Home > Services > Investment Consulting > Interest Risk
Interest Risk
In placing a current value on the future expected benefit payments for a final salary pension scheme, the scheme actuary must use an appropriate discount rate to convert the absolute future payments into a present value. This provides a figure that will be the valuation of the liabilities.
Using yields available on long dated gilts as the basis of this discount rate, this gives an indication of the amount of assets that would be required at the present time to be able to meet all the anticipated future scheme benefits if assets were invested on a “risk free” Government bond basis from that point onwards.
If the yields available on such long dated gilts change, due to market forces, then by correlation, the amount of money needed to be set aside now to be able to meet the scheme benefits due, if a “risk free” gilt investment strategy were to be followed thereafter, would vary by a proportionate amount.
Under this measure, if yields on long dated gilts go down, then the impact of discounting the current value of a scheme’s future benefit payments reduces, and the scheme is left with a higher present value of future benefit payments, i.e. the value of the scheme’s liabilities has gone up. This is known as interest rate risk.
For example, £10,000 of benefit due in 30 years' time could have a present value of £2,700 if it is discounted by a rate consistent with long gilt yields of say around 4.5% per annum. If yields reduce by 1% per annum a revised present value is placed on that £10,000 of benefit due. Allowing for this reduction in the discount rate of 1% per annum, the benefit would have a revised present value of £3,600. The amount of money now needed to be able to “guarantee” to pay that benefit has increased by a third. This shows the potentially significant impact of interest risk.
A scheme that is not fully invested in assets with payment characteristics matching the benefits will be exposed to this interest risk. Trustees should be aware of these risks and the strategies available to mitigate the risks.