What’s £50 billion between friends?
Judging by a series of recent events in sterling markets, you could be forgiven for thinking that £50 billion was now a meagre rounding item:
• The Chancellor surprised markets at the March 2021 budget to the tune of £50 billion higher borrowing. As a result, the Debt Management Office (DMO) supply remit for fiscal year 2021/22 was higher than expectations at £295 billion. Or as my colleague Mitul Patel wrote at the time, after the biggest gilt remit ever…the second biggest gilt remit.
• Fast forward just over a month and the release of the March public finance data was far better than what had been priced into the budget forecasts, which meant that funding for fiscal year 2021/22 could be revised lower by… around £50 billion (£43 billion, strictly speaking!). That meant a gilt supply remit of £253 billion, so closer to the pre-budget forecasts.
• The Pension Protection Fund (PPF) announced at the end of April that it would be proceeding, in line with assumptions, with changes in a recent consultation for its defined benefit (DB) pension scheme liability valuation methodology. In aggregate, it estimated the change would reduce deficits by (you guessed it) £50 billion.
What is the significance of these events for LDI investors? Read on, for they are more connected than you might think.
£50 billion less borrowing
First, gilt supply is best shown by the table below, where we compare 2021/22 (and revision) to previous years.
Even after the April revision, it is clear that 2021/22 supply remains the second highest ever. However, when we consider Bank of England asset purchases, the net supply remit for the year starts to look far less dramatic and, if anything, is fairly middle of the road. In fact, the bigger story is arguably 2022/23, when the Bank of England should be buying far fewer gilts and, as a result, the net supply for the market to absorb will be larger than in all preceding years.
How might this play out and, perhaps just as interestingly, when will this be a greater focal point for markets? Currently it is still some time away and we may see further downwards revisions to the gilt remit if the Bank of England’s more optimistic growth forecasts (versus the Office for Budget Responsibility) prove to be correct. We look at this in our recent post, Gilt market outlook: all that glitters.
£50 billion DB deficit reduction
Moving onto the PPF assumption change, this (amongst other things) moved longevity assumptions from 2016 tables to 2019 tables, resulting in an estimated reduction in deficits (and overall liability valuations) by around £50 billion. So, having decided to go ahead with the changes, are we about to see the same move made by pension funds in their own liability valuations?
When considered through the lens of net gilt supply, this would have the potential to be highly significant if it meant that pension funds no longer needed £50 billion of hedging.
In practice, we see much of this impact as already having taken place, because pension funds are (and have been) updating liability benchmarks over a number of years. Since the release of the 2018 tables (in March 2019), changes to longevity have been modest, so any updates which use those tables or beyond will already have allowed for the reduction in future improvements in mortality. (Having said all this, we still don’t know what will happen to longevity in the future as the 2020 tables, released in March 2021, stated it was too early to make significant changes).
Not all pension schemes will have updated liability benchmarks and it is difficult to say what remains. We have recently estimated something closer to an implicit reduction in hedging demand this year, due to longevity, at £13 billion (so far lower than £50 billion).
Bringing this full circle, we should remember that a great deal of hedging demand from pension funds comes in the form of index-linked gilts. Bearing in mind that index-linked gilt supply is only likely to be around £30 billion for 2021/22, what we do know is that structural hedging demand for inflation (running at say 4%) can certainly surpass what is on offer from the DMO by some margin.
 Produced by Continuous Mortality Investigation Limited (CMI) for modelling future mortality improvements. The CMI is wholly owned by the Institute and Faculty of Actuaries.
 The analysis was September 2020 when the PPF total liability valuation was around £1.9 billion.