UK Pension Deficit 101

Lately there have been many claims in the media that Quantative Easing (QE), i.e. the Bank of England’s money-printing programme, has been causing a lot of the problems the UK pensions schemes are facing. Pension schemes are vanishing altogether and most of the FTSE 100 companies are running deficits, especially the final salary / defined benefit schemes.

According to the critics of QE, the main reason QE is causing problems is that by driving down interest rates, pension schemes are receiving very little return on their bond investments. I find this to be a phony argument. Why? Because if you own a bond and interest rates fall, the value of you bond increases. That would improve the situation of the bond owner (the pensions scheme), not the opposite.

But what if a pension scheme was invested in the stock market and wanted to reduce the risk by moving into bonds? Well, that would be pretty much the same story. You would buy a bond that would increase in value as interest rates keep on being pushed down.

Granted, if a pension scheme wanted to move into short-term money market funds or cash it would be hard to find a decent return.

But none of this is enough for explaining the effect of QE on pension schemes. The key effect of QE is not on the asset side of the schemes, but on the liability side. How?

We already mentioned that if you own a bond and interest rates fall, the value of you bond increases. The flip side of this is that the opposite would happen to the bond issuer. To the bond issuer, the bond is a liability and it is growing to the exact same degree as the bond holder’s asset. It is after all the same bond.

Let us translate this to the final salary / defined benefit pension schemes. They have promised their members future payments, maybe as far as 50 years into the future. These future payments are an asset to the members a liability to the pension scheme. In this, they resemble the bonds we discussed in the previous paragraph. And as QE drives down interest rates, the value of the promises to pension scheme members will rise. Unfortunately, these are liabilities to the pension schemes.

Back in 1996, the GAD rates were at 8.25% and recently at an all-time low of 2%. That means they have halved the rates twice since 1996. If we discount future pension promises under these circumstances, it would basically imply quadrupled liabilities. There are few other changes in circumstances that can have an effect on pension scheme balance sheets of that massive magnitude. Poor stock markets, poor money market rates or aging population, nothing comes close to quadrupled liabilities.

Here we have the main way in which Bank of England’s QE destroys the balance sheets of UK pension schemes. They do it by blowing up a gigantic pension liability bubble.

This is UK Pension Deficit 101. How can this be so hard to understand? It is after all basic facts you learn in Finance 101.