Defined benefit pension transfers: lessons learnt

Like Comment

The dangers of low discount rates and large pension liabilities is not unique to the UK. In Germany this situation has been turbo-charged. While companies in the UK have largely stopped allowing the accrual of new benefits, Germany has many more open schemes. While UK companies have actively encouraged members to transfer out, Germany is not as far down this road. To advisers tasked with assessing the merits of these transfers on an individual level, part of what needs to be accounted for is the ability of a scheme to meet its liabilities and the effect that could have on the viability of the parent company. We thought it might help to look at more extreme example and Germany is certainly that.

It’s not a great time to be a German pension fund manager. Interest rates in the Eurozone are nailed to the floor. This has meant yields (the interest received yearly) on loaning money to the German government (via ‘bunds’) have consistently hit all-time low after all-time low.

This hits our German pension fund manager in two ways – first, bunds are unlikely to be of much help in the search for return-generating (or interest-yielding) assets. Second – and more importantly, the current available bund yield is the anchor for the ‘discount rate’ used in calculating pension liabilities. Say what? I’ll do my best to simplify below.

Imagine I bought shares a long time ago in a company called Berkshire Hathaway and now I’m a multi-millionaire. I’ve asked Heesen to build me a 100ft yacht – they are going to call mine Pay-out (creative, I know). We have agreed that I will purchase it on 20 January 2030 at a price of £10 million once it has been built. Unfortunately, I only have £5 million in my bank account today – so in order to make sure I can pay the £10 million for Pay-out I will need to turn my £5 million into £10 million by 20 January 2030. Luckily, interest rates available at my local bank are exactly 7.2%, and 7.2% annualised over ten years will double my initial investment! My future liability is effectively zero (the difference between what I have promised to pay and what I can reasonably expect to have in 10 years’ time). Unfortunately, the bank cuts interest rates from 7.2% to just 4.15% the next day. That means my £5million deposit at my local bank will only generate £7.5 million in ten years’ time – I will not have enough to pay for Pay-out! I now have a liability of £2.5 million (25%) assuming the interest rate stays at 4.15%. There are only three things I can feasibly do to make up the difference –

  1. Invest in riskier assets (hoping to make a better return)
  2. Ask someone else for money
  3. Stick my head in the sand for ten years (ie denial)

The interest rates in the yacht analogy represent the ‘discount rate’ – a reasonable guide for the returns an investor can expect over a certain time period, and therefore a key component for calculating future liabilities. German pension funds use bund yields as the basis for this. The discount rate based on this currently sits at 1.97[1]. The conundrum German pension fund managers face is how to ensure they can deliver on their pay-out promises to pensioners. Their liabilities (the gap between what they have promised and what they can reasonably expect to deliver) continue to grow as the available yields on German bunds continue to nosedive. So what can they do?

German 10 year bund yield (monthly)

German 10 year bund yield (monthly)

Source: Bloomberg

Chase the rainbow (take more risk)

German pension funds have historically maintained cautious asset allocations, which usually meant a lot of government bonds. Yet recent data[2] has shown a number of pension funds moving into high-yield credit (‘junk bonds’), emerging market debt, infrastructure financing and collateralised loan obligations (CLOs). 

The issue here is that when naturally cautious investors are pushed into the next rung on the risk spectrum, they bid up those assets. That in turn makes those valuations fragile and compromises the ‘cautious’ quality of those assets.

Stick your head in the sand (denial)

The HGB (German Pension Fund rulebook) discount rate is calculated by taking the seven year historical average of a mixture of German bund yields and some eurozone investment-grade corporate bond yields. There were fears in 2015 that when the seven year trailing window no longer took into account the higher rates available before the financial crisis of 2008, pension liabilities would soar. So – the HGB code was updated, extending the historical window to ten year[3]. The justification was to create a more ‘representative’ discount rate, but if the rates never go back up it only postpones the inevitable.

Ask someone for money 

The responsibility for the liabilities of a German pension scheme ultimately lies with either the corporate sponsor (i.e. the employer) or the government. As of 2017, the pension schemes of the companies listed in Germany’s DAX stock exchange had an average funding level of 65%. That compares to 89% in Japan, 92% in the UK and 72% in the USA[4]. The worst part is that pension liabilities will increase most in an environment where the economy is slowing. In a recession, bund yields will likely drop even further as the ECB lowers rates to stimulate the economy. Just at the point cash is tight, companies could be threatened by the need to pay up for their growing pension liabilities!  In the UK it is exactly this last point which has incentivised big companies to encourage members to transfer out of their pension schemes. Deficits might seem high now, but if interest rates stay low and asset prices plummet in the next recession, the funding gap could look even worse. If that impacts the solvency of the underlying business, then having transferred your pension could look very sensible. On the other hand, if a period of structurally higher inflation emerges, it might look quite foolish to have given up an inflation-linked income, even considering historically high transfer values. 

Want to hear more from Ruffer?

Get in touch with Charles Lynne, one of our Investment Directors by calling him on +44 (0)20 7963 8222 or alternatively you can email him at

We are also running some regional seminars to discuss the implications investors face on the front line of investing in the 2020s. As we enter a new decade, the investment environment has never been so complex: climate change; populism; a new Cold War; geopolitical instability; historic indebtedness; financial repression; the distortions wrought by low interest rates; rapid technological and social changes. These are just a few of the tectonic shifts feeding into markets. Investors also face fundamental changes in the nature of markets themselves, particularly with the rapid growth of low cost passive tracker funds.

To join the debate, register for one of our seminars by clicking here.

1. Mercer Germany  
2., April 2017, ‘Asset Allocation: Uncertainty focuses minds’   
3. Mercer Germany  
4. World Economic Forum, 

Ruffer is a limited liability partnership, registered in England with registered number OC305288 authorised and regulated by the Financial Conduct Authority © Ruffer LLP 2019. The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument. The information contained in the document is fact based and does not constitute investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities should not be construed as a recommendation to buy or sell these securities.

DFM Directory
Outsourcing Partners

Money Marketing’s DFM & Outsourced Fund Solution Centre

Browse our directory of Discretionary Fund Managers, to manage your client portfolios, and Fund Providers, to search for a suitable one-stop shop fund solution.

Ruffer LLP

Ruffer offers financial planners something deliberately different. Your clients like making money, and hate losing it. Most will hate losing money more than they like making it. At Ruffer, this shapes our investment philosophy, and the way we invest. We offer a distinctive all–weather approach, designed to perform in all market conditions. Our focus is on capital preservation and prudent growth, not chasing short–term fads or trends. Since we began in 1994, our investment process hasn’t changed. For over 20 years, it has delivered solid returns well ahead of cash and UK equities. More importantly, it has protected our clients from market crashes, including the bursting of the bubble and the credit crisis.

No comments yet.