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Category — Monetary Policy and Interest Rates

Time for a national inquiry into the impact of lower interest rates.

13 September 2016

  • Time for a proper national debate about the impacts of Monetary Policy
  • Government should launch an inquiry into the effects of lower interest rates

 Main points:

  1. QE was an emergency policy to stave off depression – it is a huge monetary experiment which must not be considered as ‘normal’ policymaking
  2. The latest round of rate cuts and QE may well have been a mistake – in August 2016 we were not facing economic collapse and the negative side-effects need to be considered
  3. Monetary policy may not be working as theory predicts as banks have failed to pass on lower rates to many borrowers, while savings rates have fallen sharply
  4. Credit card, overdraft and even SVR mortgage rates have RISEN over the past 5 years
  5. Lower rates and QE are supposed to be expansionary but also have deflationary effects as they reduce disposable incomes for both households and some corporates
  6. QE has damaged UK Defined Benefit pension schemes and placed higher costs on firms
  7. QE has increased annuity costs significantly which also damages Defined Contribution pension income
  8. Distributional effects of QE may have political implications as ordinary savers and renters suffer while QE helps the wealthiest, perhaps feeding public dissatisfaction

 This paper presents an alternative view of monetary policy to that which has been used by the authorities.  I suggest that monetary measures have impacts that are rather like a tightening of fiscal policy, which may offset the expected expansionary effects.  I hope you will find this of interest and that it may stimulate more detailed debate of the real impacts of the unprecedented policy experiment which is underway.  The Bank of England believes its latest rate cuts and QE expansion will boost growth.  The Governor says he is serene about its policies.  However, the full impact of the QE experiment will not be known or understood for many years, while its negative side-effects may have been underestimated.

No economic emergency:  QE was originally introduced as an emergency measure to boost growth and stave off economic collapse. However, with record employment levels and no recession (let alone depression as was feared a few years ago) it is hard to argue that interest rates in August 2016 were ‘too high’ or were stifling spending and investment.  Indeed, economic indicators have recovered somewhat, the economy is certainly not facing imminent collapse, so aggressively pushing rates lower from already exceptional levels may not be an appropriate policy.

QE is not normal:  It is worrying that this massive monetary experiment of printing money to artificially distort long-term interest rates may now be considered ‘normal’ – it is certainly not normal at all.  Indeed its effectiveness is unclear.  It may do more harm than good and if any post-Brexit economic weakness is structural, rather than cyclical, monetary easing is unlikely to help.

The combined impact of low interest rates and more QE reduces the disposable incomes of savers and pensioners.  In some respects, monetary policy is acting like a tax increase, so attempts to ‘ease’ monetary policy have effects that resemble a tightening of fiscal policy.  Soaring house prices and rising rents have reduced younger people’s spending power, while savings and pension income for older groups have been cut. In an aging population, the expected income, substitution and wealth effects may fail to work as theory predicts.  The table below is a quick summary of the relative balance of impacts.  The net effect of the Bank of England’s policies depend on the strength of each of these effects.

Reflationary impacts expected by Bank of England Deflationary effects that may offset expected expansionary impacts
As interest rates fall, net savings fall and savers are expected to spend more Lower savings income may lead savers to spend less
As borrowing costs fall, corporate borrowing for capital investment is expected to increase QE increases pension deficits, so higher company pension contributions may lower corporate investment
Lower borrowing costs for households are expected to help them afford to spend more Lower pension income may mean less spending as annuity income falls for new pensioners
As QE increases asset prices (e.g. house prices), a wealth effect is expected to boost spending as asset owners feel wealthier Higher rental costs as house prices rise  may reduce spending and higher house prices may lead to higher savings to afford to buy homes
Income effects of lower rates for both savers and borrowers are expected to reduce saving and increase spending As savings income falls, savers may actually spend less or save more to afford housing
A Substitution effect is expected as rates fall and households or corporates are expected to bring forward spending plans which will boost growth Households and corporates may believe QE and falling rates signal economic problems ahead and reduce spending.  There are also concerns that continually bringing forward future growth cannot continue indefinitely

 

The monetary policy transmission mechanism is not working as theory predicts:  Let’s look at the impact of the Bank of England’s policies.  The first part is the fall in short-term interest rates as bank rate has fallen closer to zero.  The second policy element is the Bank’s Quantitative Easing programme designed to lower long-term interest rates too.

  • Lower short-term interest rates

Low short-term interest rates are meant to boost household spending:   Households are expected to increase their borrowing as loans become cheaper and savers are supposed to reduce net saving as their income falls.  In fact, the pass-through of low short rates has been weak, as banks have not reduced borrowing rates much, if at all, but have lowered savings rates more significantly.  In an aging population, savers facing falling income may not just increase their spending.  They may look for better returns on their savings, or even save more for the future.

 Though short rates have been near zero for years, many household borrowing rates have actually risen:  Over the last five years, credit card interest rates and bank overdraft rates have actually increased, despite low base rate.  Indeed, credit card rates and overdraft rates are 2% higher than they were in August 2007.  Clearly, banks have not been passing on the benefit of low interest rates to these borrowers.  Therefore, low rates will have less impact than theory predicts.

Even mortgage rates have failed to properly reflect the base rate cuts:  In August 2016, average 2-year fixed rate mortgages had an interest rate 1.17% lower than five years ago.  However, rates for an average Standard Variable Rate mortgage were higher than in August 2011.  Lenders are also charging households higher fees and imposing tougher conditions on loans.  Therefore, ordinary households have not really felt as much benefit from the ultra-low interest rate environment as might be expected.  And even though fixed rate mortgage costs have fallen, the rise in house prices means the size of a mortgage required for house purchase has increased.  For many people the costs are so high relative to their income that they cannot get a mortgage at all.

