Pension deficit widens as BoE cuts interest rates and begins new £60bn QE programme

The Bank of England’s decision to slash interest rates and increase the UK stimulus package to £435bn may have adverse effects to pensioners. As if the average pensioner hasn’t got enough to worry about with record low annuity rates and gilt rates. We are now facing a further blow to the already huge pension in the UK.

Gilt and annuity rates are at record lows and have been consecutively reaching new record lows for a considerable amount of time. The problem we now face is that rates are likely to drop even more. The UK central bank will be buying a further £60bn of government bonds which could further push gilt prices up and yields down, as supply falls (yields fall as prices rise). The question that we still have to ask ourselves is “who benefits from QE?”

We have seen more inequality, low inflation and larger pension deficits as a result of QE. So why do they keep flooding the market with more quantitative easing? Banks need liquidity and without more “free money” from the central banks, the banking system could collapse like we almost saw in 2008. Unfortunately, the average investor is forced to take a greater degree of risk for an average return as the search for yield becomes much harder. During the 1990’ and 2000’s, gilts returned above a 7% yield in return for a loan to the government. In today’s market the returns are below 1%.

What this means is that ‘defined benefit schemes’ are taking more risk to provide the guarantees needed to pay out their members. This has driven the pension deficit in the UK to a staggering £935bn which is expected to reach a trillion soon.

The growing deficit means more companies are paying higher levies to fund the deficit in their pension which reduces overall all growth thus negatively effecting the economy. The Bank of England need an alternative solution if they are ever going to get out of this alive.

It’s not all bad for defined benefit schemes

Low gilt rates do have one positive affect on members. Actuaries calculate the cash equivalent transfer values (CETV) for members who wish to transfer their defined benefit scheme to a normal defined contribution scheme based on current annuity rates. A lower annuity rate means you will need a greater amount of capital to provide the same amount of income on an annual basis. In fact, many people are transferring out their Final salary schemes for this reason while the transfer values are high and the schemes have enough money to pay them, however this may not last forever. If the schemes run out of money to pay out transfer values, they could reject the transfer out of the scheme or reduce the transfer values as they won’t have the money to do so.

Anyone with a defined benefit scheme needs to seriously consider their options if they are in a scheme that is seriously underfunded.