The health of defined benefit (DB) schemes in the UK reached a “new high” in Q4 2021, with the typical scheme expected to be able to fund 98.4 per cent of accrued pension benefits, according to Legal & General Investment Management (LGIM).

The typical scheme being able to fund 98.4 per cent of accrued benefits, as at 31 December 2021, was 0.1 percentage points higher than the 98.3 per cent figure recorded at the end of Q3 2021.

LGIM noted that the health of DB schemes had been gradually improving since March 2020, when it had dropped to as low as 91.4 per cent due to the immediate impact of Covid-19 on financial markets.

Furthermore, although the latest figures demonstrated “continued improvement”, LGIM warned that the next 12 months will be crucial for schemes and other investor groups due to the move into an era of tighter monetary policy.

“The final quarter of 2021 saw continued strong performance from growth assets which helped our measure of UK scheme health edge to its strongest recorded position yet,” commented LGIM head of solutions research, John Southall.

“Scheme health also benefitted from a modest drop in inflation expectations, falling back from the elevated levels we saw in the third quarter (the highest levels since 2008). However, this was offset by a slight decrease in long-term interest rates. Overall, our Expected Proportion of Benefits Met (EPBM) measure managed to post a small gain and reach a new high.”

“The fact that the measure means it is impossible for schemes to be more than 100 per cent healthy makes large increases in EPBM challenging. However, it is encouraging to see the security of members benefits continue to improve.”

“As for previous quarters, we chose to retain a typical sponsor rating assumption of BB in our calculations. This assumption reflects current covenant strength. However, the long-term impact of the pandemic on DB schemes’ health remains unclear. It is worth noting that if a B rating was assumed instead, the EPBM figure would be around 1.1 per cent lower.”

LGIM head of rates and inflation strategy, Christopher Jeffery, added: “The fourth quarter of 2021 had plenty of twists and turns, but the ultimate outcome in financial markets was more of the same: equity market buoyed by the ongoing economic recovery, short-dated interest rates rising, and inflation overshooting expectations. Despite those headwinds, long-dated gilt yields which matter the most for discounting pension fund liabilities were almost totally unfazed.”

“For sterling investors, the most important news came towards the end of the quarter with the first hike in interest rates by the Bank of England for four years. Followed by a further increase in rates today, the Old Lady of Threadneedle Street has signalled that the days of benign neglect about the inflation outlook being over, ‘forward guidance’ has been abandoned as a policy tool, and balance sheet reduction will soon be upon us. 2022 looks to be a pivotal year for investors as the market navigates the transition from easy to tightening policy conditions both at home and abroad.”

LGIM's analysis was based on the assumption in the Pension Protection Fund's (PPF) Purple Book that a typical DB scheme holds approximately 20 per cent in equities, 70 per cent in bonds/LDI, 5 per cent in property and 5 per cent in other assets, and its own assumption of rates and inflation hedge ratios of 70 per cent of liabilities on a gilts basis, and no future accrual or deficit contributions.

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