But that is not the biggest problem. In the UK, most pension schemes are defined benefit (DB) plans (as opposed to defined contribution plans). In a DB scheme, liabilities are calculated by discounting all future payments back to present value, using the long bond yield as the discount factor. When bond yields drop, unless the pension fund has hedged this risk, the present value of future liabilities will rise.
The bad news is that the corporate sector in the UK has not been fully hedging this risk. By one estimate, UK corporates are ÂŁ90 billion worse off as a result of the latest round of QE which has driven UK bond yields down to new lows. With unfunded pension liabilities in the UK already at around ÂŁ300 billion before this latest bout of QE (approximately 30% of total pension liabilities), such a further shortfall is an unmitigated disaster (see here for details).
For individuals, the outlook is equally dire. Savers have seen their interest income plunge and the millions of baby boomers who will retire over the next 15 years will see the income from their annuity schemes being decimated as a result of lower interest rates.
If the government really wanted to support economic growth as it says it does, it wouldnât penalise the corporate sector to this extent. It would be buying gilts with short and medium term duration instead. It would possibly also be buying corporate bonds â in particular those issued by our troubled banks. And if the government really wanted to help the pensioners, it would issue longevity linked gilts instead of the 100-year gilts (Ros Altmannâs idea â not mine) which has been the talk of town recently as such bonds would help the pricing of annuities.
But the government will do nothing of the above. It will in all likelihood continue to pursue a policy of negative real bond yields at the long end of the curve, whatever the cost to the private sector. For the government such a strategy is a win-win. It can finance its debt extraordinarily cheaply and the negative real yields will allow it to accelerate the pay-back of its debt. For the rest of us, it is default by stealth.
Sadly, this is only a small part of the problem. Britainâs pension model dates back to 1948. Some changes have been made to the model but the state pension age remains the same3 despite the fact that life expectancies for both men and women have improved by some 10 years over the interim period. If you build a DB model on the assumption that, on average, your members will live 8-10 years beyond the day of retirement, and they instead live for another 20 years, you will by definition end up with a major problem.
In an attempt to address the future funding problem created by the improvement in life expectancies, the then labour government passed the Pensions Act 2007 which stipulates that the state pension age will be increased to 66 between 2024 and 2026, to 67 between 2034 and 2036 and to 68 between 2044 and 2046. As we say where I come from â this is akin to wetting your pants to stay warm!
The problem in a nutshell is that there is absolute no appetite in government for addressing this problem. What goes on is effectively a government endorsed Ponzi scheme where todayâs retirees steal from future generations. If I were 30 years old today, I would demand that the government change the pension system rather than go on the barricades to prevent change.
An obsession with AAA
Whereas the newish British government has shown little or no appetite for dealing decisively with the pensions crisis, it has said and done all the right things in order to protect its coveted AAA rating. I am just not convinced that it really matters. First of all, government debt is not the main issue in the UK; it is private sector debt which remains the problem. Given the combination of low interest rates and long average maturities of the debt outstanding, the UK government can quite comfortably support current debt levels.
Secondly, would it matter if the UK lost its AAA rating? I donât think so. The downgrade on US debt had no impact on the cost of borrowing over there. Financial markets still consider the US the benchmark of the world and the fact that US debt is now rated one notch lower means that AA+ is the new AAA. Financial markets are already tuned into the fact that most of those countries still rated AAA â including the UK â are almost certainly going to lose that rating in the next few years which means that bond prices already reflect that reality.
However, the British obsession with keeping its AAA rating risks derailing the domestic economy further. GDP growth has been slightly negative for the past two quarters so, technically, we are back in recession, and things are not likely to improve as long as the current policy is pursued.
As I have pointed out in previous letters, we currently find ourselves stuck in a balance sheet recession (see for example the March 2010 Absolute Return Letter here). Monetary policy becomes quite ineffective when that happens and fiscal policy should be expansionary to compensate for the loss of monetary efficiency. The policy currently being pursued in Britain is exactly the opposite â expansionary monetary policy and tight fiscal policy. Would someone please tell our government that they are walking down the road of self destruction!
Britainâs dilapidated infrastructure needs urgent attention. We are desperately short of runway capacity at Londonâs airports to support economic growth in and around the capital; yet the political establishment is happy to spend 15 years discussing the pros and cons of another runway at Heathrow. We live in one of the wettest countries in the world, yet we donât have enough water to meet demand in the south of the country. Our government encourages people to use public transport; yet it is the most expensive â and one of the most useless - public transport systems in the world.
I could go on and on. Now is the time to spend money on infrastructure. But the money must be spent wisely so that it enhances productivity and thus sow the seeds of future economic growth. Bond investors are intelligent enough to distinguish between such expenditures and the reckless spending that the previous government became known for.
Leadership is required
So, back to the original question: Is the outlook worse in the UK than in other European countries? It is probably fairer to say that the UK is plagued by a different set of problems than mainland Europe. Sadly, our problems here in the UK are actually manageable if only we had political leaders with spines that were not made up of boiled spaghetti. There should be a law against making a career out of politics. Most of the current generation of political leaders in the UK have gone straight from university into politics and they have no clue about most of the issues facing the people of our country and, even worse, they donât seem to care.
All they want to do is to cling on to their seat and you donât usually keep your seat if you implement policies which are right for the country in the long run but immensely unpopular when first implemented. Wasnât it the great Theodore Roosevelt who uttered the famous words (and I paraphrase): You can do what is right for the country or you can do what is right for the people but you canât do both. It has never rung truer than now.
Investment implications
Current UK economic policy is all but guaranteeing low growth for several more years, meaning that the Bank rate, currently at 0.5%, will probably stay low for some considerable time. So will yields on gilts unless there is an exogenous shock to the economy, resulting in a rapid escalation of inflationary pressures, which is quite unlikely to happen in a balance sheet recession.
Many investors predict rising bond yields in the years to come, mainly as a result of the massive amounts of QE in recent years. I donât think it is that straightforward. The combination of (i) ongoing deflationary dynamics emanating from continued deleveraging in the private sector which is only going to intensify, (ii) the pension sectorâs enormous appetite for anything with a half decent yield and (iii) the strong incentive to maintain negative real interest rates, is likely to keep a lid on bond yields.
UK equities are quite attractively priced which should offer some considerable downside protection even if the economy continues to weaken. However, the lack of economic growth is likely to limit the upside potential. Our view thus remains unchanged. In the short to medium term, UK equities are likely to be range bound. In the long run, there is considerable upside potential.
1Â UK banks have in fact managed to reduce their leverage since 2008 but non-bank financial institutions have more than offset that trend. Source: âDebt and Deleveragingâ, McKinsey Institute, January 2012.
2Â For the purpose of this discussion, I define government as including the Bank of England which is strictly speaking not correct. Please also note that the UK is merely an example of a wider problem. For example, many of the problems discussed here are also relevant to the United States.
3Â This is actually not entirely correct. The state pension age for men remains 65 but a couple of years ago it was decided to gradually raise womenâs state pension age from 60 to 65 over the next decade.
Niels C. Jensen
4 April 2012
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