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The impact of reducing interest rates on pension schemes

22nd October 2024

With recent discussions about the European Central Bank (ECB) and Bank of England (BoE) cutting interest rates, pension schemes, particularly defined benefit (DB) schemes, need to evaluate the potential impact. As interest rates decline, the financial landscape shifts, creating both challenges and opportunities for pension trustees and scheme managers. In this article, Matt Hutchinson, Head of Pensions at Rowleys shares more on the impact of reducing interest rates on pension schemes.

Rising costs of annuities

One of the most immediate effects of reducing interest rates is the likely increase in annuity costs. As annuity prices rise, so too will the cost of buy-in and buy-out policies. Pension schemes seeking to de-risk by securing annuities or transferring liabilities will need to account for these higher costs when planning their funding strategies.

Impact on scheme liabilities

Lower interest rates also have the potential to increase scheme liabilities, depending on the scheme’s investment portfolio. Pension schemes that are heavily invested in government bonds, for example, may find that declining interest rates increase the present value of their future liabilities. This could widen funding gaps for schemes that are not fully hedged against interest rate movements.

Investment strategy considerations

In light of these changes, it is crucial for trustees to carefully consider their investment strategies. Schemes that are well-hedged may be able to cushion the impact of reducing interest rates on their liabilities. Conversely, schemes with more flexible investment strategies may even be able to take advantage of the lower interest rate environment by reassessing their asset allocation.

What’s driving interest rate decisions?

The BoE’s decision-making process is currently centered around three key factors:

  1. Services inflation
  2. Labour market tightness
  3. Wage growth

Services inflation has been stubbornly high, while the labour market is loosening, and wage growth is starting to slow. If this trajectory continues, the likelihood of further reductions in the bank base rate increases. For pension schemes, the timing of these decisions will be key to shaping their investment and hedging strategies in the coming months.

Steps for DB schemes

As we move into a period of potential interest rate reductions, DB pension schemes should proactively assess their hedging strategies and investment portfolios. By doing so, they can protect themselves from potential negative impacts and, where appropriate, capitalise on opportunities presented by the changing financial environment.

Disclaimer: The information in this article is for general guidance only and should not be considered professional financial advice. Trustees and scheme managers should seek appropriate advice from their pensions consultant or investment advisor before making any financial decisions.

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