Six years ago, after reducing short-term interest rates nearly to zero, the Bank of England started its emergency policy of Quantitative Easing (QE) — creating billions of pounds of new money to buy UK government bonds (gilts) in order to force long-term interest rates lower too. The aim was to stave off economic collapse: any impact on pensions was a secondary consideration. But even though the economy has recovered, the base rate remains at 0.5 per cent and the Bank continues to buy gilts, forcing bond yields down further. Are low rates still needed? Could they be doing more harm than good on a longer-term view? And what are they doing to our pensions?
Although most commentators assume low interest rates are good for the economy, there are negative impacts that have so far been overlooked or ignored. In particular, the low-bond-yield environment has damaged pensions — which could actually depress growth. During last year, company scheme deficits rose by more than £200 billion, as pension assets increased by around 10 per cent but liabilities (which increase when bond yields fall) rose by over 25 per cent. The resulting deficits have caused serious problems for corporate UK. But so far, the Bank of England has shown scant concern for such negative impacts of its policies.
It is not just company pensions that have been hit. Private pension funds have been damaged too. Annuity rates depend on bond yields — and the lower yields fall, the lower retirees’ annuity pensions will be for the rest of their lives. This too could be a future drag on growth.
When QE was first announced, the Bank of England did not buy long-dated gilts for fear of distorting the assets used by UK institutional investors. However, it now owns more than half of the entire free-float of many long gilt issues. Although it has promised not to buy more than 70 per cent of the market in any one bond, the extent of official purchasing is self-evidently distorting markets by shrinking supply in the face of rising demand. By concentrating so much of its asset purchases on the gilts that are particularly relevant for pensions, the Bank is distorting pension fund valuations and annuities. Many companies have poured billions of pounds into their pension funds in an effort to fix the consequent shortfalls, only to find deficits increasing further as the fall in gilt yields makes it difficult to manage their pension situation. There has been a huge spike in bond prices over recent months, with 25-year UK gilts now yielding just over 2 per cent.
As long-term investors, pension funds would normally look through the current environment in anticipation of QE unwinding, but as gilt prices have driven pension deficits up, pension advisers have increasingly recommended that trustees reduce the risks of their pension schemes. The traditional way to do this has been to buy more bonds and sell shares, so trustees have felt forced into buying bonds, whatever their long-term value. This adds to downward pressure on long bond yields. It’s a vicious circle.
Investors frightened of missing out if rates keep falling buy bonds or increase their hedging — which pushes yields down further and also forces them to compete with the Bank of England for scarce long gilt supply. This could become a classic asset bubble, in the very assets that are supposed to be ‘risk-free’. The trouble with bubbles is that they are so damaging when they burst. Yet the dangers seem to have been ignored by the central bank, which is continuing to buy more of the long-dated bonds sought by pension investors.
Even though current bond yields seem divorced from economic fundamentals, pension funds are selling shares and moving into bonds as their deficits keep increasing. There has been a dramatic reduction in stock market investment. In 2006 pension funds held over 60 per cent of their assets in equities, but it is now only 35 per cent (with UK equities being less than 20 per cent), while holdings of gilts and bonds have risen from 28 to 44 per cent.
Movements in bond yields are therefore now far more important for pensions than share prices. When interest rates rise, pension funds could suffer huge losses — so chasing bond yields lower may actually be increasing risk to pension portfolios. Indeed, investing in bonds does not even provide a proper hedge for pension risks. Pension liabilities move in line with longevity, earnings and prices, not just interest rates.
Fraction of pension funds held in gilts and bonds in 2006
Fraction of pension funds held in gilts and bonds last year
Fraction of pension funds held in equities in 2006
Fraction of pension funds held in equities last year
I believe pension funds should be diversifying their asset holdings, perhaps into infrastructure and property, which could more directly boost the economy, rather than buying bonds. However, the impact of monetary policy is forcing them to buy bonds which are not necessarily boosting growth at all.
It is difficult to imagine interest rates of around 2 per cent being maintained for the next 30 years or more. At some point, official purchases will have to stop and rates will rise. When that happens, pension funds could suffer a significant capital loss on their bond holdings, which could further compound their deficits. I fear we could be repeating mistakes of the 1990s tech stock bubble, when pension funds piled into ever-rising stock markets because the markets kept going up even though valuations made little sense on a fundamental view.
It will be some years before we can properly assess the effects of QE on investment markets. It is obvious that QE has distorted the gilts market and this may mean all asset markets are now distorted. Gilts are supposedly the least risky asset, and this drives the relationships on which most investment risk models are historically based. But if gilts are no longer risk-free, what will happen when the bubble bursts? Indeed, with an election coming up, there is also a danger that markets will sell off in fear of higher government spending under a new administration.
This raises important questions. Should the Bank of England stop all further purchases of long-dated government bonds, or even sell some back into the market? How long can it keep artificially interfering with such an important market? And even more importantly, is keeping long rates so low really stimulating the economy?
It‘s quite possible that the negative effects outweigh the positives once yields have fallen so low, as rising pension deficits become a threat to many companies and annuity rates fall. Economic growth responds more to short rates, via the impact on mortgage borrowing; long rates are less relevant, but low long rates are having negative effects by depressing pension and annuity values.
I am concerned that pension funds have pulled out of stock markets and
are buying bonds at ever more expensive levels, rather than investing in assets that can boost growth. The implications of continued falls in bond yields on long-term economic performance are being ignored by policy-makers even though there are clear risks of dangerous asset bubbles: QE has distorted investment markets in ways we do not yet understand, and pension funds may be adding much more risk than they realise in their efforts to be prudent.
The Bank of England needs to engage with the negative impacts of low long-term bond yields. The jury is still out on the long-term effects of QE. The easy part was introducing it. The really hard part will be managing the fallout when it ends.