Pension funds, annuities and pensioners all damaged by low rates which could damage economic growth
Warning of dangers of another crash as result of distortion of gilt market
Calls for special measures to help pension funds and pensioners
Dr. Ros Altmann, Director-General of the Saga Group, has spoken about the impact of ultra low interest rates on pensions and the possible unintended consequences of keeping interest rates very low for long periods of time.
Dr Altmann says that very low long-term interest rates are having a damaging effect on pensions and pensioners and warn of the dangers that have been created in the current environment.
Summary of dangers of low rates:
· Short-sighted policies risk keeping rates too low and damaging long-term growth
· QE distorts 'risk free' asset market, loading risk onto all assets - another crash?
· Pensioner incomes hit by low rates as their savings income is slashed
· Inflation damages pensioners who cannot make up lost spending power in future
· Worsens final salary pension deficits - each 1% fall in rates, raises liabilities 20%
· Depresses annuity rates depressed, leading to lower pensions for millions
· Government should issue longevity bonds
· Government could consider issuing special pensioner bonds
· Government could revive National Savings products for pensioners
Ros warns policymakers that the current period of low interest rates risks causing another financial crash, possibly worse than the last one, as risk levels for all assets have been increased and institutional investors search desperately for extra returns. Pension investors and people buying annuities are being hit by low long-term rates, and pensioners suffer from low short-term rates as well as their savings income has fallen and they cannot make that up. In addition, they have been hit by high inflation, so they can no longer protect the value of their capital and Government needs to address this urgently.
Artificially low rates distort the 'risk free' asset market, loading risk onto all assets and increasing dangers of another crash.
Quantitative Easing and the maintenance of rock bottom rates risks distorting the one asset markets that is supposed to be 'risk free'. All other assets tend to be priced in relation to Government bond yields. If government bond purchases have been designed to artificially lower yields, then this will impact all other asset markets. By adding risk to the 'risk free' asset, all other assets become more risky and the short-term benefits could ultimately be outweighed by the longer-term risks. When interest rates in the supposedly risk-free market ultimately correct, all other assets could be negatively impacted, leading to another crash. The creation of asset bubbles is, to some extent, the aim of Quantitative Easing, with Central Bank officials having expressed the view that the policy works by increasing asset prices and thus helping the economy. In Dr Altmann's view this may cause severe dislocations in markets when the bubble bursts and the risk of rising interest rates and over-burdened bond markets are not being sufficiently factored into the policy debate.
Pensioner incomes hit by low rates as their savings income is slashed:
Ros Altmann also comments on the dangers of low interest rates for pensioners. Not only will income from annuities be lower for the rest of their lives, but their short-term income is also reduced because any savings income they would have been relying on has been taken away as rates have fallen. She argues that a cut in interest rates is like a cut in the State Pension, since it takes away income they had previously been relying upon. This is potentially economically damaging, as pensioners will have less money to spend and, with an ageing population, this could depress consumption and economic growth - the opposite of the intended policy outcome.
Inflation dangers are real and already damaging pensioners who cannot make up lost spending power in future
Finally, she warns of the dangers of stoking up inflation, especially if interest rates stay too low for too long. We already see signs of rising inflation and this has damaged pensioners significantly already. Their savings income has not kept up with inflation, most annuities are being purchased without any inflation protection and a continued increase in inflation will plunge more pensioners into poverty in future. This, again, could damage economic growth.
Final salary pension deficits worse - liabilities rise by 20% for each 1% fall in rates:
Liabilities of defined benefit pension funds are valued with respect to long-term risk-interest rates and the lower rates are, the higher the liabilities become. For an average final salary scheme, each 1% fall in interest rates is estimated to lead to a 20% rise in pension liabilities, whereas asset prices only increase by about 5%, leaving a much worse funding position.
Annuity rates depressed by low rates, leading to lower pensions for millions
Ros also points out the dangers for members of defined contribution pension schemes, whereby annuity rates are being depressed by low long-term interest rates. Each year, nearly half a million people buy an annuity, so those retiring at the moment are receiving much lower pension income than they would otherwise have had. Once the annuity is bought they cannot change it for the rest of their life. Therefore, depressing long-term interest rates artificially - as the Bank of England and Federal Reserve have done via Quantitative Easing - means that pensioners are being forced to live with lower incomes as a consequence of this artificial depressing of interest rates.
What policy measures could be introduced to alleviate some of these problems?
Ros recommends that, if rates do have to stay low, which she believes is dangerous, that pension funds and pensioners need special protection.
1. Government should issue longevity bonds to help pension funds better match their liabilities - longevity gilts would provide a benchmark for private sector longevity products, as well as offering the opportunity to fund the fiscal deficit. This would help to improve the annuity market and the pension funding of private schemes
2. Government should consider issuing special pensioner bonds, to help provide additional income to pensioners caught by loss of their savings income.
3. Government could consider inflation-protection products for pensioners, such as reviving the National Savings products that were recently withdrawn.