>> I assume the value of long dated gilts falls as interest rates rise.
Yes. But if your gilts are matched to your liabilities and you are holding to redemption, it doesn't matter, all else equal. That would more likely be the case in a fully funded, de-risked, scheme.
>>
>> The capacity of a pension fund to meet its future obligations depends on income and
>> capital. Whist income is unaffected by interest rate changes, the value of the holding will
>> decline.
Interest rate increases, other things being equal, will reduce the balance sheet value of liabilities and therefore deficits. But they also reduce the assets. Note that they don't actually change the liabilities, just the calculation of the present value.
>>
>> I assume that when the actuaries review pension fund projections - assets, income, anticipated growth
>> rates, pension obligations etc - they suddenly look underfunded unless income projections are increased to
>> compensate.
The issue is risk around the size of the deficit. You can have a £100m. deficit on £500m of liabilities, and changes in financial conditions can cause that to balloon to £200m (or reduce to zero if you are lucky). Schemes reduce that potential swing and downside risk for the company on the hook by hedging.
The problem with hedging is that it reduces returns. You can get more bang for the buck with leverage which is where the collateral comes in.
>>
>> This would be a risky strategy - particularly for remaining final salary schemes - their
>> obligations stretch out several decades, and interest rates and inflation must be critical to fund
>> valuation.
>>
Correct. But you can't just assume better returns. Your projected returns have to match your investment strategy. It isn't an exact science but actuaries if they are doing their job will build some prudence into the "discount rate".
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