By James Waters
Central banks have become one of the most prominent investors in the fixed income markets. Their objectives largely focus on using monetary policy to nudge inflation (and inflation expectations) to levels that are more consistent with longer-term targets. QE in the developed world has been directed at lowering the cost of borrowing, hence boosting aggregate demand and inflation. This, however, may have unintended and conflicting consequences.
By driving down longer-term yields, the central banks’ QE programmes effectively force those people worried about their retirement provision to save and invest more in order to match their future liabilities. Contributions in real terms have to increase as real yields fall, meaning the cost of retirement is pushed up. This is the case for both Defined Benefit (DB) scheme sponsors and individual investors in Defined Contribution (DC) pension schemes.
DB schemes and insurance companies usually have actuaries and other experts managing any mismatch between their assets and liabilities; regulators are also heavily involved. A scheme normally has a plan in place to reduce its deficit over a number of years by defining an appropriate investment approach alongside an increase in contributions from the sponsor. If contribution levels have to rise, the sponsor mainly bears the cost.
Individual investors in DC or personal pension schemes face similar challenges. The concept of surplus and deficit still applies, but most people are unlikely to have access to sufficient investment advice to be able to appropriately assess or match their liabilities. This is particularly worrying in the light of the new UK pension freedoms. If real yields fall then, all else being equal, the real value of a set of future liabilities will rise. For those investors not fully funded, the cost of retirement has increased.
This could trigger a positive feedback loop where demand for matching assets further reduces their real yield, which then encourages more demand and can have a significant effect on the underlying economy. Asset values are likely to rise as real yields fall. How this directly affects an economy will very much depend on who owns the existing stock of assets. Rising asset values are likely to benefit only those who have already built up significant investments over time.
There are other important variables that need to be taken into account. One of the most important is demographics. A young population is less likely to focus on retirement savings and liability matching, and would benefit more from a lower cost of borrowing. A maturing population such as that of Japan or Europe focuses more on retirement provision and will undoubtedly face stronger headwinds as the real cost of purchasing a future stream of income increases. The rate of change in retirement saving with age also depends on the other social safety nets; the greater the safety net available, the lower the need for matching.
QE drives down longer-term yields in an attempt to encourage borrowing, but may have a perverse effect in that it forces those who are worried about their retirement provision to save more, pushing real yields down and asset values up. This could negatively affect the economy. We may still be far from such a scenario, but savers, investors, regulators or central bankers need to be mindful of it.
James Waters is client portfolio manager at Threadneedle Investments
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