Posts Tagged ‘Interest Rates’

Brendan McLean

How low can rates go?

The recent decline in yields is a sign of how quickly market expectations can change.

While the UK base rate has remained at 0.75% since August 2018, longer dated rates have recently been falling fast. Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.52% and 20-year rates from 1.77% to 1.11%. This will have dramatically increased pension scheme liabilities unless they have been fully hedged.

Global decline

It is not just the UK where rates have seen dramatic declines – it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.69% in August 2019, with a 0.38% fall in the last few weeks alone. This huge decline can be explained by the US Federal Reserve reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule.

PIMCO estimates that $14 trillion in government bonds, or 25% of the global government bond market, has negative yields. In early August 2019, German 10-year yields were -0.58%, and the Japanese 10-year yield was -0.22%. Large bond managers say it would not be impossible for the US Federal Reserve to reduce rates to 0%; they are currently 2% to 2.25%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns in government debt.

Monetary policy driver

The driver of the recent declines is changing central bank monetary policy. Global central banks have started to reduce interest rates due to slowing economic growth and investors are pricing in more rate cuts. Recently, India, New Zealand and Thailand surprised investors with larger than expected rate cuts. Investors are becoming more concerned about global growth, particularly in light of the US/China trade war which is showing no sign of ending and is beginning to develop into a currency war. Investors are worried, which is leading to declines in equities, more flows into safe-haven fixed income assets and depressing yields even more.

A popular recession indicator is the yield spread between US 10-year and 3-month Treasuries. It has turned negative before every recession since the Second World War and has been negative since May – so investors could have good reason to believe a recession is likely.

A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for developed economies, they will not be able to pull this lever and will need to find alternative solutions to avoid a prolonged recession.

So – just how low can rates go?

No one knows. We are in a period of low but stable global economic growth (except for the UK) with high employment – central banks are beginning to reduce rates to prolong the business cycle. Therefore, when the next recession occurs, central banks will cut rates even more. We may not have seen the bottom yet.

The recent decline in yields poses a question for pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.

Angela Burns

There have been huge increases in the numbers of individuals taking transfer values from their defined benefit pension schemes over recent years. This has been driven by numerous factors, one of which being all time low interest rates, giving us record high transfer values. Individuals have been seeing multiples upwards of 30 times pension in many cases, which when added to the increased flexibility now available, is proving a mixture all too difficult to resist.

With the Bank of England raising interest rates for only the second time in a decade (up 0.25% p.a. from 0.50% p.a. to 0.75% p.a.), having been stuck at 0.5% for over nine years, this change is likely to have an negative impact.

Gilt yields rising results in liabilities falling, all other things being equal, so we are likely to see a reduction in transfer values. At this stage the impact is likely to be relatively modest with a 0.25% p.a. increase in gilt yields reducing a £150,000 transfer for a 45 year old by about £10,000 and for a 60 year old by about £5,000.

Such a change means that the amount transferred needs to return a lot more to be able to match, or improve on the benefits offered by the scheme. This change is likely to see the investment return needed to match or improve on the benefits increase by around 0.5% p.a. for the 45 year old and by 1.0% p.a. for the 60 year old.

The investment return required in the period until retirement (also knows as the critical yield or in recent parlance ‘personalised discount rate’) is often seen as a benchmark which needs to be reached before an adviser can even consider if a wider discussion on transferring benefits is even possible. So lower transfer values, which result in higher critical yields, is likely to mean that fewer people reach the threshold and so many more stay with their existing scheme.

For employers incentivising staff to transfer through the use of enhanced transfer values, lower transfer values will mean that higher top-ups are required to reach an attractive level, placing a greater cash requirement on the employer and therefore making exercises less attractive. Alternatively, retaining the same top-up value may result in a lower take-up.

As the transfer value basis in some schemes may not react immediately to changes in gilt yields this may provide individuals with a short window of time before any changes are made. In addition, individuals who are currently within their transfer guarantee period may be keener to have their transfer value processed within the guarantee window, to ensure they take advantage of a higher value than would be likely to be available post the guarantee, given the gilt yields rise.

Further rate rises may be on the horizon. We don’t have a crystal ball to see what will happen in the future, however, current perceived wisdom seems to be that rates will slowly rise over time on the basis that they can’t possibly stay this low. However, this has been the general belief since around 2009! Some think we have entered a ‘new norm’ where rates are unlikely to rise materially.

Individuals and sponsors should take care when considering transfer values or transfer exercises as gilt yield increases can materially affect the ‘real’ monetary value of any transfer, with timing now increasingly important.

Andrew Kerrin

Christmas presents? Fine. Out of season clothes? Sure. Those trainers you bought two years ago that you’ve worn once but you’re definitely going to go running with again? Absolutely, chuck them out. How about your retirement savings? Under the bed!? Surely not.

As the Brexit splash continues to ripple through the economy, we are now facing the very real possibility of the UK joining the growing club of major states with negative base interest rates. In terms of pension schemes themselves, this won’t be a significant shock – they have been feeling the pain on their funding levels for a number of years with the low interest rate environment. Putting a ‘–‘ in front of the base rate isn’t going to shock schemes who have been seeing the number behind the ‘–‘ in their funding results growing year on year. Their pain will continue, but it’d hardly be a game-changer in the current environment.

The group that could truly be shocked are savers, and in particular, pensioners. To finally make some sense of my opening, Ros Altmann reacted to the news that Natwest had warned corporate customers that they may have to charge interest on accounts in credit, should the Bank of England dip the interest rate into the sub-zero waters. Should that happen, many will anxiously wait to see if those charges seep across to personal savings accounts too. If that levee were to break, the outgoing Pensions Minister said “the danger is many people will just think, “I’m going to put the money under the mattress.””

In truth, pensioners have been feeling the pain of low interest rates for some time now, right across Europe. Despite showing real patience – or perhaps acquiescence – with little to no returns, surely those same people would jump into action if their savings actually started to shrink. For many, it could be the watershed moment and see them rescue their savings and bring them closer to home. After all, if it’s good enough for the Commerzbank in Germany (who are reportedly considering shifting billions of euros to their vaults, rather than pay for the ECB to hold it under its negative rates) why isn’t it good enough for Joe Bloggs Snr.

While it may be reasonable to follow the actions of a big bank with its hundreds of financial advisors, Mr Bloggs Snr is different – he doesn’t have a vault. Should pensioners take such action, there have to be real security fears for their savings, as well as their own health and safety. Beyond the concerns of large amounts of cash being under beds, there is also the real possibility that these concerned pensioners may be more susceptible to pension/investment scams, offering a safe haven with fantastic (aka. positive) returns on their savings, just like they used to have. Should negative interest rates come our way, the industry should be alive to these risks arising.

Some may sneer and feel this is an overreaction. Some may say that it will never come to that. Well, we live in a world where Brexit is happening, Donald Trump is 270 electoral college votes from the White House and Leicester City are preparing to defend their Premier League title. Stranger things have happened…

Baroness Altmann (or perhaps her successor) may yet have to fetch Workie out from under the bed.

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