I realize that I have posted on this issue before but the issue keeps rearing its head on the periphery of the mainstream media in Europe and surprisingly gets very little coverage in the United States and Canada. I suspect that 99 percent of us probably find our eyes glazing over when the subject is mentioned and that a very tiny fraction of the general public understands the concept at all even though baby boomers will very quickly figure out just how the actions of a few central bankers have had a massive negative impact on their retirement livelihood.
Every time the Fed rattles its QE sabre, the markets get all excited and have an up day. While this is an interesting reaction that really impacts very few of us unless we happen to be heavily invested in equities, the threat (and yes, it is a threat) of additional bond purchases by the Fed and other central banks around the developed world has a very strong negative impact on what will be important all of us at some time in our lives - our retirement income.
From a recent presentation by Dr. Ros Altmann, Director General of Saga (which stands for Social Amenities for he Golden Age), a travel and insurance company that focuses on the needs of those over 50 years of age, provides some interesting background information about the negative impact of QE on pensions, both defined benefit and through the purchase of annuities . Here are some interesting issues that she raises about quantitative easing that apply to those living in the U.K., United States, Canada and just about any other jurisdiction that has seen central bank bond purchases shove their interest rates to all-time lows.
1.) Our private defined benefit pension system is underpinned with government bonds, usually of a long duration.
2.) Equity prices have not increased substantially.
3.) Pension outlays are increasing as the first baby boomers reach age 65.
4.) Pension under-funding is soaring.
Dr. Altmann goes on to note that pension funds are highly sensitive to changes in interest rates as follows:
1.) A 1 percent drop in interest rates leads to a 20 percent rise in liabilities.
2.) A 1 percent drop in interest rates leads to only a 5 percent rise in the value of assets (i.e. equities).
In the United States, since 2008, interest rates on 10 year bonds have dropped from just under 4 percent to just under 1.6 percent as shown here:
In Canada, since 2008, interest rates on 10 year bonds have dropped from 3.6 percent to 1.7 percent as shown here:
In the United Kingdom, since 2008, interest rates on 10 year bonds have also dropped from 4 percent to 1.5 percent as shown here:
In all three cases, a drop of 2.5 percentage points in yields on 10 year sovereign debt has led to roughly a 50 percent rise in the liability of our pension plans. Rather than investing in job creation and capital expansion, corporations are now finding themselves increasingly on the hook for pension shortfalls.
Pension plans around the world are finding it increasingly difficult to find risk-free assets. QE is reducing the supply of sovereign debt available to the open market, leading to bond price distortions on the upside which is pushing yields to a highly distorted downside. This is why we are now experiencing previously unimaginable lows in interest rates on the debt of the so-called safe haven nations of the United States, Canada, the United Kingdom, Germany and its fellow northern European neighbours. Here is a graph from the Bank of England showing the ballooning volume of gilts on their balance sheet (in fuchsia):
Not only do ultra-low interest rates have an impact on the fortunate few that still have defined benefit plans, there is an impact on retirees who are planning to purchase an annuity to fund their golden years. Let's compare some estimates of income from a $100,000 annuity with 25 years to payout:
With a rate of return of 5 percent, the annual payout amount is $6757.38.
With a rate of return of 4 percent, the annual payout amount will be $6155.00.
With a rate of return of 2.5 percent, the annual payout amount will be $5295.21.
With a rate of return of 1.5 percent, the annual payout amount will be $4755.02.
From a 5 percent growth rate to a 1.5 percent growth rate, the annual payout amount drops by 29.6 percent. That is a major cut in retirement income. This same cut in retirement income is present for pensioners who prefer to live off of their savings without investing in an annuity.
While central bankers like the Bank of England's Charlie Bean love to go on about how the impact of QE on pensions has been negated by rises in equities, this graph shows that such is not particularly the case:
The yield on 15 year gilts has dropped, particularly during QE2 but unlike during QE1, equity prices have pretty much stalled at the level that they reached in early 2010. While pension fund managers that counter-intuitively bought equities at the nadir of the market in early 2009 have done well, such is really not the case ever since. As the Japanese decade-long experiment with QE has proven, central bank bond purchases have very little impact on stock market returns over the long-term as shown on this chart of the Nikkei 225, keeping in mind that the Bank of Japan implemented its first period of easing which started on March 19, 2001 and ended on March 9, 2006:
Note that Japan's Nikkei 225 is now trading between 8500 and 8600, 40 percent below the level that it was at when the Bank of Japan began its experiment. So much for the positive impact of QE on the stock market, a lesson that seems unlearned by Mr. Bernanke, Sir Mervyn and others although it is entertaining to watch them take credit for positive swings in the market.
Unfortunately, the most influential central banks around the world insist that their policies will benefit the economy over the long-term, even though it is a stretch to suggest that the impact has been measurably positive thus far. On the upside, as I posted here, at least we know that this period of ultra-low interest rates has benefitted a couple of central bank VIPs. Bully for them.