CRACKS IN THE NEST

Ultra-low interest rates have put the majority of pension funds at risk – and there seems little most savers can do about it

Low interest rates are having a catastrophic effect on pensions

In personal finance there are some figures ballooning too fast to think about – and others shrinking far too rapidly for comfort. Nowhere is this more true than in our pensions after the spectacular collapse of interest rates in recent years. Let’s take the shrinking numbers first. It’s great for businesses and home-loan borrowers that Bank of England interest rates have been brought down to just 0.25 per cent. But for those saving for a pension it has been an unmitigated disaster. For example, despite 20 years of saving £200 a month, retirees today could expect a pension of just £3,774 a year. When they first took out the policy, they were told they could expect nearer £29,000. That means their pensions will have shrunk by 87 per cent compared with insurance company estimates two decades ago. That rate of shrinkage has accelerated sharply in recent months. The fall in bond yields since the UK’s vote to leave the European Union in June has been startling. According to calculations by investment giant BlackRock, market movements following the EU referendum will mean you now need to save 13.7 per cent more to fund the same level of retirement income. In June last year, the firm’s Cost of Retirement Index indicated that a 55-year-old would have to save £19 for every £1 of annual retirement income. Fast forward to this autumn and the same saver now needs £28 to fund every £1. This is an increase of 42 per cent – and the steepest sweep of the curve has come in the past few months since the referendum result. So much for the shrinking numbers. Now for the ones that are ballooning. The UK’s aggregate pension deficit has billowed out to a terrifying £383.6 billion as a result of the long period of low interest rates and record low bond yields on fund returns.

According to the Pension Protection Fund, 84 per cent of pension funds are in deficit. The remaining 16 per cent has a combined surplus of £37.4 billion. Overall, the pension deficit has widened from £294 billion at the end of May and the total private-sector pension deficit surged by £89 billion in June due to the reaction of financial markets to the UK’s vote to leave the EU. A perilous state Tom McPhail, head of retirement policy at Hargreaves Lansdown, warns that the UK’s gold-plated pension system is starting to look tarnished. ‘Deficits are soaring,’ he says, ‘employers are reneging on their promises and still more money is needed.’

BlackRock senior manager Andy Tunningley is more blunt: ‘UK pension scheme funding has never been in a more perilous state.’

The problem, of course, is not confined to the UK or to pension funds in particular. Government bond yields around the world have followed a similar trajectory, with Swiss bond yields turning negative and long-dated Japanese and German bond yields both turning negative. This October the International Monetary Fund warned that insurance companies and pension funds are at risk of becoming insolvent if ultra-low interest rates persist for a prolonged period.

Many might feel that little of this affects them – they are in defined benefit pension schemes where the employer promises a specified monthly benefit on retirement based on the employee’s length of service and earnings history. A pension equivalent to two-thirds of final salary was once typical.

But in September, accountants PwC found that defined benefit scheme deficits had now reached £710 billion, up by £100 billion in August alone. According to PwC, just 67 per cent of the £2.2 trillion of estimated future liabilities of these funds is covered by their assets. The clear implication is that many pension funds are now at risk.

Another complacent response is that these ballooning pension deficit numbers, while scary, don’t much matter. They are statistical

‘Funding retirement incomes this way is costly, and it defies conventional investment logic’

projections by actuaries, and, as bond yields (and prices) are so volatile, such numbers can change radically, as can the response by savers, who will turn to other assets.

But the numbers do matter, firstly because pension regulation has obliged many funds to ‘de-risk’ by investing almost entirely in bonds and fixed-interest instruments, and while this ‘liability-driven investment’ helps to reduce uncertainty over long-term returns, it can trap pension savers into a fund with low returns and no prospect of escape.

Second, billowing pension deficits, if uncorrected, would oblige companies to make ever greater cash injections into their funds – cash that might otherwise have gone to business expansion and investment. Pension fund members would also be called upon to make higher contributions to help compensate for the lower long-term returns on the funds’ investments.

All this can get very circular – and selfdefeating. Actuaries use the yield on gilt-edged stock as a means by which to calculate how much they will have to pay out in pensions in the future. A fall in the interest rate means a company needs more now than it had previously calculated. Thus, the more that yields fall, the more that pension savers have to put into the fund to meet their retirement income expectations.

Funding retirement incomes in this way is costly, and it defies conventional investment logic: the more expensive bonds become (the obverse of falling yields) the more of them schemes must buy.

No magic bullet

Now, of course, pension funds have benefited from the rise in the price of bonds, so on a total return calculation it can be argued that the damage may not be as great as those actuarial calculations suggest. Government bonds are also widely perceived as being ‘safe’ investments – or at least ‘safer’ than equities or property.

But how valid is that assumption? There is a growing view that we are approaching a crunch point in bond yields – they have fallen as far as they can and will now start to rise. This, after all the scares of negative interest rates, might sound like the cure. But do you want to be holding your pension fund in an asset class where prices are falling?

Some are bracing themselves for a bond market crunch point. Richard Woolnough, manager of the £15 billion M&G Optimal Income, the UK’s largest bond fund, has moved to ‘negative duration’ on UK debt for the first time in response to the rising threat of inflation and the surge in bond prices since the referendum.

Bond market sceptics have been warning for two years that the market is vulnerable to a reversal. So why worry now? There are clear signs that the era of central bank monetary easing is drawing to a close, and that the US Federal Reserve wants to see rates higher.

There is no magic bullet for this conundrum, other than the time-honoured wisdom of risk diversification – spreading long-term savings over domestic and overseas equities, cyclical as well as defensive stocks, property and gold or gold-related assets as well as bonds. As always; hedge your bets.