Low interest rates - too much of a good thing?
Irish bond yields fell to an all-time low last week. That's good news for the Government and also for borrowers - but it's really bad news for the pension funds, writes Dan White
Irish Government bond yields fell to a record low last week. The yield on Irish ten-year bonds is now down to just 0.37pc compared to 0.84pc in the week before last June's UK Brexit vote.
These lower interest rates are good news for the Irish Government as it reduces the cost of servicing its €200bn debt pile. Every one basis point (0.01pc) fall in the average interest costs saves the Exchequer over €20m a year. Borrowers also stand to benefit.
But are we in danger of getting too much of a good thing? Extremely low interest rates pile further pressure on pension schemes already struggling under the burden of increased longevity and poor investment returns.
Coincidentally, in the same week as Irish bond yields fell to record lows, pension consultants Mercer published figures showing that the combined deficit in the pension funds of the 20 most valuable companies whose shares are traded on the Irish Stock Exchange had risen from €2.9bn at the end of 2015 to €5.1bn at the end of June and to €5.9bn by the end of last month.
What's going on here? While the ISEQ index of Irish shares has fallen by almost 12pc so far this year, most of the major international stock markets are either up or stable with the S&P 500 index of major American shares up 7pc, the UK's FTSE 100 up 11pc and the German DAX virtually unchanged over the same period.
So why are pension fund deficits rising at the same time as share prices are also increasing? Surely the opposite should be the case? Blame falling bond yields.
Pensions are the ultimate long-term investment. Someone in their mid-20s joining a pension fund for the first time today could still be receiving payments from that fund in 70 years time - yes, in 2086.
So how on earth does one value these obligations which don't fall due for payment for decades to come?
This is where low interest rates come in.
Actuaries use long-term bond yields (basically the interest rate on those bonds) to try and value these long-term pension liabilities.
What they are trying to do is put a present value on these liabilities. Present value is basically a fancy term for a euro today being worth more than a euro tomorrow.
When long-term interest rates are high these future liabilities have a very low present value but when they are low the opposite is the case.
If long-term annual interest rates were at 10pc, then the obligation to pay a pensioner €1 in 2066 would have a present value of just 0.85 cent while an obligation to pay the same euro in 2086 would have a present value of just 0.12 cent.
A halving of interest rates to 5pc would increase the present value of the pension obligation to pay €1 in 2066 to 8.72 cent while the present value of the 2086 obligation would rise to 3.28 cent.
But it gets worse, much worse.
If we use this week's 0.37pc bond yield to value these future pension liabilities, then the present value of €1 falling due in 2066 rises to 83.13 cent while the present value of a pension payment paid in 2086 jumps to 77.21 cent.
The moral of the story clear: even small movements in interest rates can have an enormous impact on the present value of future pension liabilities.
This is despite the fact that many major Irish companies have pumped hundreds of millions of euro, including AIB which has topped up its fund by €1bn and Bank of Ireland which has chipped in an extra €400m, into their pension funds in recent years.
But surely the current ultra-low interest rates are an historical aberration and that rates will soon return to more normal levels?
Maybe, maybe not.
"We don't know what future interest rates will be. I can remember people telling me seven or eight years ago that interest rates had gone as low as they could possibly go and would soon rise", says Pensions Regulator Brendan Kennedy.
Low interest rates and increased longevity are transforming the way we save for our retirement. The old defined benefit pension fund, where the employer guaranteed employees a fixed proportion of their pre-retirement income after they retired, has become unaffordable for most companies.
Instead employers are offering their employees defined contribution pension funds, where the post-retirement income is not guaranteed. At the end of 2014 there were 778 private sector defined benefit pension schemes with just under 140,000 members, down from 890 schemes with 167,000 members at the end of 2013.
Even most of the surviving direct benefit pension schemes in the private sector are either frozen and/or closed to members. Increasingly defined benefit schemes are confined to the public sector, which had 99 defined benefit schemes with 339,000 members at the end of 2015.
So is the current system of pension provision broken beyond repair in an era of very low interest rates?
"Low interest rates are good for borrowers - but are lousy for savers. Pension schemes have to buy bonds match their liabilities and when they get low returns on those bonds then they have to set aside more money. I would not say that the model is broken beyond repair - but it is under severe pressure? Yes, it is," says Sean O'Donovan, head of defined benefit risk at Mercer.
So are we in a freakish period of abnormally low interest rates - after all, the Bank of England's current 0.25pc official interest rate is the lowest in its 322-year history. How realistic is it to use what could be merely a temporary dip in interest rates to value liabilities occurring a generation or more into the future?
"The liabilities are real. Is the value being put on those liabilities linked to current bond yields real? If you assume 4pc-5pc yields, then the liability would be much lower. If I could be guaranteed a return above current bond yields then yes [it is unrealistic to be using current bond yields to value future pension liabilities], but if they are not guaranteed, then no," says Mr O'Donovan.
"It is the combination of people living longer and very low interest rates. Funds could deal with one very difficult situation but are finding it much harder to deal with both", says Mr Kennedy.
"People are going to have to save more. Retirement is expensive. People have always underestimated the cost of retirement. Expectations will have to come down".
Even when interest rates do increase eventually, we are all going to have to put more into our pension funds, work longer and accept lower post-retirement incomes.
Sunday Indo Business