Bank of England’s new stimulus policy creates bankruptcy risk for corporate pension funds
on August 12, 2016

UK pension Aug16The Western BabyBoomers (born between 1946-70), have been one of the luckiest generations in history.  By and large, they have escaped the major wars that have plagued society down the ages.  They have also lived in a world where living standards and material wealth have made astonishing gains.  Equally priceless has been the rise in life expectancy, which means the average 65 year-old can now expect to live another 20 years.

But politicians didn’t want to acknowledge the impact of this shift in life expectancy on the economy.  Nor did central bankers want to reveal that it was demographics that created the long economic SuperCycle between 1983 – 2007 (when the US suffered just 16 months of recession in 25 years).  That would have spoiled the myth of their genius, and the forecasting ability of their supposedly all-powerful Dynamic Stochastic General Equilibrium economic models.

Similarly, nobody rushed to have a conversation with the voters about the need for a major increase in pension age:

□  The UK introduced state pensions just a century ago in 1909, when life expectancy was just 50 years.  Only 400k of the UK’s 40 million population were eligible to receive it
□  It was “social insurance” – “a small amount of money for a small number of people for a small amount of time”
□  Today, it has become a universal benefit, received by 17% of the population.  And this proportion is set to rise as the Boomers move into retirement

Of course, no politician wanted to tell voters that pension age should be increased in line with life expectancy.  Nor did they want to face the consequences of the post-1970 collapse in fertility rates.  This means that in more and more countries,there are more people over the age of 65 than children under 15.  And as Bloomberg notes:

A shrinking workforce cannot foot the pension bill”.

CENTRAL BANKERS DON’T WANT TO ADMIT THEY WERE LUCKY, NOT CLEVER
But now, the Boomers’ luck is running out, at least in the UK.  The warning sign was seen in 2008 with the financial crisis.  This highlighted the fact that today’s ageing population are creating a “replacement economy”.  Monetary policy is irrelevant when confronted with the fact that 65-year olds do not have the same spending power as when they were 35.  Equally important is that they now own most of the things they were buying when they were younger.

But it would be too embarrassing for central bankers to admits they had been lucky rather than clever.

Now the Brexit vote is bringing the chickens home to roost.  Last week, the Bank of England put on its “Superman” tunic again – deciding to take interest rates even lower, and weaken the value of the pound.

They chose to ignore the fact that their action probably created a “disaster scenario” for pension funds.

The interest rate for government borrowing is the major factor in determining the solvency of any pension scheme. And a zero, or negative, rate for government bonds makes it almost impossible for a pension fund to meet its commitments to pensioners.  The chart above, based on new data from the official Pension Protection Fund highlights the problem:

□  Massive funding deficits have developed since the Bank began its stimulus programme in 2009
□  More than 4 out of 5 defined benefit corporate pension funds are now in deficit – 84%
□  Their total deficit (including the surplus schemes) increased in July to £408bn ($530bn)
□  They were then only 77.4% funded – and the situation will be worse today due to the further decline in interest rates

As the former Pensions Minister, Ros Altmann, told the Financial Times yesterday:

The Bank wants to stimulate the economy by bringing down interest rates, but the Bank is not acknowledging the negative impact these measures are having on pension deficits, and neither is the government.”

As Altmann warns, this deficit will have real world consequences.  Either employers will have to increase their contributions, or pensioners will not get their promised pensions. Both outcomes will have negative consequences for the UK economy, as they will either reduce company profitability or reduce pensioners’ future spending power.

One also cannot ignore the potential for political fall-out if pension funds fail to meet their commitments to pensioners.

The problem is that the Bank – like its peers in Europe, USA and Japan – loves to be the centre of attention.  It therefore chooses to ignore the fact that by creating further artificial demand for gilts in the short-term, it is creating major economic and political risks for the medium and longer term.  And as we all know, there is a moment when a medium-term risk becomes short-term reality.

We may not be too far away from that moment now, as millions of pensioners start to realise their pension funds may well go bankrupt.

 

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