18 August 2016
QE: Catch 22 For Pension Funds
The unintended consequences of quantitative easing could be terminal for the pensions industry.
by Frank O’Nomics
The latest round of quantitative easing from the Bank of England risks driving businesses into failure and retired households into penury. That may seem an overly dramatic statement, but a minor event at the start of the latest round of QE, where the Bank was unable to buy all the long-dated gilts it wanted because pension funds refused to sell them, is a striking illustration of the dilemma into which it has been placed. The reluctance of the funds to sell comes from a disinclination to invest the money in other, less safe assets, which may be understandable given the high level of equity markets and the uncertainty surrounding the terms of our forthcoming departure from the EU. However, by refusing to sell their gilts, pension funds effectively force the Bank to offer higher prices to tempt other institutions to sell them bonds. This might seem clever in the short-term, as the value of pension fund gilt holdings will increase accordingly, but higher prices mean lower yields, which are then used to calculate the value of the future liabilities of the fund. Put simply, the lower yields prompted by QE are effectively, and rapidly, increasing the size of pension fund deficits. As these deficits grow, and the corporate entities behind the funds struggle to cover them, the chances of the funds becoming insolvent increase, raising the prospect of them falling on the pension protection fund, which in turn potentially leads to cuts of up to 20% in payments to pensioners. In addition, these lower yields are driving down the level of annuity rates, which means that those looking to retire face doing so on a much lower income. This is serious, and needless to say, finding ways around it is not easy, but there are potential changes that could limit the damage and they need to be adopted as soon as possible. Before looking at these alternatives it is important to understand just why QE has been re-adopted.
The MPC is clearly worried that the consequences of the Brexit vote will be a significant slowing of the UK economy, with a risk of a technical recession. Given this fear they have cut interest rates further and embarked upon a further round of QE, which consists of buying £60 billion of UK government bonds and £10 billion of corporate bonds. This is intended to encourage investors to sell gilts and to reinvest in other assets, such as equities and property, which will give a direct stimulus to the economy. At the same time the combination of an interest rate cut and the reduction in bond yields occasioned by QE will help to reduce the cost of borrowing for businesses, thereby encouraging them to invest for future growth. The problem, however, is not that companies are baulking at the cost of borrowing, but more that they do not have the confidence to borrow – i.e. it is a lack of demand for, not a supply of, finance that is restricting borrowing. Hence the effect of QE merely drives down the level of bond yields without stimulating growth as intended.
It is not easy to strip out the QE effect on bond yields from the other factors, such as the fall in inflation, slowing growth and an increase in regulatory requirements on pension funds (which has led them to increase the proportion of fixed income securities in their portfolios), but 30 year yields have fallen from a level in excess of 4% before the financial crisis to a little over 1% now. These yields are used to evaluate the future liabilities of pension funds and as a result the aggregate level of the deficit within the 6,000 final salary schemes has risen from £294 billion in May, to £386 billion in June and £408 billion on the most recent estimates. It is not just defined benefit schemes that have been impacted, with those on defined contribution schemes suffering tremendous falls in annuity rates. A £100,000 pension pot for someone aged 65 would have provided almost £8,000 of annual income just 8 years ago, yet now will provide just under £5,000, and with every further fall in long bond yields these annuity rates will come under still further pressure.
What can be done to resolve a situation, which is potentially pushing corporates to the PPF and households to the workhouse? The simple answer would be to stop QE now, but given that the bank has only just embarked on the latest initiative that is clearly not going to happen. One very logical move would be to stop buying longer duration bonds and focus only on bonds out to 7 years. This would help steepen the yield curve and reduce pension fund deficits. It may increase the cost of longer-term borrowing for corporates but, given that there are only limited signs of demand for this, the impact would be minimal, and fixed mortgages rarely go beyond 5 years, so the increased pressure on 5-10 year yields would actually be a benefit to households. There is a strong case for taking a more significant step by selling the Bank of England’s current holdings of longer-dated bonds back to the market and buying shorter dated bonds instead. This would maintain the pool of assets that the bank owns, but make it much easier for pension funds to buy the long bonds they need at yields that would help them reduce their deficits. The US did something similar (in the other direction) in its QE programme, in a move called Operation Twist. Given the preference for 30 year fixed mortgages in America, it made sense for the US Treasury to sell its shorter bonds to buy longs and hence reduce borrowing costs for households. The other way to counter some of the effects would be to shift the balance of issuance of gilts towards the longer end of the curve, and to potentially increase borrowing overall.
The shortfall in the first purchase of long gilts was a mere £52 million, which in a £60 billion programme is relatively insignificant and may have partly been caused by the new initiative catching funds by surprise, at a time when many key decision makers were on holiday, but the fact that the Bank is looking to make up the difference over the next 3-4 months suggests that they appreciate that it may not be a straightforward process. There are many reasons why long-term yields are so low, and with an ageing population, it is unlikely that we will see a dramatic rise regardless of whether the policy of QE is continued or not. However, it does seem that QE is exacerbating an already very serious situation and any further sustained fall in long yields risks causing corporate failure and an increase in household poverty. The early response to QE may illustrate that we are reaching the limit of what monetary policy can achieve, but if bond purchases are a necessary evil for now, there are ways in which the unintended consequences for the pensions industry can, to some extent, be mitigated. This needs to be addressed as soon as possible.
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