Pensioners squeezed by bail-out plans
The Bank of England’s plan to create more money to get banks lending again could have a devastating impact on pensioners, experts have warned.
On 5 March, the central bank announced that it would be creating £75 billion of new money, a process known as quantitative easing, that would be used to buy assets, such as gilts and bonds, from banks, insurers and pension providers. The idea is that banks will then have more capital to channel into their lending activities.
At the same time, quantitative easing can also help to bring down interest rates on overdrafts and mortgages, which are often determined by gilt yields. As demand increases for gilts, their price increases – and as the price rises, the yield (which is the fixed payout from the gilt, as a proportion of its current price) goes down.
But while it is hoped that quantitative easing could increase lending and make borrowing cheaper, there are also concerns that pensioners will be penalised as a result. Apart from the fact that pensioners tend to be debt-free, and therefore won’t benefit directly from lower interest rates, quantitative easing could damage their pension income.
For a start, the income provided by annuity products is set to take a tumble. As well as setting interest rates on overdrafts and mortgages, the yield on gilts is also used to determine rates on annuity income products.
The surge in demand for gilts immediately after the Bank of England’s announcement forced yields down 0.35% in one day, according to independent financial adviser Hargreaves Lansdown. Tom McPhail, head of pensions research at Hargreaves Lansdown, predicts that annuity rates will decrease as a result of the action.
“The implications of this action for UK final pensions are not encouraging,” he adds. “We anticipate that rates are likely to continue to fall.”
Annuity expert MGM Advantage is also concerned about the potential squeeze on pensioners’ incomes as a result of quantitative easing.
Its figures show that last July, a 65-year-old man with a £100,000 fund could have bought an annuity of £7,920 per annum – today, the same man would only get £7,240 per annum.
Craig Fazzini-Jones, director and head of retirement at MGM Advantage, says: “Typical annuity rates have been around the 7% level for a 65-year-old male, and these will start to fall.”
Pension funding volatility could also be heightened by quantitative easing measures.
Danny Vassiliades, principal at pensions actuary Punter Southall, explains: "Quantitative easing seeks to remove government and corporate debt from the financial system – effectively replacing it with cash. By writing off its debt, the government will reduce the amount of debt in circulation and reduce the corresponding government and corporate bond yields as bond market prices rise.”
One consequence of this could be a rise in the value of pension fund liabilities, Vassiliades adds. However, once the economy recovers the government will need to issue more gilts – this will depress prices and yields will rise. This will mean that the value of liabilities could fall.
The latest figures from the Pension Protection Fund show that over 90% of defined benefit schemes have insufficient assets to meet their liabilities. The organisation claims that almost 7,800 schemes had a deficit of £218.7 billion in February 2009, compared to a deficit of £190.6 billion the previous month.
Steve Webb, shadow work and pensions secretary for the Liberal Democrat Party, predicts that the size of deficits in final salary schemes will keep growing as the recession continues.
“If the recession forces many more schemes to close, ministers will have to explain how the pensions lifeboat will be kept afloat," he adds.
One of the main risks cited in association with quantitative easing is inflation; experts fear that by pumping more money into the economy, the cost of living could increase sharply potentially even creating a cycle of hyperinflation such as seen in the 1970s.
A big increase in the rate of inflation would leave the Bank of England with little choice but to hike the base rate sharply in order to try and cool it. So, as well as having to cope with an increased cost of living, consumers would also have to cope with payment shock as the rates on their loans, mortgages, credit cards and even overdrafts potentially jump.
Some commentators have, however, brushed off concerns about inflation; Douglas McWilliams, chief executive for Centre for Economic and Business Research, argues that inflation as a result of quantitative easing could actually be a good thing as it would help offset the risk of deflation brought on by the recession.
However, others are not convinced. Ros Altmann, a pension expert and former policy adviser, says the deflation argument is a “smokescreen” and inflation is the real danger. If she is right, then pensioners are set to suffer the most as inflation will wipe out their savings.
“Once again, pensioners and savers will be the innocent victims,” she adds. “They have lost the income on their savings today [as a result of the historically low base rate] and, as inflation remains high, they are struggling to afford to live.”
According to the Institute of Fiscal Studies, last year’s food and energy bill hikes have left pensioners suffering with much higher inflation rates that younger households, with the latter benefiting from cheaper mortgage rates and lower petrol costs.
Age Concern estimates that the personal inflation rate of people aged over 60 is 10 times higher than the rest of the population.
Gordon Lishman, director general of Age Concern, says: "Older people still find much of their income is swallowed up by high food and fuel bills, forcing many to make drastic cut-backs.”
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.