UK Defined Benefit (DB) schemes have over £1 trillion of unhedged interest rate exposure, according to Hymans Robertson, the leading independent pensions and benefits consultancy. This is despite the value of assets held in bonds nearly tripling over the past decade.

Commenting, Jon Hatchett, Head of Corporate DB at Hymans Robertson, said:

This underlines the need for schemes to understand what their biggest risks are and manage these strategically. Risks have not been paramount in people’s minds and companies continue to foot the bill for this oversight. In the FTSE 350 alone, companies have paid in £250bn to try and plug funding holes since the start of the millennium yet deficits have remained persistently stubborn. The deficit for the FTSE 350 has gyrated between £110bn and £40bn over the course of 2015 alone, and was £55bn at the year end. The industry has spent far too much time debating what it “expects” to happen, and far too little time focussing on what might happen. It’s noteworthy that the three big positions taken by most schemes since the start of the millennium have backfired: equities are at half the level expected in 2000, interest rates have increased liabilities by over 50% and continued rises in longevity have added a further 10-15%. Risk management needs to be higher up the agenda for DB schemes. Companies are running much bigger risks in their schemes than they would ever run in their core business. The £1 trillion of unhedged interest rate exposure is just one example. While both short and long term interest rates are low by historical standards, that doesn’t mean it is a one way bet that they will rise quickly from here. Since the start of the financial crisis the majority of commentators have been talking about yields rising faster than priced into markets, and the majority have been proved repeatedly wrong. As with any risk, schemes need to assess their strength of belief in generating a return and their capacity for loss if they are wrong. From this they can right size the level of exposure they want to run.

Discussing one of the biggest un-managed risks arising as a consequence of schemes maturing, he added:

Most DB schemes are now in a situation or are approaching one where they are cashflow negative – in other words, the pensions being paid out exceed the contributions coming in to the scheme. Across the whole UK private sector DB universe, schemes are paying out around £20bn more per annum than they receive in contributions. Looking at DB schemes in the FTSE 350 specifically, half are already cashflow negative or soon will be. As such, investing in assets that will deliver the income needed to pay today’s and tomorrow’s pensioners is key. This is because cashflow negative schemes face a risk that many are not aware of. Once they are regularly drawing down, if they don’t have the assets in place to provide the necessary income streams, they run the risk of becoming forced sellers of assets. Being a forced seller of an asset with a volatile price is unattractive, as during a market slump a greater proportion of the asset base needs to be sold to meet benefits. The remaining funds then have less potential to bounce back in a market recovery. This cashflow risk should be front of mind for those responsible for DB schemes. Market volatility is an inescapable reality. Already this year we’ve seen a plunge in the Chinese stock market leading to a global equity retreat. You can’t be certain of much in markets except the fact that future prices are inherently uncertain.