Today’s rate cut and announcement that there will be more QE means more pain for UK pensions – yet the Bank of England statement seems to completely ignore the pension impacts of its policies. Estimates suggest pension deficits are now approaching £1trillion – which, surely, cannot be sustainable. Here are some thoughts on the today’s decision to cut the interest rate to 0.25pc and to rev up QE again.
- Lower rates make pensions more expensive: The amount of money that is needed to pay promised pensions over future decades depends on how much return one is expected to earn on the money set aside for pensions right now. The lower the future expected returns, the more money must be put in today. The cost of pensions, whether Defined Benefit or Defined Contributions, ultimately depends on the returns on gilts. As gilt yields fall following QE, annuity rates fall and pensions become more expensive.
- Rises in asset prices don’t offset rise in the liabilities so pension deficits worsen: The sensitivity analysis shows that for every one percentage point fall in long gilt yields there will be an increase in the average pension fund’s liabilities of 20%, while its asset values will only increase by around 7-10%. Therefore, as gilt yields decline, pension deficits increase and any rise in asset prices is less than the rise in the liabilities or annuity costs.
- Deficits are approaching £1 trillion: Hymans Robertson estimated that deficits of UK final salary-type schemes post-Brexit had risen to £935 billion. A further fall in interest rates as a result of today’s Bank of England announcement will see this figure increase further towards the £1 trillion mark. The value of liabilities, as measured at today’s interest rates, is well over £2 trillion.
- This damaging side-effect of monetary policy means bigger burdens on UK employers: The consequences of rising deficits are that employers struggling to support these schemes face pressure to put in more money. The more money they put into the pension scheme, the less they can spend on supporting their operations. This undermines the aims of QE which is meant to stimulate the economy as this supposedly expansionary policy weakens the ability of the employer to grow its business. So monetary policy that is meant to boost growth has a damaging side-effect that can undermine companies. Ultimately, more employers may fail as pension deficits balloon. That would mean pension scheme members enter the PPF and their benefits are not paid in full.
- Trustees caught between a rock and a hard place need to take more risk, but expected to take less: Trustees of pension schemes, whose deficits keep rising, are facing almost impossible investment dilemmas. They are locked into a vicious circle and struggle to break out. If the scheme deficit has risen, trustees need to consider asking the employer to put more money in to fill the shortfall. But if the employer has already put huge sums in or cannot afford to do more at the moment, then trustees ideally need to find other ways to reduce the deficit. This means achieving better investment returns or reducing the benefits (which is not normally allowed under UK pensions law unless the employer is about to go bust). So trustees would in theory need to take more investment risk, buying assets that can be expected to outperform their liabilities, to reduce the deficit over time. However, in practice, trustees are usually advised to take less risk, not more risk, if the employer is considered less able to fund the deficit. They are told to ‘de-risk’ by buying assets that better match their liabilities.
- ‘De-risking’ becomes a vicious circle that ultimately increases risk of failure: Trying to ‘de-risk’ generally means buying gilts (or other high quality bonds or hedging), since these are supposed to better match the performance of the schemes’ liabilities. As liabilities are calculated with reference to gilt yields (conventional actuarial basis) or AA corporate bond yields (accounting measure), gilts and bonds are considered the assets that will best match the liabilities. But buying more gilts or bonds will, at the margin, force yields down further, especially in light of further QE (buying £50bn of gilts and £10bn of corporate bonds). Trustees will be competing with the Bank of England for scarce assets and pushing yields even lower and their schemes’ deficits will keep rising – a classic vicious circle.
- Index-linked gilt yields are negative so trustees already face deflation: Pension schemes are facing a further dangerous dilemma in addition to the pure interest rate impact on their liabilities. Index-linked gilt yields have been negative for some time and the more negative the index-linked yield becomes, the more impossible it is for pension schemes to match their index-linked liabilities over time. There are no ‘safe’ assets that pension trustees can buy to match their inflation increases. This further drives them to need to take investment risk. Indeed, this is what the Bank of England specifically suggests it is expecting, however pension schemes have been unable to do so because they are frightened of the employer position weakening further.
- The Bank of England seems oblivious to the pension impacts of its policies: This is what the Bank said today: ‘The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses. It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy.’ There is no mention of the effects of this policy on pension funds. In fact, if pension funds are unable to move into riskier assets, the policy is actually going to damage growth in some cases, rather than boost it. Weakening parts of corporate UK is hardly helping the economy. Monetary policy is also risking poorer pensioners in future via the impact on annuity costs. Thankfully, DC pension investors are no longer forced to annuitise too soon if they would rather wait.
- The government must address these pension problems urgently: The Government has given some relief to DC scheme investors with the freedom and choice reforms. DC savers are no longer effectively forced to buy an annuity if they want to take just a small amount out of their fund. However, there has been no such relief for employers. If the Bank of England ignores the effect of monetary policy on pension schemes, Government and the Pensions Regulator need to take the issue more seriously. So far, very little has been done to address the stress on employers. I had started some work on this but it did not receive sufficient attention and is even more urgent in light of today’s announcement.
- Trustees and employers seem frightened to use flexibilities already built into UK pension system: The UK pension system does have significant flexibilities which could help employers and trustees cope with difficult circumstances, however there seems to have been a reluctance to use the leeway designed to alleviate these burdens.
Ros Altmann served as Minister of State for Pensions from May 2015 until July 2016