MANY BORROWING INTEREST RATES HAVE RISEN, NOT FALLEN

Date Credit Card  %

 

 

Overdraft

Rate %

Standard Variable Rate Mortgage % 2-year fixed

Mortgage

75% LTV %

Aug 2011 16.73 19.38 4.11 2.69
Aug 2012 17.26 19.53 4.27 3.54
Aug 2013 17.87 19.54 4.36 2.8
Aug 2014 17.39 19.67 4.52 2.74
Aug 2015 17.91 19.67 4.48 1.72
Aug 2016 17.96 19.68 4.33 1.52
Interest rate change over past 5 years +1.23% +0.3% +0.22% -1.17%

Source:  Bank of England

Of course, over the past five years, savers’ interest rates have fallen sharply:  While the above table shows the low interest rate environment has not fully fed through to borrowing costs, the average interest rates for savers have fallen quite significantly over the past five years.  Banks do not need savers’ deposits as the Bank of England gives them plenty of cheap funding, while the latest Term Funding Scheme helps further.  .  Thus, interest rates on Cash ISAs, fixed rate ISAs and fixed savings deposits were significantly lower in August 2016 than five years ago. Banks have cut saving rates by more than the base rate fall and cut borrowing rates by less, to boost margins

 

SAVERS’ INTEREST RATES HAVE FALLEN SHARPLY

Date Cash ISA 1 yr fixed ISA 2 yr fixed Deposit rates
Aug 2011 2.37 2.54 3.08
Aug 2012 2.52 2.53 3.08
Aug 2013 1.26 1.74 1.93
Aug 2014 1.09 1.5 1.52
Aug 2015 1.01 1.51 1.55
Aug 2016 0.6 0.94 1.02
Int. rate change -1.77% -1.6% -2.06%

Source:  Bank of England

 

  • Quantitative Easing

The second part of the Bank of England’s policy has been forcing long-term interest rates down, by creating billions of pounds of new money to buy gilts.  Buying more gilts forces up gilt prices which means lower yields, but also artificially distorts these supposedly ‘risk-free’ assets.

Bank of England suggests QE protects the value of savings and wealth, but higher asset prices are irrelevant to cash savers:  The Bank of England claims QE has boosted the value of financial asset holdings and that this ”protects the value of savings and wealth”.  However, asset prices are irrelevant to cash savers.  Most people’s savings are in deposits of less than 2 years’ maturity, so they do not benefit from increases in asset prices resulting from QE.  The majority of households hold their savings in bank or building society accounts, ISAs and National Savings which have been damaged by the low base rate policy and have not necessarily benefited from QE.

QE has distributional impacts as rising asset prices helps the wealthiest:  The Bank of England admitted in 2012 that ”those households with significant asset holdings will benefit by more than those without”.  It said it had boosted the value of stocks and bonds by £600bn and that this is ‘equivalent to £10,000 per person if assets were evenly distributed across the population’. But assets are not evenly distributed so gains have gone largely to the wealthiest 5% of households.  Further QE merely magnifies those effects.  The Chart below shows the Bank of England’s 2012 estimates of the redistribution of wealth resulting from QE.  The ongoing and further rounds of QE exacerbate this redistribution of wealth, with the wealthiest households becoming even wealthier.

QE has deflationary effects which may undermine its effectiveness:  QE is designed as an expansionary policy, but some of its effects are similar to a tightening of fiscal policy.  There are several ways in which QE has deflationary side effects.

High house prices can be deflationary:  The Bank of England has suggested that its policies have supported house prices and that this benefits the economy.  However, artificially boosting house prices is not necessarily reflationary.  The wealth effect of high house prices may not be strong enough to offset the income effects of falling disposable incomes for renters or those saving more to try to get on the housing ladder.  Housing wealth is not evenly distributed, with significant regional, demographic and income disparities.  The high cost of housing relative to salaries prevents younger generations getting on the housing ladder and forces up rental costs.  Rather than supporting house prices, policy needs to address the shortage of housing by building more homes.

 Lower gilt yields damage UK Defined Benefit pensions:  The Bank has underestimated the dangers of low gilt yields for company-sponsored pension schemes.  Artificially depressing long-term interest rates increases pension deficits and imposes extra costs on companies sponsoring pension schemes.  Deficits have soared to nearly £1trillion on some estimates.  All measures show rising deficits for UK pension schemes following the latest gilt yield falls.  The Bank of England itself is insulated from the effects, because its own scheme has ‘employer’ contributions of over 50% of salary which are funded by levypayers.  Private sector firms are struggling to meet these costs and addressing their ballooning pension deficits will weaken their business.  As firms put more money into their pension schemes, they have less money to spend on expansion and job creation.  For example, Carclo had to withdraw its planned dividend payment in order as a result of its pension deficit.  Pension funds are becoming locked in a vicious circle.  The more the Bank of England buys gilts for QE, the more expensive – and unaffordable – it becomes for trustees to buy assets to try to reduce risk.  If they compete with the Bank of England to buy more gilts, they drive gilt prices up more, which increases their deficits even further.  For many schemes, this can be a ‘death spiral’.  Some firms have been bankrupted as a result of their pension problems.  QE makes Defined Benefit scheme funding seem like a bottomless pit.  The Bank’s insouciance on pension issues is troubling.

QE has driven up the cost of buying annuities but Bank of England has ignored this effect:  The impact of QE on annuity rates has not been investigated.  This may be a serious omission.  Rising annuity costs have potentially serious implications.  QE has forced up the costs of buying bulk annuities, making it too expensive for companies to remove defined benefit pension liabilities from their balance sheets.

QE has damaged Defined Contribution Pension savers too:  In addition to the problems created by increasing annuity costs for employers running Defined Benefit schemes, annuity problems can affect ordinary households too.  Retirees buying an annuity will have lower incomes for life as a result of QE and will never be able to recover their losses.  In 2012, the Bank of England claimed: ”QE has raised the value of pension fund assets too.  Once allowance is made for that, QE is estimated to have had a broadly neutral impact on the value of the annuity income.”  This conclusion is flawed.  Most ordinary investors’ Defined Contribution pension savings are invested in with-profits or insurance funds which have not performed well enough to offset annuity falls resulting from QE.

QE artificially distorts asset markets – nobody knows what this means:  Gilts are supposed to be ‘risk-free’ assets, but by artificially boosting gilt demand, the Bank of England has distorted gilt prices.  Thus, QE has added risk to gilts, potentially creating an asset bubble in the very market that is supposed to be risk-free and on which other asset valuations are based.  This adds risk to all financial assets and nobody knows what the medium term impacts will be. Printing new money and debasing a currency may be politically expedient short-term political palliatives, but will usually fail to solve underlying problems and generally have damaging long-term consequences.

 

In summary, monetary policy may not work as the Bank of England’s theoretical models predict:  This paper suggests that the current stance of monetary policy and the most recent policy decisions may not work as intended and have damaging side-effects that could even offset any expected stimulus.  So what other measures might Government consider for boosting growth, with less damaging side-effects?

