Charles Bean: Pension funds and quantitative easing
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
to the National Association of Pension Funds' Local Authority Conference, Cotswolds,
Gloucestershire, 23 May 2012.
All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx
* * *
Thank you, Joanne (Segars), for that kind introduction. When I was invited to address this
conference, I was asked to discuss how the Monetary Policy Committee's asset purchases
- colloquially, though rather inelegantly, known as quantitative easing or QE for short - affect
pension funds. I was actually quite pleased to be assigned this brief, as in my view some of
the commentary regarding QE has taken a rather partial view of its effects. Not only is the
adverse impact of QE on pension funds often exaggerated, but the excessive focus on QE
as a cause of low long-term risk-free interest rates also risks distracting attention from other
factors driving yields which may present a more durable challenge to the sponsors and
trustees of pension funds.
To begin with, it may be helpful if I remind you how QE works and what it seeks to achieve.
QE essentially involves us trading one liability of the state - gilts - for another - monetary
claims on the Bank of England.1 The maturity structure of our purchases is designed to
ensure that the gilts are largely sourced from private sector non-bank investors, such as
insurance companies, pension funds and hedge funds. So, as a result of our operations,
investors end up holding fewer gilts, together with more cash in their bank accounts. And
corresponding to that increase in bank deposits, the banks themselves see their reserves
accounts at the Bank of England increase.
If the seller were indifferent between holding the gilt and holding the associated bank deposit,
then that is where things would end. But because deposits tend to yield less than gilts and
assets such as corporate bonds and equities, the seller is likely in due course to want to buy
some other asset instead. The consequence is upward pressure on the prices of a whole
range of assets, including corporate bonds and equities. That in turn increases the
availability, and reduces the cost, of finance to corporates. It also boosts the value of
people's wealth, which should encourage more spending. And, more generally, QE is likely to
have boosted confidence by removing some of the worst downside risks associated with a
potential slide into deflation.
As I noted a moment ago, we aim to source the gilts from institutions other than banks.
Because the banks end up with more customer deposits and more liquid assets, they may be
encouraged to extend more bank credit. In this way, QE could boost the supply of credit
through the banking system, as well as through the capital markets. But in the circumstances
prevailing after the financial crisis, with the banks engaged in repairing their balance sheets,
this particular channel was expected to be weak. What is probably more relevant to the
supply of credit at the current juncture is the amount of bank capital and the cost and
availability of bank funding. QE may then boost credit supply indirectly if it leads investors to
increase their demand for bank debt and equity.
As you will be aware, the Monetary Policy Committee has so far purchased £325 billion of
gilts, £200 billion in a first phase during the worst of the recession in 2009 (QE1) and
£125 billion in a second phase as the economy slowed at the end of last year and which was
completed shortly before our latest policy meeting (QE2). To give some context, that
represents around a quarter of the total stock of UK government debt in issue. It is, though,
important to remember that throughout this time the Debt Management Office has been
issuing substantial net quantities of new gilts in order to fund the Government's budget
deficit. So, despite the scale of our purchases, the stock of conventional gilts held by the
private sector is actually higher now than when we started our purchases (see Chart 1).
What impact have our purchases had on asset prices? Chart 2 shows the evolution of a
representative gilt yield and an equity price index from the beginning of 2007, just before the
start of the financial crisis. I have also marked on the periods when the MPC was buying gilts
in grey. When there is bad news about the economic outlook, one would expect to see gilt
yields and equity prices both falling. That is indeed what one observes during late 2008/early
2009 at the worst of the crisis after Lehman's collapsed, and again in the early autumn of last
year as the euro-area crisis intensified and growth slowed.
As already noted, though, our asset purchases should drive down gilt yields and push up
equity prices, other things equal. Equity prices behave as expected in both QE1 and QE2, as
does the gilt yield during QE2. The gilt yield was, however, broadly flat over the period of
QE1. That probably reflects the influence of other factors working against our asset
purchases. In particular, during 2009 market concerns about the lack of a fully credible plan
to close the fiscal deficit over the medium term increased somewhat, which would have
tended to push up yields. In recent months the opposite appears to have been true. Market
confidence in the UK Government's commitment to fiscal consolidation, together with
heightened concerns about the fiscal positions of some euro-area sovereigns, has exerted
downward pressure on gilt yields.
