How QE has harmed UK pensions

As gilt yields fell, annuity rates plunged to 5 per cent last year from around 7 per cent in 2009, while inflation-linked annuities have become exceptionally expensive. 

QE has distorted markets and economies in ways we do not yet fully understand

This immediately and permanently impacts DC scheme retirees and also causes problems for DB trustees, as lower bond yields increase the costs of derisking, buy-in or buyout and worsen scheme funding. 

Despite potentially higher asset values, quantitative easing has a negative net impact. Sensitivity analysis by academics and the BoE itself show that a 100 basis point fall in gilt yields inflates pension liabilities by 18-20 per cent, but only increases assets by 6-10 per cent. 

If these low yields result from temporary policy decisions, should pension funds, as long-term investors, adjust to them or look through the current environment in anticipation of unwinding?

Schemes are torn between switching from gilts into riskier investments, or buying bonds to derisk in such uncertain times. 

QE has caused these pressures by interfering with the supposedly risk-free interest rate, against which other asset classes are priced. If the lowest-risk assets are distorted, investors cannot be sure how to assess investment risk.

This is exemplified by gilts, which were a top-performing asset class to mid-2012, but then lost more than 10 per cent of their value the following year. Hardly characteristic of a low-risk asset.

If gilts have become more risky, does this mean riskier assets are relatively less risky? Historic volatility and correlation models may be less reliable, due to the artificial distortions of QE, although nobody yet understands the full impact.

Derisking is not straightforward in the face of distorted asset prices. Being fully hedged when interest rates are more likely to rise than fall may not be optimal for schemes with large deficits and weak sponsors, especially as there are no perfectly matching assets.

Under-hedging could help deficit reduction. Downside protection is of course important, but allowing room to capture the upside is also critical to long-term success. The case for increased diversification has strengthened.

QE has distorted markets in ways we do not yet fully understand. Asset risks may have risen, but controlling those risks is more challenging if historic models are less reliable. 

Increased deficits have caused company failures and the Pensions Regulator’s belated new objective to consider scheme sponsors’ long-term survival is a welcome acknowledgement that deficits may be distorted.

The jury is still out on how damaging the pension ramifications of QE may be. Will any short-term gains be offset by longer-term pain? The real policy challenges come when it is unwound. 

Having significantly increased allocations to bonds that are not a perfect liability match, the downside risks for pension schemes from QE unwinding could pose further threats.

Ros Altmann is an independent pensions expert