As QE operates indirectly and its transmission mechanism may not work, direct stimulus might be more effective:  QE creates new money which is intended to find its way into the real economy to boost growth.  However, the transmission mechanism is indirect and the Bank of England cannot ensure that this newly created money does go where it is needed in order to create growth and jobs.  There may be better policies to pursue, for example:

  • Temporary tax breaks for capital projects: Introduce temporary tax breaks for capital spending to encourage companies to bring forward investment plans.  The biggest benefit of QE is that it has allowed companies to borrow more cheaply and large firms are flush with cash.  However, they are not spending it, so an incentive to invest could help economic activity.
  • Boost construction:  Introduce incentives for new housebuilding or construction
  • Use pension assets to build new housing: The UK has billions of pounds in pension assets which could be used to build new housing, rather than trying to invest in gilts.  This can help to deliver better returns as well as overcoming the UK housing shortage.
  • Use pension assets to invest directly in infrastructure with Government underpin:  Using the billions of pounds of pension assets to bypass banks and invest in infrastructure or even lend directly to small firms would offer more direct stimulus.  It may require a Government to guarantee that the pension assets will receive at least a gilt yield return over, say, 1 years, if the project does not return more than the yield on 10 year gilts.  This would mitigate some of the risk for the pension scheme and allow pension funds to use these potentially higher return assets in the liability-matching portion of their asset allocation, while hoping to benefit from higher returns as well.
  • Consider ‘helicopter’ tactics:  It might be more effective if the Bank had sent a “time limited” cheque to all households, rather than letting low interest rates continue to squeeze people’s income. This would encourage spending directly.  The Bank of England rules this out, but it is possible that it would be more expansionary than QE.  In fact, the £25billion paid directly to households since 2011, in the form of PPI compensation, may have boosted growth more than the low base rate and gilt-buying program.

 

Conclusion:  QE, coupled with ultra-low rates, is supposed to be expansionary, but some of its effects are deflationary.  It is not yet clear whether the expected expansionary impacts are being more than offset by the contractionary side-effects.  Indeed, if any economic weakness following Brexit is structural, rather than cyclical, then monetary policy will not work as expected.  In some ways, QE and the base rate cuts have acted rather like a tax increase.  They have reduced current and prospective disposable incomes.  Savings income, annuity income and prospective pension income are all lower as a result of the Bank of England’s policies.  Monetary Policy can buy time for Government to introduce new demand-stimulus measures, supply-side reforms and reducing fiscal imbalances.  But, without other measures, buying gilts is unlikely to generate growth.

 

And finally, some politics…The Bank of England’s policies have distributional effects and the Government has perhaps not sufficiently recognized this.  The following table summarises which groups have largely benefitted from monetary policy moves and which groups are damaged by it, with the wealthiest gaining while ordinary savers, renters and younger households lose out.  Might it be possible that monetary policy could have contributed to the dissatisfaction among voters who feel left behind in recent years.  The rise of anti-establishment nationalist movements, epitomized by the Brexit result, may reflect anger at the financial difficulties facing some parts of the population, which policymakers have failed to recognize.  Politicians might like to consider how this balance of winners and losers fits with a desire to help the many, rather than the privileged few.

Groups benefiting from monetary policy

 

Groups damaged by monetary policy

Wealthiest asset owners

People trying to buy a home

Investment firms

People renting a home

Banks

Savers relying on interest income

UK Government

Pensioners buying annuities

Borrowers with large tracker mortgages

Companies with defined benefit schemes

Gilt traders or market makers

Pension scheme members whose schemes failed due to QE impact on deficits

 

September 13, 2016   3 Comments

Bank of England pension scheme shows dangers of QE

12 September 2016

  • Bank of England’s own pension scheme highlights the problems of QE
  • Bank says QE should make gilt owners rebalance portfolios into riskier assets – but BofE pension scheme isn’t doing this
  • QE may not work as pension funds and insurers are constrained from taking more risk
  • As QE worsens pension deficits and has pushed contributions to ruinous levels – Bank of England scheme requires employer contributions over 50% of salary

The Bank of England has recently published its Annual Report and Financial Statements for the year ended February 2016.  It makes interesting reading.  Despite being invested totally in gilts and bonds, the scheme has had to overcome a deficit and, by end February 2016, the deficit was reduced.  http://www.bankofengland.co.uk/about/Documents/humanresources/pensionreport.pdf

Bank of England is relatively insulated from pension impacts of its own policies:  However, the Bank of England Pension Scheme Report acknowledges it was damaged by falls in long-term interest rates and clearly the latest round of QE will cause further problems.  However, the Bank’s scheme is relatively insulated from some of the negative impacts which the Bank of England’s policies have inflicted on private sector schemes.  This is because levy-payers fund the enormous employer contributions which have been required to overcome the deficit, while Bank of England employees do not contribute at all.  The Bank itself, as an employer, does not face the cost pressures that private sector firms are under as contributions need to keep rising.  This may help explain why the Bank of England seems so complacent about the pension problems created by its policies.  However, the problems are real for most employers and may undermine the effectiveness of QE itself.  These side-effects need to be taken more seriously.

BofE pension scheme holds only bonds and they have not kept up with liabilities:  The Bank of England’s pension scheme is invested entirely in bonds and has a deficit.  In the year to February 2016, its pension scheme assets increased by 4.5% but its liabilities rose by 5.14%, meaning that, even with its asset allocation entirely in the safest bonds, which are supposed to match the liabilities, the assets did not actually keep up with liabilities.

Falling bond yields mean rising pension deficits:  The Bank’s pension fund Report acknowledges that QE imposes ‘yield risk’ which worsens its pension deficit, even though the scheme is only invested in bonds.  It states ‘the liabilities would be expected to grow by more (than the assets) in monetary terms, increasing the deficit’. The conventional wisdom that bonds will match pension liabilities is not reliable and either extra returns are required, or employers must pay significantly more to support their schemes.

BofE pension scheme has employer contributions well over 50% of salary:  The Bank of England scheme required employer contributions of well over 50% of salary for the year ending February 2016.  It also pays all the administration and PPF costs, on top of the employer contributions.  Such costs would be ruinous for most private sector employers struggling to fix their defined benefit pension deficits.  .The latest round of QE will have worsened deficits again, thus increasing costs of running UK Defined Benefit schemes, and requiring further contribution increases.  Some pension purists are suggesting that employer contributions will just have to keep on rising and sponsors will keep having to increase funding, however QE is supposed to boost growth and these pension impacts are damaging many parts of the corporate sector.

