Impact of QE on pensions
by Dr. Ros Altmann
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Quantitative Easing has harmed UK pensions. By creating £375billion to purchase gilts, the Bank of England has damaged both Defined Benefit and Defined Contribution pensions.
As gilt yields fell, annuity rates plunged from around 7% in 2009, to 5% last year, while inflation-linked annuities have become exceptionally expensive. This immediately and permanently impacts DC scheme retirees and also causes problems for DB trustees, as lower bond yields increase the costs of de-risking, buy-in or buy-out and worsen scheme funding due to lower liability discount rates. Despite potentially higher asset values resulting from lower rates and portfolio rebalancing, QE has a negative net impact.
Sensitivity analysis by academics and the Bank of England itself show that a 100bp fall in gilt yields inflates pension liabilities by 18-20%, but only increases assets by 6-10%. Thus, deficits rise.
Trustees face a quandary. If these low yields result from temporary policy decisions, should pension funds as long-term investors adjust to them, or look through the current environment in anticipation of QE unwinding. Trustees are torn between switching from gilts into riskier investments, or buying more bonds in an effort to de-risk in such uncertain times.
QE has caused these conflicting pressures because it interferes with the supposedly ‘risk-free’ interest rate – against which other asset classes are priced. All financial asset markets are distorted by QE gilt-buying. If the lowest risk assets are distorted, investors cannot be sure how to assess investment risk.
This is exemplified as gilts were a top-performing asset class to mid-2012, but then lost over 10% of their value the following year. Hardly characteristic of a low-risk asset. If gilts have become more risky, does this mean riskier assets are relatively less risky? Historic volatility and correlation models may be less reliable due to the artificial distortions of QE, although nobody yet understands the full impact.
Pension trustees have a difficult balancing act. De-risking is not straightforward in the face of distorted asset prices. Being fully hedged, when interest rates are more likely to rise than fall, may not be optimal for schemes with large deficits and weak sponsors, especially as there are no perfectly matching assets. Under-hedging could help deficit-reduction. Downside protection is of course important, but allowing room to capture the upside is also critical to long-term success. The case for increased diversification has strengthened.
QE has distorted markets and economies in ways we do not yet fully understand. Asset risks may have risen, but controlling those risks is more challenging if historic models are less reliable. Increased deficits have caused company failures and the Pension Regulator’s belated new objective to consider scheme sponsors’ long-term survival is a welcome acknowledgement that deficits may be distorted by QE.
The jury is still out on how damaging the pension ramifications of QE may be. Will any short-term gains be offset by longer-term pain? The easiest part was introducing QE, but the real policy challenges come when it is unwound. Having significantly increased allocations to bonds which are not a perfect liability match, the downside risks for pension schemes from QE unwinding could pose further threats.
Dr. Ros Altmann