The Government's management of the economy is posing significant risks to pensions, expert Dr Ros Altmann has warned.
In a critical new year analysis, the government's 'tsar for older people' has said the Bank of England continues to distort the financial markets by depressing interest rates and ignoring the dangers of its quantitative easing (QE) or money-printing strategy.
Dr Altmann says pension scheme deficits soared by £200billion in 2014, and annuity rates continued to fall, largely because the BoE is propping up the market in long-term gilts (government bonds), continuing to depress the yields which pension funds rely on.
Dr Altmann says: "The impact of QE on corporate pensions and annuities has not been properly appreciated and is one of the dangerous unintended consequences of this policy experiment. Pension deficits, the ageing population and the irreversibility of annuity purchases are likely to pose a threat to economic growth and there is no sign of the Bank reassessing its commitment to buying long term gilts."
She says the stronger economy and sharply falling unemployment would normally have led to rising interest rates and share prices last year. Instead, interest rates remained low, shares fell, and gilts became increasingly expensive, with the yields on long bonds falling to record lows. This partly reflected falling oil and commodity prices and subdued inflation, but was also the result of pension funds having to compete with the Bank of England to buy long-term gilts.
"It led to defined benefit scheme deficits ballooning by nearly £200bn, as low bond yields inflated the present value of pension liabilities and asset prices did not keep up," Dr Altmann says. The Pension Protection Fund reported that pension fund assets increased by 9.8 per cent, but liabilities rose by a massive 26.4 per cent, so UK pension deficits rose to £221bn at end November 2014 (from £28.5bn the previous year).
"Many companies have poured billions of pounds into their pension funds, in an effort to fix the shortfalls, only to find deficits increasing further," Dr Altmann adds. "The fall in gilt yields was so dramatic that many companies are finding it almost impossible to manage their pension situation. This could be damaging to economic performance, even though QE aims to boost growth."
She goes on: "UK share prices not that relevant to pensions any more. In the past few years, UK pension funds have sold shares and invested more money into bonds instead. In 2006, they held over 60per cent of their assets in equities, but it is now only 35per cent (with UK equities being less than 20%), while holdings of gilts and bonds have risen from 28per cent to 44per cent. It is no longer safe to automatically assume a booming stock market will mean much better pensions."
Meanwhile pension scheme trustees are feeling under pressure to buy even more bonds, to 'derisk' their funds, but are competing with the Bank of England for the scarce supply of long gilts. "The obvious danger is that this is creating a classic bubble," Dr Altmann warns.
Having initially said it would not buy long gilts so as not to disrupt the pension fund market, the BoE now holds £139bn of long gilts, three to four times the amount issued in a year.
She urges pension funds to diversify away from gilts into other suitable alternatives. "Investing in infrastructure projects, housing and other illiquid assets could be beneficial in the longer-term as well as boosting the economy directly."
Those who have already retired and been forced to use a defined contribution (DC) pension to buy an annuity have suffered directly, Dr Altmann notes. "As QE has depressed gilt yields, annuity rates plunged from around 7per cent in 2009, to around 5per cent now, which immediately and permanently impacts DC scheme retirees, who will be poorer for the rest of their lives. Even if rates do rise when QE unwinds, their annuity income will not increase in future."
Meanwhile pensions minister Steve Webb this week committed to offering those who are locked into annuities the opportunity to exchange it for a lump sum - if he can get cross-party support for legislation in the next parliament.
Kate Smith, regulatory strategy manager at Aegon UK in Edinburgh, commented: "The industry is already under significant pressure to deliver the various legislative changes this year. The latest proposal from Steve Webb generates a long list of issues and risks for the industry and customers.
"The first and most obvious of these is the fact that a lifetime annuity is priced on the life and medical conditions of that particular customer. So if it was sold on, the new risks and medical conditions would need to be re-priced in as part of the transaction. This might not turn out to be attractive to either the buyer or seller. While the former annuitant would get cash in hand, they would be losing out on the certainty of a guaranteed income and risk falling back on the state."
Ms Smith went on: "The assumption appears to be that the new flat rate state pension will be enough to live on but we know that for most it won't. Further issues include changes to legal contracts, tax implications for both buyer and seller, clarity on how this fits with the 'guidance guarantee' as well as the system changes providers would need to make to accommodate this approach."
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