QE is meant to be expansionary as institutions switch to riskier assets – but even BofE scheme isn’t doing this:  Since the Referendum the combined impact of Brexit uncertainty and the £70billion QE boost has led to a significant further drop in long yields.  The Bank of England says QE will impart monetary stimulus and “trigger portfolio rebalancing into riskier assets by current holders of government bonds”.  It expects QE to be expansionary because it boosts asset prices, as sellers of the bonds it buys will switch to higher yielding – riskier – assets.  But even the Bank of England’s own pension scheme is not switching to higher risk assets.  Most institutional investors, such as pension funds or insurers, do not take more risk due to regulatory constraints.  Therefore, QE may not be working as intended.  This helps to explain why the Bank has already struggled to find enough bonds to buy.

Pension impacts of QE are deflationary:  The pension side effects should be taken more seriously by the Bank of England when assessing the effectiveness of QE.  Many employers struggling to support their pension schemes are coming under pressure to increase contributions, meaning less resources available to grow their business.  Recently Carclo had to pass its dividend because of its pension deficit, which may damage the firms’ long-term prospects.  Smaller employers are facing bankruptcy.  QE will potentially require even more corporate resources to be diverted from productivity enhancing investment into pension deficit funding and will weaken corporate balance sheets.  This is hardly expansionary.

UK pension funds and insurers are a large proportion of the economy:  In an economy with such an enormous accumulated value of funded pension schemes relative to its size – the UK has more in funded pensions than the rest of Europe put together – the pension damage of QE could well dampen growth prospects and damage growth, the opposite of its intended effect.

QE impact on annuity rates adds further deflationary pressure:  Not only does QE distort the capital markets and increase pension deficits, it has also caused potentially even worse damage to annuity rates.  This has deflationary effects.  Firstly because companies cannot afford to buy-out their pension risks as the costs have risen so high and secondly because individuals buying annuities will have lower incomes for the rest of their lives. The combination of pension regulation and financial regulation is conspiring to magnify the negative impacts of QE and, in an aging population, this increases the likelihood that monetary policy is having side effects that undermine its efficacy.

In any case, gilt investments do not actually match pension liabilities:  Although gilts and bonds may be a proxy for liabilities, they are not a proper match, due to duration and inflation mis-matching, credit risk in corporates and longevity risk too.  The Bank of England scheme is testament to that.  Therefore, ‘de-risking’ by just holding bonds will not necessarily stop deficits worsening.  As demand for bonds rises, long-rates fall further, which increases pension deficits and imposes punishingly high contribution rates on employers.

Pension funds need to find alternative and higher sources of return:  Artificially boosting asset prices is likely to result in asset bubbles – and further QE gilt-buying may simply aggravate the bubble in the gilt market, that is meant to be ‘risk-free’.  Relying just on bonds could be dangerous but there are no easy answers to the pension investment conundrum.  Higher returns and increased diversification could come from infrastructure or housing investment, with a Government underpin perhaps, that will boost economic activity as well as offering potentially better returns to meet pension liabilities.

Use pension assets to boost growth directly rather than relying on QE:  The Bank of England’s pension scheme shows that just investing in gilts and bonds is doomed to failure because it entails such huge employer costs and still carries deficit risks.  As the effectiveness of QE and further monetary measures is open to question, using the billions of pounds in long-term investment funds to boost growth more directly makes more sense than relying on indirect transmission mechanisms.

September 12, 2016   3 Comments

Government must help savers – bring back guaranteed high interest bonds

9 August 2016

  • Monetary policy is not helping ordinary people and low rates may be doing more harm than good
  • Ordinary savers are being hung out to dry and pension problems have worsened
  • Government should issue more high interest 65+ guaranteed growth bonds – but for all age groups

The latest decision by the Bank of England to cut base rate from 0.5% to 0.25%, as well as expanding Quantitative Easing by £60billion, is supposedly designed to boost the economy.  But millions of savers and pensioners are suffering serious potential income shortfalls as a result of this policy.

I believe the damaging side-effects of low interest rates have been under-estimated.  Not only are significant sections of the population being hit near-term, the consequences for the medium and longer term are also negative.

Bring back special savers’ bonds:   As the banks no longer want or need ordinary savers’ money, the Government could offer better interest rates directly.  Bringing back the special savings bonds that were issued from January to May 2015 for the over 65s, but this time for all age groups, would prove popular.  They had market-beating interest rates of 2.5% or 4% and were the most successful financial product for years.  A new issue of such bonds, but not just limited to older savers would reward savers for setting money aside.  This is vital if we are to sustain a savings culture in this country.  Until a few weeks ago, the Bank of England had been suggesting the next move in rates would be upwards – signalling some relief for savers after years of misery.  Now that rates have fallen even further instead, the authorities need to consider the impact on prudent people who want to provide for their own future.  The Government also needs to consider how to help companies that are struggling with rising pension deficits.  Issuing special bonds for pension funds, offering to underpin investments in infrastructure and housing, would be direct ways of helping alleviate the damage of monetary measures.  The Government needs to find ways to offset the negative side-effects of the Bank of England’s latest moves.

What is the damage to savers?  With interest rates staying so low for so long, and rates continually falling further, savings incentives and savers’ incomes across the economy are being destroyed.  This has two damaging consequences which could actually weaken economic growth.

Lower savings income means savers save less and spend less:  Firstly, many people who have saved over the years for their future are facing further income falls.  This may cause them to cut spending, especially if they are in retirement and cannot see a way for their income to increase in future.  Indeed, many savings account interest rates are being reduced by more than the 0.25% rate cut.  Banks and building societies do not need to attract savers now, as the Bank of England’s decision to introduce its new Term Funding Scheme gives the banks cheap money directly from the Bank of England instead.

Destroying saving incentives for younger generations:  Secondly, many people are deciding it is not worth bothering to save as the returns are so tiny.  People who might have saved but decide not to bother will be poorer in future.  Young people are losing the savings culture that the current older generations often grew up with.  Modern societies still need savers, especially as life expectancy increases and the population is aging rapidly.  This lack of savings, and potentially higher borrowing risks damaging growth in future.

What is the damage to pensions?  Again there are two damaging consequences for pensions, both of which are likely to weaken growth.

Rising annuity costs means less pension for life:  Firstly, as interest rates are pushed lower, the costs of buying an annuity have soared.  People looking to lock into a guaranteed lifetime income will be offered much less pension than ever before.  Even if the value of their pension fund has increase a bit, the cost of annuities has usually risen by much more.  And, of course, once they lock into an annuity for life their income will never recover, even if rates rise in future.  So pensioners will have less money to spend, which is hardly an expansionary policy.

