What lies ahead for housing associations with pension obligations?

Rising interest rates and corporate bond yields

What many thought was a significant spike in interest rates at 31 March 2020 at the start of the pandemic is now dwarfed by the increase in yields seen since March 2022, driven in part by the autumn Mini Budget. 

Liability valuations for funding purposes measured with reference to gilt rates have improved significantly and FRS 102 positions measured with reference to high-quality corporate bonds have followed suit. 

FRS 102 discount rates adopted at 31 March 2023 are expected to be over two per cent higher than at 31 March 2022. The gap will be even higher for some housing associations with assumptions specific to their own population and circumstances.

Short-term inflation shock

The rising cost of living over the year and the short-term inflation ‘shock’ will offset the liability reduction from interest rate rises to a smaller degree.

LGPS pensions in payment and in deferment are receiving a full 10.1 per cent Consumer Price Index increase over the year. (The majority of SHPS and other trust-based pensions are currently capped to a lower level). 

However, long-term inflation expectations from 31 March 2023 remain relatively stable and are in fact now below the three per cent per year seen at 31 March 2022. 

The impact of ‘LDI’ hedging strategies on funding positions

One relevant point this year is how many pension schemes have introduced ‘liability-driven investment’ or ‘LDI’ strategies in recent years. This is aimed at matching asset levels to liability measures through the hedging of interest rates and inflation.

Interest rates can of course be hedged by investing assets directly in bonds, but LDI uses derivatives to provide leverage. 

This allows continued investment in a range of return-seeking assets while at the same time also hedging more fully against bond interest rates and inflation.

SHPS has had an LDI strategy in place covering all of its liabilities. LGPS funds have not.

LDI works well to protect against volatility in bond yields and inflation. However, there have been two particular impacts seen in practice in these schemes over the past year.

First, when interest rates rose by so much and so quickly after the government’s Mini Budget in autumn 2022, many pension schemes with LDI strategies in place found themselves unable to provide the collateral needed to continue their hedging position. This drove up gilt yields even further and started a spiral that only stopped with Bank of England intervention. 

Schemes as a result may have lost their hedge and in any case have had to review and readjust their position with a knock-on impact on funding position.

Second, the rise in interest rates over the year has led to a much-improved funding position for schemes without interest rate hedging, such as the LGPS. 

On the other hand, the full extent of these improvements are not reflected in schemes that have LDI in place, albeit an improvement may have come out of the size of scheme reducing overall.

Why specific circumstances matter

On the asset side, those invested in bonds will have reduced over the year proportionately with liability measures, whilst assets invested in equities and other return-seeking investment classes have broadly retained value. 

LDI hedging strategies can leverage up the impact of interest rate changes on assets to try to match the impact on liabilities. While the LGPS does not employ this approach, SHPS and other TPT schemes generally do. 

On the liability side, there need to be assumptions for future experience that are informed, but not explicitly set, by the accounting standards. 

Therefore, the resulting position for a particular housing association depends heavily on scheme specifics and assumptions chosen. 

Overall, it is the responsibility of an organisation’s directors to take a judgement on accounting assumptions and treatments suitable for its particular scheme and circumstances.

And auditors are increasingly asking for an independent review and evidence base to do this where deemed material.

There is a lot to think about when it comes to reflecting your pension scheme appropriately at the 2023 year end for accounting purposes.

But taking the time to understand the underlying position and your own population profile can only help in making any strategic decisions.

 
Katy Taylor, social housing lead, Isio