A debt crisis in the UK could see well-funded UK defined benefit (DB) pension scheme funding levels fall by 7 per cent and deficits increasing by millions, analysis from Van Lanschot Kempen has found.

The modelling looked at the potential impact of five future risk scenarios relevant to UK DB schemes across well, medium and lower funded schemes, and assessed the impact of each risk on funding and deficit levels per £100m of liabilities.

In the event of a UK debt crisis, the research predicted a fall of 7 per cent and 2 per cent in funding levels for well and medium funded schemes, respectively, with deficits for well-funded schemes increasing by £4m per £100m of liabilities.

However, it found that, "interestingly", lower funded schemes experienced a marginal 1 per cent increase in funding levels.

In addition to this, deficits for medium and lower funded schemes decrease by £2m and £8m respectively in the case of a UK debt crisis.

The modelling found that a US balance sheet crisis is also a key risk for most schemes, similar to a UK debt crisis, except all global markets are expected to be affected.

In particular, the modelling estimated a fall of 8 per cent, 11 per cent and 12 per cent in funding levels and deficit increases of £9m, £12m, and £14m per £100m of liabilities for well, medium, and lower funded schemes respectively.

Of the five future risk scenarios modelled in this research, however, a US/China strategic conflict which results in an escalation of tensions in Taiwan received the most attention from the wider market, impacting all risk assets and leading to a "flight to safety".

In this scenario, schemes with higher return targets and more investment risk take the largest funding level ‘hit’ due to the expected impact on both equities and from lower levels of liability hedging.

These lower-funded schemes would also see funding levels fall by 16 per cent and deficits increase by £20m per £100m of liabilities in such a scenario, according to the research.

However, Van Lanschot Kempen pointed out that certain risk scenarios, whilst generally bad news for funding levels for all schemes, may have a far more muted impact on deficits, which would likely be good news in the event a scheme’s covenant is simultaneously challenged in this scenario.

Commenting on the findings, Van Lanschot Kempen head of investment strategy, Alistair Greenlees, said: “At the end of 2023, the UK debt to GDP ratio stood at 97.7 per cent and in November, Office for Budget Responsibility (OBR) estimates put the government’s gross financing requirement at £277bn in 2024-25, or 16 per cent higher than the UK’s debt sales for the previous year.

“In its latest assessment of the world economy, the International Monetary Fund (IMF) 'advised the UK against further tax cuts' until debt is securely on a downward trajectory, while pockets of the financial services industry have additionally warned of a return to ‘bond vigilantism’ if looser fiscal policy is enacted.

"Our research suggests a UK debt crisis is front of mind for UK DB schemes as well.

“Such an event has the greatest impact on UK gilts and credit and is a larger risk for well-funded ‘de-risked’ schemes – high corporate credit holdings (which most schemes de-risk towards) present a risk if not carefully managed.

“This scenario presents a modest benefit for less well funded schemes reflecting their lower liability hedges and relatively modest use of credit assets. However, less well funded schemes which employ higher leverage may experience a dual shock through liquidity constraints.”

Adding to this, Van Lanschot Kempen investment strategist, Calum Edgar, said: “Our research shows that even well-funded, de-risked schemes can still face significant downside risks when considering certain scenarios.

“The specific risks faced by schemes will be very dependent on funding levels and asset allocation, in particular the approach to liability hedging, credit quality, and equity exposure.

“How can pensions schemes manage tail risks? There is no magic bullet but implementing a bespoke portfolio can help address these specific risks and align risk management strategies appropriately.

“It is crucial to have a partner who can effectively communicate risks and adapt techniques as market conditions evolve, providing schemes with diversification, discretionary-led portfolio dynamism and explicit downside risk management strategies.”

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