Pension deficits weaken company growth prospects and reduce pension contributions for younger workers:  Secondly, employers who are running final salary-type Defined Benefit pension schemes are facing much higher deficits as a result of the expansion of QE.  As gilt yields fall further, employer pension liabilities have soared.  Just today, the Pension Protection Fund PPF7800 index announced that its measure of pension deficits rose last month to around £400billion.  It will rise further this month as a result of the extra QE.  This will weaken the employers sponsoring such pension schemes, damaging their business prospects, potentially preventing them from investing or borrowing to fund growth and sapping corporate resources away from both their business and employment expansion.  As most private sector final salary-type schemes are now closed, the rising deficits are likely to mean employers have less money to spend on providing good pension contributions for those workers who do not belong to these schemes, – usually younger employees.

Monetary policy is too focussed on financial institutions and borrowing:  Monetary policy seems to be overlooking the negative consequences on households (and parts of the corporate sector).

Low rates do not necessarily help mortgage holders and QE has led to rising rental costs:  Typically, if short-term interest rates fall, borrowers’ incomes increase, and they are expected to spend more (or even borrow more to finance extra spending).  However, falling base rates may not help borrowers as much as expected.  Mortgage payments are a major element of household borrowing, but around half of mortgages are on fixed rates, so they do not benefit from the base rate cut to 0.25%.  Indeed, the other element of monetary policy – QE – has damaged especially younger people because it has caused rising property prices.  Ordinary people have to either take out a much larger mortgage to get on the housing ladder, or must pay much more in rent.  So monetary policy has made them worse off.

The Government could help offset damaging impacts of monetary measures:  Because these changes in Bank of England policy have many potentially harmful side-effects, the latest loosening of monetary policy may need to be offset by fiscal measures.   Certainly, the transmission mechanisms of lower interest rates are very indirect – relying on sellers of bonds to boost asset prices or stimulate extra borrowing.  More direct help is likely to have a better outcome.  The indirect stimulus cannot be relied upon to prevent an economic slowdown, while direct measures to increase household incomes and spending, as well as helping offset the effects of rising pension deficits, will be more beneficial to the British people.

August 9, 2016   1 Comment

Pension consequences of QE could undermine policy intent

4 August 2016

  • Further pain for UK pensions as QE worsens deficits and increases annuity costs
  • Bank of England statement completely ignores pension impacts of its policies
  • Estimates suggest deficits now approaching £1trillion – this cannot be sustainable
  • Government needs to consider help for employers

Today’s decision by the Bank of England to cut short-term interest rates and expand the QE programme is another blow for UK pensions.  Both defined benefit and defined contribution pensions have become more expensive as rates keep falling.

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 every one percentage point fall in long gilt yields will increase the average pension fund’s liabilities by 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 £1trillion:  Hymans Robertson estimated that deficits of UK final salary-type schemes post-Brexit had risen to £935billion.  A further fall in interest rates as a result of today’s Bank of England announcement will see this figure increase further towards the £1trillion mark.  The value of liabilities, as measured at today’s interest rates, is well over £2trillion.

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 scheme deficit will keep rising – a classic vicious circle.

Need to outperform liabilities, not just match them and gilts are not a perfect match anyway:  In practice, although gilts and bonds may be a closer proxy for the liabilities than other asset classes, they do not actually match liabilities properly.  There will still be duration and inflation mis-matching, as well as rising longevity, so even buying gilts may not prevent a rising deficit.  And there is a further problem.  If the employer cannot manage to meet the deficit payments, the trustees really need to invest in assets that will outperform the liabilities, not just match them, which means taking more risk, not less.  They seem caught in a trap at the moment.

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.

 

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.

 

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.

 

Must not just help one favoured scheme:  The problems of Tata Steel and others have highlighted how many big businesses are simply unable to afford paying the full pension promises at current interest rates.  The costs have mushroomed out of all proportion to previous expectations.  The British Steel consultation proposed law changes to allow its trustees to cut members’ benefits without consent and even to make them worse off than going into the PPF itself.  I believe this would be unwise and set a dangerous precedent.  Rather than trying just one favoured employer, the Government needs to look at the whole system.  How can employers and trustees manage their liabilities in the best long-term interests of the both the members and the business in light of QE?  Too much comment seems to focus on the apparent funding levels as measured today, rather than ensuring the strength of the sponsoring employer to back the scheme in future decades.

 

In danger of making the best the enemy of the good:  Liability management exercises, scheme pooling, longer recovery plans, member consent to benefit changes and benefit streamlining are all possible methods of managing liabilities over time in more affordable ways.  Encouraging members with small entitlements to transfer to DC schemes and facilitating small benefit changes such as a statutory over-ride for schemes that need to change the inflation measure used for uprating could provide much-needed relief for many schemes.  Offering pension schemes favourable terms for investing in infrastructure and social housing projects could also provide some upside for pensions while boosting the economy.  It is time the authorities addressed the serious side effects of monetary policy on UK pensions before more schemes fail.  I was working on these issues but there was no sense of urgency, I hope that the new Government will take this matter more seriously now.

August 4, 2016   2 Comments

Rejoice or despair? Five years of record low rates and QE

28th February 2014

It is almost exactly 5 years since the Bank of England cut short-term interest rates to 0.5% and started printing billions of pounds to force long-term interest rates lower.  Good news for some?  Dreadful for others.  Should rates be rising or stay where they are?

TEN REASONS TO REJOICE – these policies are great and have had tremendous benefits

  1. Borrowers have had a bonanza with mortgages getting cheaper and cheaper, encouraging people to borrow far more than they will be able to afford when rates reach more normal levels
  2. Wealthy investors have benefited from exceptional gains on their portfolios of bonds
  3. Gilt yields have fallen to record low levels which reduces interest costs on Government debt, thus helping the Government in its management of the economy through austerity
  4. The financial sector – an important part of the UK economy – has been boosted by official support that created flows of new money and allowed debts to be restructured or written off
  5. As the Bank of England has bought record amounts of gilts, investors have switched funds into other assets, both bonds and equities, but also emerging markets and real estate
  6. Top earners have seen their pay rise rapidly as companies have taken advantage of benign market conditions
  7. Stock markets have reached record highs, especially FTSE250, but even FTSE100 with dividends reinvested is well past its previous peak
  8. House prices have rocketed due to rising mortgage borrowing – most expensive homes have risen most in price
  9. Consumer spending has been buoyed up by borrowing
  10. Companies have record amounts of cash in their balance sheets and large firms have been able to afford to borrow on the bond markets at record low rates, due to the fall in gilt yields

BUT

TEN REASONS TO DESPAIR –  despite benefiting some groups, these policies have caused serious damage

