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.