The events of recent weeks have been a culmination of what has already been a volatile year in the financial markets, which has led us to reevaluate prevailing assumptions about market behaviour. As we draw breath from the recent rapidly evolving crisis in the UK gilt market, we thought it would be worth reflecting on some of these price movements and putting them into historical perspective.
UK RPI inflation
UK Retail Price Index (RPI) inflation is now at its highest level per annum (p.a.) in 40 years, as seen in Figure 1.
Figure 1: UK RPI Inflation (p.a.)
10-year gilt rate
At the start of the year, insurers that rely on the Standard Formula Solvency II capital model specified by the regulator would have calculated solvency capital assuming an increase in interest rates over a one-year time horizon with a 1-in-200 probability as +1.0%.1 The UK gilt rate increased by +1.0% by the end of May and was +2.0% by mid-September. Then, with the aftermath of the UK government’s “mini-budget,” at one point it reached +3.5%. Therefore it was 3.5 times the level of move used in some insurer capital models at the start of the year.
Figure 2: 10-year gilt rate
GBP vs. USD exchange rate
Already rapidly declining this year, the GBP to USD exchange rate has reached its lowest ever quarter-end level (according to Bloomberg data),2 as shown in Figure 3.
Figure 3: GBP X USD exchange rate
Equity and government bond correlation
Prices of equities and UK government bonds have both fallen steadily this year, and the two asset classes have been pretty well correlated as a result. See Figure 4.
Figure 4: 2022 year-to-date performance – Global equities vs. UK gilts
FTFIBGT = FTSE Actuaries All Duration TR. NDDUWI = MSCI World TR.
Reflecting on all this, it is hard not to argue that we may now be witnessing the widely talked about transition from the “Great Moderation” to the “Great Volatility”3—i.e. a potential regime shift in economic variables, and a potential scope for increased volatility in economic variables. Part of this is driven by governments at historic levels of indebtedness after the pandemic, which has limited their ability to follow credible expansionary policy while making it challenging for central banks to tame both inflation and maintain financial stability simultaneously.
More broadly, as we look to the future, a systemic wholesale change of the global economy is likely required in the coming decades to achieve the challenging task of delivering on net zero initiatives. Increasingly, this is going to demand a need for an exponential rate of scaling innovation, technology, implementation and policy change, to address the exponential increase in impacts from climate change and biodiversity loss. A fast-changing world is only going to amplify the scope for more unexpected events in future that may go beyond the measures of risk that we have traditionally relied upon, as well as the potential for more regime shifts to come.
Impact on retiring defined contribution scheme members
Recently, the focus has been on how volatility has exposed challenges around managing the liquidity risk associated with the liability-driven investment (LDI) strategies used by many defined benefit (DB) pension schemes. However, what about those retiring in defined contribution (DC) schemes?
The Financial Conduct Authority (FCA) recently released its latest data on how people are accessing and using their pension pots. There is little change in the trend of recent years, with most retirees opting for drawdown over an annuity (or full encashment) at retirement. With the significant increase in interest rates this year, annuities could make a resurgence in months to come, though buyers need to consider the elevated inflation risk now. Judging whether current annuity rates offer sufficient compensation is not an easy task. However, the level of income provided isn’t the only driver behind annuity reluctance. Psychologically, going from full to limited access on what is potentially one of your largest sources of accumulated wealth, can be a difficult thing to do. It is reasonable to expect that income drawdown is likely to be the dominant decumulation choice for a while.
Figure 5: Annual retirement flows
Source: 2021-2022 FCA data.
Drawdown is essentially an investment product, with many invested in a diversified multi-asset strategy. Bringing this back to the extraordinary market events of this year, the increasingly positive correlations seen between most asset classes, and more specifically with UK government bonds, is leading to heightened concern to retirees—the large market moves will, within a short space of time, lead to significant reductions in what income is deemed affordable from a retirement planning perspective through very short-term changes to what is affordable for them in retirement.
To illustrate, let’s compare how the impact of market volatility has progressed through some historical market events that involved a 20% fall in equities, considering a 50% equity/50% bond fund, and a 4% sustainable income level (kept constant with time). We compare the level of income implied with the sustainable rate and fund value at the start of the period, and reevaluate at the end of the period, assuming that the retiree is still approaching retirement. The reduction in income is then expressed in terms of number of years of original income.
Figure 6: Comparative loss of income
|Year||Period||Equity movement||Gilts movement||50:50 fund movement||Estimated loss of income|
Equities = MSCI World total return. Gilts = FTSE UK Actuaries All Duration total return.
As we can see, loss of income is much accentuated this year compared with previous crisis events. Generally, most retirees will have the state pension to cover a large part of their basic spending, and so a DC pension may largely be used to cover “lifestyle spending.” However, the market falls this year—in this specific example—equate to 4.4 years of lifestyle spending needs that have potentially been lost, if markets don’t recover. It is likely that markets will recover at some point, although no one can predict exactly when, and a market recovery doesn’t necessarily negate the concerns retirees may have before the recovery is realised.
Who has been impacted more by this market crisis: DC or DB pension scheme members?
Whereas there has been much attention on how DB pensions have managed their way through the current crisis, potentially we should also be just as concerned for the impact on DC pension scheme members. We have gone from a framework ensuring that the vast majority of pensioners go into some form of insurance product at retirement (i.e., an annuity) to protect themselves from risks to significant changes in lifestyle in retirement, which are too challenging for them to perceive and to manage, to a framework where we now largely have members going into what is essentially an investment product at retirement (i.e., drawdown) and asked to manage a set of complex risks themselves, with (so far) little in the way of support. With the balance between improved funding ratios and addressing a liquidity squeeze on LDI, most DB pension scheme members ultimately may not feel any impact on their end benefits from the big market movements this year. The typical DC pension scheme member approaching retirement, in comparison, may see some tangible impacts on what is now affordable in retirement—assuming that markets do not rebound quickly in the months to come.
Should we not swing the pendulum back to decumulation being largely a domain for “insurance-like products” (although not necessarily an annuity), to help protect members against such risk and uncertainty? As we have seen, these risks can arise rapidly and unexpectedly. “Insurance-like” products may not necessarily be in the traditional sense of what we see on the market, but may include new products that aim to strike a balance between offering some level of protection without sacrificing too much flexibility or markedly increasing costs.
Regulation is not going to change overnight. However, pension schemes do still also have influence through the choices they can offer to their members. Ultimately insurance techniques already exist to help spread risk—either between generations, between collective pools of lives or out to the capital markets (to less risk-averse investors). Such techniques could be combined to offer more flexibility than the traditional annuity, even before collective defined contribution (CDC) pension schemes finally arrive in the UK. Insurance, and the transfer of risk, does come at a cost. But hopefully this market crisis helps to highlight that, in decumulation, focusing on end benefits and the stability of these benefits is likely more valuable to your average retiree, than focusing purely on providing optimal investment performance for minimal cost.
1 Although we note that those using an Internal Model would have likely set capital based upon a different assumption for an extreme movement in interest rates. The increase in interest rates assumed by the standard Solvency II model would have also likely changed during the year.
3 For example as quoted by Isabel Schnabel of the ECB Executive Board: Monetary policy and the Great Volatility (europa.eu).