extermination without pity

The death of pensions

One side effect of quantitative easing (QE), which has so far received perhaps too little attention in some quarters, has been to exert significant collateral damage on insurance and pension funds. Both sectors have substantial long-term liabilities - particularly in the case of defined benefit schemes, for example either final salary or career average pensions. In both these cases the liabilities are not guaranteed to be covered by the contributions from either current or future members but rely on the fund producing sufficient returns on investment of contributions. If the fund fails to achieve those returns it falls into deficit, with too little money to pay it’s future liabilities.

To determine if a scheme is in surplus or deficit one needs to calculate the expected present value of future liabilities and the present value of assets. To do this calculate future payments we expect to make and then discount them by a factor related to the expected return on a ‘risk-free’ investment between now and the payment date. That is, we calculate how much money we expect we need to have now in order to have the required amount in future, given we could earn some money by investing in the intervening period. This is essentially related to the concept of the time value of money. Money now is worth more than the same quantity of money in the future, because we could always put that money now into some very low risk investment and get back a larger amount in future.

As a measure of this ‘risk-free’ interest rate it is normal to use government bonds, or gilts, as, in normal circumstances, if it is sovereign with its own money supply and central bank, a country can always print money if necessary to pay its debts and should never have to default. (Countries do, of course, sometimes default on their debts, though this is usually only the case where they have tied their currency to that of another country - see e.g. Argentina fixing its exchange rate with the dollar or Greece’s membership of the euro.)

The larger the risk-free rate, the less money we need now, as the larger interest rate will increase our current money by a larger amount. Conversely, if gilt yields decrease, interest rates go down, our expected future liabilities go up.

When central banks enact quantitative easing they buy bonds. This forces up the price of the bonds, as demand increases while supply stays constant, which correspondingly forces yields down. In this way QE allows the bank to push longer-term interest rates in the market lower, even when the base rate is already at or near zero (as it is at the moment in the UK).

So one effect of QE is to increase liabilities. If you had a completely balanced portfolio of assets and liabilities, of the same type of financial instruments, the change in the value of one should balance the change in the value of the other and overall you should be no worse (or better) off. 

But say, at the other extreme, your assets are all in cash. This won’t increase in value, but your liabilities will still increase. So you are now worse off overall. (The effect is essentially the same as if inflation had reduced the value of your cash.) If your assets are all equities (shares for example), you’ll likely find that some of that additional money supply filters through and increases their value; despite the protestations of the Bank of England that equities and gilts have changed by exactly the same amount, though, it is likely you’ll still see some overall loss. Finally, if your assets were already less than your liabilities, that deficit will also have been inflated. You will now be more in deficit.

This is the unfortunate situation for many pension funds today.

But what does this mean?

Well, at a superficial level the funds will probably be more in deficit than they were a few years ago, and with that deficit will come a pressure to cut payments in retirement, change scheme terms and conditions and increase contributions in order to re-balance the books. But is that really necessary? 

The actual liabilities haven’t materially changed; the number of members in the scheme, the current assets, the average life expectancies, the required payments in future are all the same as they were. All that is different is that those future liabilities are now valued at a higher cost today because of the change in long-term interest rates. So the question then becomes, are those rates realistic?

It could be that the low rates predicted today are merely a reaction to a set of specific conditions we’re currently experiencing and which will, in time, pass. In the wake of the financial crisis poor economic management has led to a double dip recession and little prospect of growth. Investors are scared of eurozone instability and seeking safety in government bonds. But in time growth and confidence will return and with them higher interest rates that reduce liabilities and re-balance funds without the need for any attack on current conditions.

But, as I talked about previously (echoing a long-running theme on FTAV) perhaps that picture of a return to business as usual is too optimistic and we are, instead, entering a new period of economic normalcy. Perhaps instead we should be preparing for years, decades or even perpetual low to zero growth and low or even negative interest rates as we move into a realm of material abundance and value scarcity.

In which case, what future is there for pension funds as we currently know them at all? With no natural fund growth from investments the amount of money one has to put aside to fund a retirement of 20-30 years on a working lifetime of 30-50 years quickly becomes all but impossible for most working class people - especially at a time when real wages are stagnant at best and unemployment and underemployment are stubbornly high.

Private pensions and insurance begin, in that case, to look increasingly unsustainable. To prevent mass poverty post retirement we face one of four options: much high real wages, fundamentally shifting the balance in the economy between labour and capital; working many more years for a far shorter retirement; a guaranteed income from the state in the form of much more generous universal benefits; or the abolition of capitalism. You can guess where my preference lies.