Quantitative easing has made saving for old age a lot harder
Years of near-zero interest rates and ultra-low government bond yields in major economies are posing huge challenges for pension providers
Long gone are the days when final salary pension schemes used to be the gold standard for people entering retirement. Our pensions' culture is heading into hard times and it is not just our ageing population to blame.
Years of near-zero interest rates and ultra-low government bond yields in the major economies are posing huge challenges for pension providers. And for many people looking forward to a generously funded retirement the outlook looks discouraging. The impact of quantitative easing in recent years has caused a lot of the problems.
Without a doubt, the world would have been a lot worse off without quantitative easing from the United States, Japan and Britain in recent years. The flood of new money created by central bank bond-buying helped secure global economic recovery and stopped the slide into financial Armageddon. But not everyone is a winner.
Borrowing costs sank as short-term interest rates plunged to zero and bond buy-backs forced long-term interest rates to record lows. It was good for economic recovery and borrowers, but it has been a disaster for savers and retirement plans linked into long-term bond yields.
In Britain, pension annuities - insurance policies which pay out a regular income in retirement - have been falling in value for many years. Annuity returns are typically linked to 15-year British government bond yields (gilts), which have been in long-term decline but more recently went into meltdown thanks to the impact of quantitative easing.
The consequences of the Bank of England's quantitative easing bond buying programme were dramatic. The central bank reduced the supply of gilts in the market by buying them up from banks, insurance companies and pension funds. The resulting shortage has pushed up gilt prices and led to a sharp drop in yields, thereby reducing the value of annuity income a pensioner can buy from a pension provider.
In March 2009, when the first quantitative easing took place in Britain, annuity rates were yielding almost 7 per cent. Six years on, average annuity rates are running close to 5 per cent and look set to go a lot lower. It will make the task of saving for old age much more difficult.
British gilt yields will remain under downward pressure for a number of reasons. The Bank of England is starting to waver on its expected timeframe to "normalise" British rate policy. Plans to tighten interest rates this year are being compromised by the economy's sudden dip into deflation. And it may take years before the bank makes serious inroads into reducing its stockpile of asset purchases, slowing the return to higher gilt yields and better annuity rates.
British bond yields are also being depressed by heavy demand for gilts from European investors looking for better investment returns. Market anticipation of quantitative easing by the European Central Bank has been a driving force for lower German government bond (bund) yields for months. Investors can get three times their return by switching into gilts out of bunds in the 10-year area. This heavy switching flow looks set to continue for a long while, especially with ECB quantitative easing just in its infancy. Fifteen-year British gilt yields have already plunged to a record low 1.7 per cent and the stage looks set for British annuity rates to head towards the 3 to 4 per cent area in future.
It is causing distortions in the labour market. Britons cannot afford to retire early and are having to postpone their retirement dates further into the future, staying longer in the workforce and blocking younger entrants from the jobs market in the process.
What is needed is higher growth, more inflation, bigger budget deficits and for the US Federal Reserve and Bank of England to start unwinding their huge stock-pile of debt before global bond yields stand a chance of moving higher again.
The odds of this happening in the short run are low. Global growth is starting to lose momentum, deflation is getting more embedded, austerity policies remain in force and central banks are holding on to their quantitative easing bond spoils for the time being. The 34-year bull market for mainstream government debt looks far from running out of steam, especially while safe haven demand keeps the bond market well bid.
There is no end in sight to pensioners' plight right now.