  1. The £375bn of newly created money has not been directed into small firm lending or investment in long-term growth projects – it has been used to boost bank balance sheets and financial transactions rather than real long-term growth projects.
  2. The banking sector has still not dealt properly with its problem debts and has not been lending to small businesses – instead it has focussed on increasing revenues from market trading and financial engineering, rather than investing in the real economy
  3. Monetary policy is lulling borrowers into a false sense of security and enticing people to take out loans that they will struggle to afford at ‘normal’ interest rates, so the policy is great for short-term benefits, but carries dangerous longer-term consequences.  Instead of building a lasting recovery on new investment, the focus has been or pushing up house prices instead of building new homes and on enticing people to borrow to buy more houses – this kind of irresponsible borrowing led to the financial crisis in the first place.
  4. Low mortgage rates and rising house prices are not necessarily a ‘good thing’.  Only one third of UK households have a mortgage.  Those with mortgages have benefited significantly from a boost to their income, but those who are renting (another one third of UK households) have faced rising rents which have hit their standards of living.
  5. By distorting gilt yields, the Bank of England has interfered with the supposedly risk-free interest rate, thereby distorting investment risk in ways that investors cannot understand, while also increasing the volatility (risk) in financial markets
  6. Younger generations have suffered as rising house prices have led to rising rents and, as real wages have been under pressure and interest on savings is so low, it has become even more difficult for them to afford the costs of living.  Unemployment and underemployment have remained problematic as businesses have failed to invest their cash piles
  7. Pension fund deficits have ballooned
  8. Annuity rates have plunged leaving millions of pensioners permanently poorer throughout the rest of their lives If you have reached retirement in recent times, your pension savings will buy you a much lower pension income than you would previously have expected
  9. Savers have lost most of their income and their capital has been eroded by higher inflation (boosted by QE) although price inflation has subsided now, with price rises moving to asset markets rather than goods markets. If you were expecting to live on your savings in retirement, low rates have been disastrous.  The more you had saved, the more your income will have fallen
  10. National and regional income and wealth inequalities have risen significantly – National income and wealth has been redistributed from middle income to the wealthiest and higher earners,  from north to south, from least prosperous areas to most prosperous and from older generations to middle aged groups

So what is your view? 

ENDS

February 28, 2014   1 Comment

Analysing BoE’s statistics on mortgage and savings interest rates

4 February 2014

  • No surprise there’s a housing bubble as latest Bank of England figures confirm bonanza for mortgage holders
  • 100,000 Mortgage borrowers £3,300 a year better off
  • Savers with £100,000 saved up are now £4,000 a year worse off

Analysing the Bank of England’s statistics on interest rates in mortgage and savings markets since 2007 shows fascinating results.  The extent of income gains for mortgage borrowers is startling and the losses for savers are significant.  Those with the largest mortgages benefit most, of course, which has particularly benefited people living in London and the South.  Meanwhile all savers have lost out as a result of record low rates.

£100,000 tracker or SVR mortgage repayments now c.£3300 a year lower than 2008: Loan repayments on a £100,000 mortgage are now £3200 a year less, giving borrowers substantial extra income as a result of the drop in mortgage rates since end 2007.  Those with tracker mortgages have seen an income gain of £3,280 a year lower and those on Standard Variable Rates are paying £3290 a year less than in December 2007.  The huge rise in housing prices is hardly a surprise when mortgage borrowers are receiving such an income boost.  Even though house prices have risen, the availability of cheap loans makes initial repayments seem much more affordable.  Is this sustainable?

One third of households with mortgage have had enormous income boost: The huge gains for mortgage holders may help explain the support for low rates that has persisted even in the face of economic recovery. Although only one third of households actually has a mortgage, while the other two thirds either own their home outright or are renting, the interests of those with mortgages have been driving the policy agenda. Those with mortgages have a vested interest in opposing rate rises. Meanwhile, savers have little voice or power to alleviate their losses, or are being forced to take much more investment risk.

Savers with £100,000 is Cash ISA or fixed bonds are losing at least £4,250pa income: By contrast, a saver with £100,000 of savings in Cash ISAs or fixed rate bonds is more than £4,000 a year worse off than in December 2007 due to the interest rate falls.  The average Cash ISA in December 2007 paid £5350 a year interest, but by December 2013 it was just £1090 a year – £4260 a year lower.  The average fixed rate bond paid £5990 a year in 2007, but only £1440 a year in December 2013 – a loss of income of £4550. The Table below summarises the borrowers vs. savers situation

Interest saved on £100,000 mortgage vs. interest lost on £100,000 savings 

 

Annual interest

Dec 2007

Annual interest

Dec 2013

Difference

BORROWERS

     

£100,000 tracker mortgage

£6200

£2920

 £3280pa gain

£100,000 SVR mortgage

£7680

£4390

 £3290pa gain

SAVERS

   

 

£100,000 savings in Cash ISA

£5350

£1090

 £4260pa less

£100,000 savings in fixed rate bonds

£5990

£1440

 £4550pa less

Source:  Bank of England statistics, Table G.13

– uses closest comparable figures

February 4, 2014   No Comments

Prolonging the party – who wants rates to rise?

31 January 2014

  • Bank of England statistics confirm bonanza for mortgage holders
  • Mortgage borrowers may be £3,300a year better off and savers over £4000pa worse off
  • Low rates are huge help for mortgagees – no wonder so many don’t want rates to rise

Analysing the Bank of England’s statistics on interest rates in mortgage and savings markets since 2007 shows fascinating results.  The extent of income gains for mortgage borrowers is startling and the losses for savers are significant.  Those with the largest mortgages benefit most, of course, while all savers have lost out as a result of record low rates.

£100,000 tracker or SVR mortgage repayments now c.£3300 a year lower than 2008: A borrower with a £100,000 tracker mortgage have benefited by over £3200 a year extra income as a result of the drop in mortgage rates since end 2007.  Tracker mortgage repayments are £3,280 a year lower and those on Standard Variable Rates are paying £3290 a year less than in December 2007.

Saver with £100,000 is Cash ISA or fixed bond now losing £4,250 or £4,500 income: By contrast, a saver with £100,000 of savings in Cash ISAs or fixed rate bonds is more than £4,000 a year worse off than in December 2007 due to the interest rate falls.  The average Cash ISA in December 2007 paid £5350 a year interest, but by December 2013 it was just £1090 a year – £4260 a year lower.  The average fixed rate bond paid £5990 a year in 2007, but only £1440 a year in December 2013 – a loss of income of £4550.

