This huge gamble will affect pensioners directly and indirectly. The viability of final salary schemes is made more uncertain. Annuity rates and drawdown limits will fall. Deflation will be replaced by inflation, possibly rampant.
Quantitative easing
The Governor of the Bank of England has played the interest rate card to its limit, by reducing Bank Rate six times from 5% in September 2008 to 0.5% in February 2009. The Governor obtained the Chancellor’s agreement to use by the Monetary Policy Committee (MPC) of the Asset Purchase Facility to buy £150bn of assets, mostly gilts but including £50bn of private assets like corporate bonds. The Bank authorised the MPC to buy an initial £75bn of assets, predominantly gilts, over three months starting in March 2009.
The ostensible reason for such purchases was to prevent inflation falling below the MPC’s target of 2%, but the bigger reason was to stimulate bank lending and economic activity.
Although the Bank of Japan apparently tried a similar tactic to break stagnation in 2001, quantitative easing is held to be an unproven measure. It assumes that the institutions from whom the gilts will be bought will use their new monies to back extra lending.
But the measure could be ineffective if the banks simply rebuild reserves, or purchase overseas assets instead. Also, pumping such sums into the economy could result in an overshoot, with inflation returning to double digits.
Liabilities rise
Final salary schemes offer much better value than the higher risk/lower contribution money purchase schemes, and it is important for the pensioner population that final salary schemes survive. But, massive purchases of bonds can only drive down the gilt and corporate bond yields that are used under accounting standards to evaluate pension scheme liabilities.
In early March the consultants Hymans Robertson estimated the immediate impact of quantitative easing as a lowering of government and corporate bond yields by 0.3%. The aggregate pension deficit of the FTSE 350 companies under the IAS 19 accounting standard, which uses AA rated corporate bond yields as its reference point, had increased overnight by £12bn, from £43bn to £53bn. Higher deficits can only put more final salary schemes in jeopardy.
Annuity rates fall
The introduction of quantitative easing was followed by a reported reduction of annuity rates by several companies, including Legal & General, Norwich Union, Prudential and Standard Life. Legal and General’s two cuts, amounting to 3%, meant that someone with a £100,000 pot would receive an annuity of £6,920 pa in mid March compared to £7,128 pa two weeks earlier.
The annuity levels for joint lives in suggest that, for a pension pot of £100,000 annuities have ranged over the past five years from a low of about £5,920 in February 2006 to a high of £6,780 in July 2008 – a difference of 14%.
Although quantitative easing did lower the 10 year UK FTSE gilt yield below 3% for the first time ever, the joint life annuity level of £6,140 for 13 March 2009 in Table 1 shows that annuity rates have still to fall below the low of February 2006.
They may well do so in the next tranche of the easing package, or if the Bank announces a follow-up buying spree later in the year.
Drawdown limits also hit
Alarm bells were set ringing when the Government Actuary’s Department (GAD) stirred itself to issue new GAD tables with illustrative GAD rates ranging down to 2% rather than 3% as previously, as shown in . Clearly official circles recognised the substantial effect on GAD rates of the first and possibly subsequent quantitative easing packages.
Those who opt for drawdown of their pension pots are subject to GAD limits – a maximum of 120% of a basis amount for those in unsecured pensions up to age 75, and a range of 65% to 90% for those over 75 in alternatively secured pensions.
The calculation of maximum income withdrawals is through the following steps:
(a) Fix the reference date, ie, the date when withdrawal is to start, eg 1 April 2009.
(b) Find the gross redemption yield on the 15 day (or nearest prior working day) of the month preceding the reference date, eg, 3.42% on 13 March 2009.
(c) Round down that yield to the nearest 0.25%, eg 3.25%. (d) Take the age and sex/status of the member at the reference date, eg 65 year old male.
(e) Insert age and rounded yield in the appropriate GAD table and read off the appropriate basis income per £1,000 (there are separate tables for males, females and dependent children), eg a 65 year old male and a rounded yield of 3.25% in Table 2 gives a basis income of £63.
(f) Determine the realisable fund value, ie, pension pot less any tax free lump sum taken, to the nearest £1,000 – say £100,000.
(g) Multiply the realisable fund value (in thousands) by the basis income to give a basis amount, in this example 100 times 63, giving a basis amount of £6,300.
(h) Raise the basis amount from 100% to 120% to give the maximum income withdrawal; in this example £6,300 is raised to £7,560.
Maximum income withdrawals have to be reviewed every five years for those in unsecured pensions, and each year for those (over 75) in alternatively secured pensions.
Looking at Table 1, a 65 year old male starting a drawdown in July 2008 would have had a GAD rate of 5%. Using such data in Table 2 gives a basis income of £75 per £1,000. With a pension pot of £300,000, the basis amount would be £22,500, and the maximum income withdrawal (120% of the basis amount) £27,000.
In April 2009, a 65 year old male starting a drawdown would have a GAD rate of only 3.25%. Using Table 2 gives a basis income of £63 per £1,000. With a pension pot of £300,000 the basis amount would be £18,900, and a maximum income withdrawal of £22,680 – 16% lower than nine months earlier.
Unit linked guarantees
Third way annuities, including unit linked guarantees, had a very good year in 2008, with new business doubling to £1.15bn, and numbers of plans sold rising by 80%.
But some will also be affected by the fall in drawdown limits. For example, where the maximum guaranteed withdrawal under the Hartford Guaranteed Retirement Income Plan exceeds maximum income withdrawal allowed under GAD rules, Hartford GRIP policyholders are offered alternative lifetime annuities.
With lower GAD limits more alternative annuities will be offered.
Deflation, then high inflation?
Table 1 also shows movements in two inflation indices, the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). The RPI is used in adjusting pensions, pay settlements, etc. The CPI is an internationally comparable measure. The CPI basket does not include council tax and mortgage interest payments, both in the RPI basket, but does include items like charges for financial services, which are not in the RPI. A mathematical difference in methods of calculation generally means CPI shows a lower rate than RPI.
As Table 1 shows, in March the RPI fell to zero, while the CPI rose to 3.2%. Pundits suggest that the RPI could be negative by June and very probably negative by September. Such deflation should be welcome to pensioners on fixed incomes.
Final salary pensions accrued after April 1997 and in payment will increase either on a statutory default basis or in line with a particular scheme rules. Increases in schemes on a default basis will depend on inflation to September each year. If the RPI is then negative, pensions would stay flat in cash terms and therefore rise relative to prices.
In due course, the easing should achieve the desired CPI inflation rate and help restore economic growth. Easing should then be replaced by contraction of money supply. But the timing of the switchover could well go awry, with pensioners then being exposed to rampant inflation.