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.