One third of households with mortgage have had enormous income boost: The huge gains for mortgage holders may help explain the support for low rates that has persisted even in the face of economic recovery. Although only one third of households actually has a mortgage, while the other two thirds either own their home outright or are renting, the interests of those with mortgages have been driving the policy agenda. Those with largest mortgages (middle-aged with more expensive houses particularly in the South East) have a vested interest in opposing rate rises. Meanwhile, savers have little voice or power to alleviate their losses, or are being forced to take much more investment risk.  The Table below summarises the borrowers vs. savers situation

Interest saved on £100,000 mortgage vs. interest lost on £100,000 savings

 

Annual interest Dec 2007

Annual interest

Dec 2013

Difference

Monthly interest Mar 2008

Monthly interest

Dec 2013

Difference

BORROWERS

£100,000 tracker mortgage

£6200

£2920

 

£3280pa gain

£517pm

£pm

 

£273.33pm gain

£100,000 SVR mortgage

£7680

£4390

 

£3290pa

gain

£640pm

£pm

 

£274.16pm gain

SAVERS

 

 

£100,000 savings in Cash ISA

£5350

£1090

 

£4260pa

less

£445.83

£90.83

 

£355pm

less

£100,000 savings in fixed rate bonds

£5990

£1440

 

£4550pa

less

£499.16

£120.00

 

£379.16pm

less

Source:  Bank of England statistics, Table G.13

– uses closest comparable figures

January 31, 2014   2 Comments

Well done Mr. Carney ….

28 November 2013

… for focussing Funding for Lending on business loans – which is what it should always have done.

At long last some relief in sight for savers?

The Bank of England’s announcement today that the Funding for Lending scheme will only be available for business lending, not mortgage lending, is fantastic news. At long last, there seems to be a recognition that there are real dangers of a housing bubble based on unsustainably cheap mortgages and that the real problem in bank lending has been for small firms. Whether or not the recent revelations of poor practice by banks has led to this sudden announcement is not important, but the news is really great.

SMEs have been starved of loans for the past few years, whilst banks have refused to lend to them on reasonable terms, even after Funding for Lending started. Banks have failed to offer reasonable terms to small firms, often imposing high fees or draconian collateral requirements that have made it impossible for these businesses to borrow the money they needed.

Bank of England figures show clearly that banks have not been playing their part in lending to support growth for smaller enterprises and far too much of the increase in lending has been based on mortgage loans. This has caused distortions in the housing market, has pushed up rents and runs the risk of a painful period ahead when interest rates normalise.

Savers have also suffered as a result of the banks’ focus on using funds from FLS to drive mortgage lending. In effect, banks no longer needed savers money and could fund mortgages without having to pay for savers’ deposits. From next year, however, mortgage business will require other sources of funding, so perhaps banks will start offering savers better deals. It is too soon to pop the champagne corks just yet, but hopefully there will be much better news in 2014.

There was a dramatic drop in savings rates straight after FLS began and a return to higher saving rates is long overdue. Interest rates are still lower than inflation for most savers and as the economy is growing strongly now, a rate rise is likely sooner or later.
Well done Mr. Carney for finally focussing Funding for Lending on business loans, which is what is should always have done.

November 28, 2013   3 Comments

Rates are too low as economy booming – Forward Guidance looking backwards

Interest Rates are too low as economy booming - Forward Guidance looking backwards

14 November 2013

  • Bank of England repeating past mistakes – rates should start rising as UK growth set to surge
  • Mortgage borrowers enticed into large loans at low rates as loan to income ratio returns to pre-crisis peak
  • Keeping rates at 0.5% is about politics, not economics
  • Take the squeeze off pensions and savers – and encourage companies to spend their £200bn cash pile
  • UK economy is booming – but BoE looking backwards instead of forwards:

The Bank of England has finally realised that the UK economy is actually performing well.  All the forward indicators have been signalling strong growth for months now, yet policymakers and commentators have been failing to see the road ahead.  Monetary policy has been steering while looking in the rear view mirror.

Forward guidance is looking backwards – Unemployment is a lagging indicator:  The policy of ‘forward guidance’ is focussed on a backward indicator.  Unemployment has always been a lagging economic indicator.  Meanwhile, the leading economic indicators point to rising consumer spending, rising business confidence, rising construction activity, booming house prices and increased job creation.  By the time unemployment falls to 7%, the economy will already have been growing strongly for some time.

Repeating pre-crisis errors of encouraging unaffordable debt:  Worryingly, many more people are being encouraged to borrow huge sums to buy homes at inflated prices, at multiples of salary that are back to the levels of the pre-crisis euphoria, but at interest rates that are clearly unsustainable.

Mortgage loans back to pre-crisis peak, house prices booming outside Circle Line too:  The policies of Funding for Lending and HelptoBuy have stoked up a housing boom which has led to over-exuberance.  Coupled with the billions of pounds of new money created by Quantitative Easing, the economy is being driven by debt once again.  The ONS reports that house price inflation is over 4% in 10 out of 12 regions of the country and there has been an increase of 34% in first-time buyers coming into the market.  They are borrowing a record 3.39 times their join £35,600 incomes, which equals the peak of the noughties boom – as shown in the chart.

If borrowers can’t afford their debts as rates rise from 0.5% to 1% then loans eventually will default anyway:  One of the reasons given for not beginning to raise rates now is that people would be unable to afford to repay their mortgages.  This is not a sufficient justification, certainly not now that the economy is motoring.  Surely, if borrowers cannot afford their loans with interest rates moving up from 0.5% to, say, 1%, 2% or even 3%, then those loans are too large for them.  Rates cannot stay at these levels for ever and the sensible move is to gently edge rates up from the emergency crisis levels.

Rates are at depression levels, rising from 0.5% is hardly ‘tight’ policy – more about politics than economics:  Rates were cut to 0.5% in order to stave off depression.  Given that the economy is clearly recovering, one has to wonder why rates are still stuck near zero.  This seems much more about politics than economics.  Prudent monetary policy would normally recognise that interest rates operate with a lag and, if growth is set to be strong twelve months out, rates need to start rising now.

Companies have £200billion cash pile – Chancellor should introduce tax breaks to encourage investment:  Instead of keeping rates so low, the Chancellor should use his Autumn Statement to introduce temporary tax breaks for corporate capital spending.  Companies have over £200billion in cash sitting on their balance sheets – that could help the economy achieve long-term sustainable growth, rather than fuelling more borrowing that will eventually have to be repaid or default.

