assets and liabilities (two times the negative of which is shown in green) has increased a lot too. This is because pension fund assets have become more correlated with pension fund liabilities over time (Figure 4):
Figure 4: Twelve month rolling correlation of UK defined benefit pension fund assets and liabilities
Source: Pension Protection Fund 7800 Index and author calculations.
Changes in interest rates push around the present value of liabilities, so pension fund liabilities are ‘bond-like’. Pension fund assets have become more correlated with liabilities because assets have effectively become more ‘bond-like’ too and so more similar to the liabilities. There are two main reasons for this:
1. Bonds make up a bigger share of pension fund asset portfolios
Pension funds hold more bonds and fewer equities than a decade ago (Figure 5). The increase in bond holdings includes both government bonds and corporate bonds.
Figure 5: Bonds as proportion of UK defined benefit pension fund total assets
Source: Pension Protection Fund Purple Book and author calculations.
2. Bonds and equities (which together make up around 80% of assets) are behaving more similarly than before
Having been positively correlated for most of the 18th to 20th centuries, bond and equity returns became negatively correlated in the early/mid 2000s. But more recently, the correlation of bond and equity returns has ventured back into positive territory – e.g. here is a one year rolling correlation of weekly total returns on the FTSE All Share with sterling investment grade corporate bonds (orange) and gilts (blue) (Figure 6):
Figure 6: 52-week rolling correlation of equity returns with corporate bond and gilt returns
Source: Bloomberg and author calculations.
Without these two factors, pension fund assets and liabilities would be less correlated and deficits would be more volatile. Such volatility, if sustained, could have affected pension fund investment decisions. For example, pension fund sponsors might respond to volatile deficits by investing in more bonds and fewer equities to match their liabilities better and reduce the risk in their portfolio. If done in sufficient scale, this could put further downward pressure on bond yields.
Matt Roberts-Sklar works in the Bank’s Capital Markets Division.
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