Pensions and Monetary Folly

I recently wrote an article where I likened the current stance of monetary policy to a Monopoly game where The Bank continued to provide liquidity so as to allow all Players to gather assets. As such it adds to the perception of wealth. The Game must continue. One shall gather assets. Nice for those that already own assets. Bummer if you're just someone with a job, trying to make a living and saving a little for a nest egg. Or a pension for that matter. You can find it here: https://www.dhirubhai.net/pulse/monopoly-monetarism-bas-iserief/

While the article focused on asset growth, it didn't show the cost to that poor guy with just a salary, trying to save a little.

Recently ECB president Mario Draghi hinted that any further monetary easing into negative yielding territory should be accompanied by a mechanism that would mitigate that banks get a negative interest rate on monies they are obliged to hold at the Central bank, while not being able to charge a negative interest rate on customer deposits. The cost of this "monetary tax on banks" was calculated to be tens of billions of Euro's for the Eurozone banking sector and thus a significant piece of banks' profitability. Without such a mitigating mechanism, the risk would of course be that banks would increase margins on lending to insure for continued profitability, thus annulling the transmission of low rates to those parties that seek bank financing.

What strikes me as odd is that the ECB seems ready to mitigate the impact on banks, completely overlooking the impact low rates have on pension savings. To show the impact, let's have a look at one of the best funded pension systems in the world, those of the The Netherlands. With pensions savings at around EUR 2.5 trn, savings here are a factor 5 times Dutch GDP. We calculate the coverage ratio by dividing the market value of assets by the present value of future pension pay-outs. With interest rates now so low, the present value of those future liabilities stands at approximately the same value as those of the assets. The coverage ratio stands at around 100%. That is just enough to cover only NOMINAL (not inflation adjusted) future pay-outs. Actually there are large pension funds with a coverage ratio below 100% that can only create capital through slashing pension rights.

The interest rates set by the ECB, combined with their purchase of some 35% of the Eurozone bond market has led to longer term yields in negative territory and that are around 1.5% to 2% below inflation. Seen over a longer history yields on safe bonds more or less equaled the same as nominal GDP (real growth + inflation). So a "normal" yield on these assets should be some (let's say) 3% / 4% higher then they are today. Sure, the world has changed. We face horrible demographics and the Eurozone's potential GDP might well be below what it was. Let's agree then conservatively that yields are 2% below where they should be. Let's agree that real rates should at least be 0% (interest rates should compensate at least for inflation).

Pension actuaries will tell you that 2% higher yields will lower the present value of pension liabilities by some EUR 750 bln (at a "duration" of 15). It will also lower the market value of the bond portfolio of the funds, but with a lower interest rate sensitivity this would wipe the asset value of the bonds by some EUR 125 bln (at a "duration" of 5 and a portfolio allocation of 50% of assets), all things being equal. So the impact of ECB policy could well have cost the pension saver some EUR 600+ bln on that. Now, to be sure loose policy has also added to the value of equities and other risky assets on the balance sheets of pension funds, but the very long term future pension pay-outs' interest sensitivity has more than negated the increase in value of total assets and actually lowered the coverage ratio.

This is the impact for The Netherlands only. A wealthy country of some 17 mln people and a decently funded pension system. Now compare to the whole of the EU with over 500 mln people. Or to the US with some 300 mln inhabitants. And that have a much more poorly funded pension system.

Isn't it interesting that the ECB worries about the transmission mechanism of monetary policy through the impact of the "tax on banks" and doesn't seem concerned about the "tax on pension funds". A "tax" that can be valued at massive multiples of the opportunity loss for banks?

So while the very loose policy by global monetary authorities has caused an amazing rally in risky assets that has boosted the wealth of the rich, the average worker depending on a salary and saving for a pension will on aggregate be down. A situation that the pension industry will solve by lowering pension rights and not correcting pension pay-outs for inflation.

I contend that monetary policy makers are simply too stuck on ECON-101 that states that lower interest rates are always supportive for growth. In an ageing society there is a point where the loss for savers has the perverse effect of people spending less to make up for the loss of future income. And if you think the average John and Jane Doe aren't smart enough to get this complicated math, you might be in for a surprise. Because somewhere this year, many of them will receive a letter from their pension funds telling them that their future pension will be lowered.