The Bank of England MPC has announced a cut in interest rates of 0.25%, together with £60 bn. of gilt purchases and additional purchases of up to £10 bn. of UK corporate bonds. The Bank has also cited the potential to do more of the same. Since it seems very unlikely that lower borrowing costs from current extreme levels will have any meaningful direct impact on consumer or corporate actions, the aim must be largely to boost confidence.
This further loosening in monetary policy will accentuate the already dire state of (defined benefit) UK pension funds as it will help to sustain gilt yields at extreme artificially low levels. For a fairly typical pension fund, a fall in gilt yields of 0.5% increases the value of the liabilities by 7% – 8%. Depending on the amount of bonds held in the fund and the level of funding, this could increase the pension fund deficit by about 5% of the value of the liabilities. The Pension Protection Fund has reported that UK pension fund deficits increased by £89 bn. during June 2016 when Brexit led to gilt yields falling by around 0.5%.
As the latest infusion of monetary stimulus contains a corporate bond component, corporate bond spreads over gilt yields are liable to reduce, exacerbating the situation as pension funds are often valued using corporate bond yields.
The dramatic fall in bond yields since the credit crisis has led to pension fund deficits soaring, even as equity markets have risen by 100% or more, and to pension benefits being greatly reduced. Published data show that the number of UK funds closed to future accrual of benefits for existing members has doubled since 2008 to 34% of all funds. This is over and above the 51% of all funds which are now closed to new members. In many cases the level of existing benefits has been cut, in particular when the fund has had to be taken over by the Pension Protection Fund. This can hardly be good for consumer confidence and consumer spending.
The situation is no better from an employer perspective. Large and ever increasing deficit repair contributions have had to be made to pension funds, yet funding levels are little changed. There has been much analysis of why capital expenditure has been subdued and productivity low, but cash flow which might have been used for capital expenditure has had to be ploughed into pension funds. In some cases, pension fund liabilities have put the company’s existence at risk. Again confidence suffers.
An important feature of the impact of very low yields on pension funds is that the damage done will not be reversed by a change in policy at some later date. Pension funds will not be reopened to new members and it is highly unlikely that accrual of benefits will be restored to existing pension fund members. If deficits turn to surpluses then employers are not permitted to remove the excess assets from the pension fund (although legislation could be changed).
Of course, central bankers cannot normalise monetary policy nor allow credit to be correctly priced because of the massive leverage which is now built into the system. Pension funds obviously benefit from healthy economies and buoyant equity markets.
Nor does the Bank of England act in isolation. The Bank’s actions have been mild compared to the policies being pursued at present in the Eurozone and Japan.
However, one needs to question whether the benefits of lower rates, flatter yield curves and lower risk premiums are now outweighed by the collateral damage inflicted through pension funds and the financial sector. Extraordinarily low interest rates and very flat yield curves are also hitting banks and insurance companies, restraining the creation of credit and provision of finance.
It also seems rather strange that the policy tools being used to support the UK economy are those which most directly impact the more vulnerable and extreme parts of financial markets: sterling has fallen sharply and is considered by many to be vulnerable to further falls while gilt yields are at an extreme.
It is time to pass the baton from monetary policy to fiscal policy and structural reform before the danger arises of a crisis of confidence in central bankers themselves.