Rates should normalise to stop pension funds and savers being penalised to support unsustainable borrowing:  Keeping rates at 0.5% for so long is leaving pension funds and savers struggling to cope with interest rates that do not reflect economic reality.  Pension deficits continue to hamper some companies unnecessarily, annuity rates are so low that millions of pensioners will be permanently poorer for decades to come and those who have saved for their future are still struggling as their income and capital is not keeping up with inflation.

Delaying rate rises is risking another crash:  Come on Mr. Carney, you can rebuild confidence by signalling a small rise in rates to more normal levels, rather than leaving it too late.  The longer a rate rise is delayed, the greater the risk of a sharp rate rise later and another crash.

November 14, 2013   No Comments

Potential good news for pensioners as gilt yields rise

17 September 2013

  • Rising gilt yields and revised regulations could increase pensioner incomes from income drawdown by 50%
  • But inflexibility prevents pensioners from accessing more of their money
  • By the time they are allowed to, the opportunity may be lost
  • Need to make drawdown more flexible and allow for ill-health

 Recent rises in gilt yields and Treasury rule changes for income drawdown mean people could now take much more money out of their pension funds than last year.  This should be really good news for pensioners, but they are often unable to benefit.

40% increase for men and 50% for women since August 2012:  In August 2012, the drawdown income limits fell to a record low, with a combination of Bank of England policies and Treasury rule changes conspiring to drive down pensions from income drawdown.   Since then, conditions and rules have improved dramatically resulting in far higher potential incomes for pensioners in drawdown.

 Treasury rule change in March 2013 allowed people to take out 20% more: In March 2013, Government rule changes allowed pensioners to take out 20% extra from their funds.  The Treasury bowed to pressure to increase the drawdown limits as government bond yields fell sharply following the Bank of England’s Quantitative Easing policy.

Recent rise in gilt yields increases amounts that can be withdrawn as GAD rate rises:  The second factor increasing drawdown incomes is the recent increase in gilt yields.  15-year gilt yields have risen from 2% in August 2012 to around 3.25% now.

65 year old man with £100,000 drawdown fund could take extra £2,000pa now: The table below shows the changes that have occurred since August 2012, with an increased maximum allowance of 120% of the GAD rate and higher gilt yields.  A 60-year old man is now entitled to over 40% more income than this time last year and a 65-year old to 38% more.  This amounts to around £2,000 a year extra income that they should be able to take out of their drawdown fund.

 Change in maximum annual withdrawal allowed for 65 year old men since August 2012

15-yr gilt yield 2% Aug 2012 Male rate

15 yr gilt yield 3.25%

Difference as gilt yields rise 2% -> 3.25%

Extra income per year

100% of GAD

120% of GAD

Age 55

£ 4,100

£ 5,880

43.4%

£1780

Age 60

£ 4,600

£ 6,480

40.9%

£1880

Age 65

£ 5,300

£ 7,320

38.1%

£2020

Age 70

£ 6,200

£ 8,400

35.5%

£2200

Age 75

£ 7,700

£10,200

32.5%

£2500

 

Women also benefit from unisex rates too, meaning potential 50% higher income: For women there has also been a third positive factor.  Annuities moved to gender neutral pricing at the end of 2012, which meant that the Government Actuary had to make its drawdown tables unisex too.  Moving women onto men’s drawdown limits has boosted the income withdrawal allowances for women, since the female rates were previously lower than male rates due to women’s longer life expectancy.

 Change in maximum drawdown income allowed for women age 65 since Aug 2012

15-yr gilt yield 2% (Aug 2012

female rate)

15 yr gilt yield 3.25%

Difference as gilt yields rise 2% -> 3.25%

Extra income per year

100% of GAD

120% of GAD

Age 55

£ 3,900

£ 5,880

50.8%

£1980

Age 60

£ 4,300

£ 6,480

50.7%

£2180

Age 65

£ 4.900

£ 7,320

49.4%

£2420

Age 70

£ 5,800

£ 8,400

44.8%

£2600

Age 75

£ 7,000

£10,200

45.7%

£3200

 

This is all great in theory, but in practice drawdown rules are too inflexible to allow pensioners to benefit:  This all sounds great in theory, however in practice drawdown scheme rules are so inflexible that they may not permit access to this increased income now.

Can only get 120% of GAD at start of next ‘scheme income year’:  Pensioners can only move from 100% to 120% of GAD limit from the ‘scheme income year’  following March 2013, which could mean waiting till March 2014 to increase their income withdrawal.

Can only move to new GAD rate or unisex rate at next ‘recalculation point’ which could be up to three years away: In relation to the other factors which have also boosted the permitted income withdrawals from income drawdown, the inflexibility of the drawdown rules can be even worse.  Increases due to the rise in the GAD rate and unisex rates cannot be reflected until a ‘recalculation point’ is triggered in their income drawdown policy.  A ‘recalculation point’ will only be reached automatically at the next statutory review point, but for some this could be up to three years away.  During that time, some of the beneficial changes may actually have reversed and people’s money will remain stuck in their drawdown plan without them being able to take advantage of the better environment.

No allowance for poor health:  Even though the annuity market does give higher income for those in poor health, income drawdown rules do not offer ‘impaired life’ rates.  Those who are in ill-health may be reluctant to give all their money away to buy an annuity, but may also need to take more money out of their drawdown pension fund to live on.  The inflexibility of drawdown rules can cause hardship and it is particularly frustrating at the moment because there is a theoretical opportunity to take more money out, but pensioners seem too often unable to take advantage of this.

 

Can anything be done? There are some possible avenues:

1.  Activate an annual review:  It might be possible to request an additional review, before the next one is officially due.  Anyone who takes out an income drawdown policy  before age 75 will usually have a three year statutory review period.  After age 75, the review period falls to one year.  However, some schemes will allow you to opt for an annual review facility.  This allows a yearly check on whether more money can be withdrawn than the current maximum.  It is up to the administrator of the fund, however, to decide whether to allow these non-statutory reviews.

2.  Top-up the income drawdown fund:  Another option for anyone under age 75 might be to use other pension fund money or set up a new pension contribution.  Transferring new pension fund money into an income drawdown fund can trigger a new calculation point, which could allow the pensioner to take advantage of the more favourable conditions and take more money out of the fund.

3.  Buy an annuity or scheme pension with part of the drawdown fund:  If the pensioner decides to use a part of their drawdown fund to buy an annuity or scheme pension, then the rest of the fund can be reassessed in light of current circumstances.  That could allow the pensioner to benefit from the higher levels of maximum withdrawal.

You can access the drawdown tables by clicking on the link on the following page: http://www.hmrc.gov.uk/pensionschemes/gad-tables.htm

September 16, 2013   No Comments