Fraser Smart, managing director at Buck Consultants walks us through the effects that quantitative easing has on pension schemes and pensioners - are they seen as collateral damage?
The UK economy is back into recession and has barely grown for a year and a half. Usually the Bank of England would try to increase the amount of lending and activity in the economy indirectly, by cutting interest rates. Unfortunately with the base rate at a record-low 0.5% interest rates cannot go much lower. The Bank's only option is to create money out of thin air and pump it into the economy directly; known to us as quantitative easing (QE).
QE is generally understood to reduce long-term interest rates – though there is debate by how much – and to push up inflation, which is generally bad news for pension schemes. It is on the face of it likely to further drive down annuity rates attached to bond yields, reducing the annual income for someone buying a pension from their accumulated pot. Even if the economy comes out of recession, anyone buying an annuity now (with annuity rates at a record low) will get a very poor annual pension for their pension pot and never get their lost income back. When annuity rates improve insurance companies will not suddenly give pensioners on a poor rate a higher pension.
Pension scheme deficits, calculated monthly by the Pension Protection Fund are spiraling upwards. The cost of paying pensions from defined benefit schemes is based on the assumption that all the assets are invested in bonds. As the yield on them drops so the amount of assets needed to generate a scheme's pension increases. Schemes have to carry out a valuation once every three years and if they are in deficit a recovery plan has to be put in place. Employers of schemes currently carrying out their triennial valuation are therefore facing substantially increased bills for their pension schemes.
What if...
Has QE worked so far? We will never know, for we will never know how bad the economy would have been had the Bank not stepped in. One argument is that asset values would have fallen dramatically without intervention damaging pension plans. I am sure the Bank is well aware of the collateral damage it is doing to pensions and pensioners, but feels it has no alternative but to act.
The jury is out as to whether this latest round of QE will do as much damage to pension schemes as previous rounds. The latest £50bn QE programme, designed to give a further boost to the UK economy, is the first since February 2012 and brings the total amount of QE stimulus to £375bn. £50bn in the scheme of things is a relatively small amount. Interestingly, bond yields have hardly moved since the latest round of QE was announced yesterday and each successive round of QE has demonstrated the law of diminishing returns. With annuity rates already at an all-time low, like interests rates there is not much room for them to fall further.