Quantifying the impact of QE requires one to abstract from these other influences on asset
prices. One way of doing that is by looking at the immediate movements in asset prices
around announcements of purchases. As market participants are forward-looking, one might
expect the bulk of the movement associated with QE to happen when the purchases are
announced rather than when they take place. And indeed that approach seems to work
reasonably well for identifying the impact of QE1 on the yields on gilts, and those on close
substitutes such as corporate bonds. Analysis by Bank staff2 suggests that long-term gilt
yields were around one percentage point lower than they would otherwise have been; that
corresponds to a rise in long-term gilt prices of around 20%. Investment-grade corporate
bond yields3 fell by about the same amount, while high-yield corporate bonds fell by
somewhat more.
This approach is less suited to analysing the impact of QE2. The deterioration in the
economic situation, speeches by MPC members, and the minutes of the September policy
meeting all encouraged market participants to expect a re-commencement of the purchase
programme. As a result, the effects were already largely incorporated into the general level
of bond prices prior to the MPC's actual announcement of the new programme in October, so
it becomes difficult to disentangle the effect of QE. Ahead of that announcement, however,
UK sovereign bond yields did fall relative to those in Germany and the United States,
consistent with an effect from QE.
Moreover, in February we did make an unexpected announcement of a change in the
maturity structure of our purchases. This was intended to prevent the Bank's holdings
becoming unduly concentrated in any particular segment of the market and had the
consequence of shifting them more towards shorter durations. The subsequent response of
yields at different maturities was broadly in line with what would have been expected on the
basis of our first round of purchases (see Chart 3).
The approach is also less suited to analysing the impact on the prices of assets which are
less immediate substitutes, such as equities. These are likely to take longer to adjust, as it
probably takes a while for portfolio managers to decide how they want to rebalance their
portfolios. But, as Chart 2 shows, equity prices rose substantially once QE was actually
under way - by around 50% during QE1 and around 10% during QE2. In both cases, the
switch from decline to growth coincides with the commencement of asset purchases.
It seems unlikely that all of the recovery in equity prices during these periods was down to
our QE. During both phases of the programme, the US Federal Reserve undertook similar
policies, and in recent months the ECB has injected large amounts of liquidity through its two
longer-term refinancing operations. Equity prices rose in those jurisdictions too. Many of the
companies in the equity price indices are international in focus and will be as exposed to
developments abroad as in their home market. Moreover, there will have been other factors
affecting equity prices, though during the second programme those other factors - slowing
growth and the worsening euro-area situation - seem more likely to have depressed equity
prices, rather than boosted them.
Given that QE is supposed to operate by driving asset prices up, however, it would seem
peculiar not to ascribe some part of the rise to our actions. Econometric studies4 carried out
at the Bank imply that equity prices probably rose by about 20% as a result of the first phase
of purchases. Assuming QE2 has proportionately the same effect as QE1, this implies an
increase of around 10% as a result of the second phase of purchases. In other words,
around half of the rise over the two episodes taken together appears attributable to QE. I
should, however, emphasise the considerable uncertainty around these estimates.
Let me now turn to the question of how this all affects a pension fund. Conceptually we can
split the obligations of a Defined Benefit pension scheme into two components: pension
obligations to current and former staff that have already been accumulated; and new
obligations arising from the additional pension rights earned by the current staff in the current
year through additional service and any increase in pay. The first component will dominate in
the case of anything other than a very new scheme, so let me concentrate on that for now. In
turn, I will consider the impact on: a fund that is balanced and hedged; one that is initially in
balance but exposed to market risk; and one that is initially in deficit, as well as being
exposed to market risk.
Now the existing pension obligations will typically be for a fixed flow of real income, that is
the pension entitlement will be adjusted for inflation. In principle, an employer could therefore
exactly match his pension obligations by holding a portfolio comprising indexed government
debt of appropriate durations.5 In this case, a change in the yields on government bonds as a
result of QE, or indeed on any other assets, would not alter the position of the fund one
iota - its obligations would still be completely covered. In this case, the change in the
valuation of the liabilities is exactly matched by a change in the valuation of the assets.
Of course, most pension funds do not seek to match their assets exactly to their obligations
in this way. Most will seek to cheapen the cost of meeting their obligations by holding higher
yielding assets, such as corporate bonds and equities, rather than just (indexed) government
bonds. This implies some extra risk, but is presumably judged acceptable if it reduces the
contribution rate sufficiently in most states of the world. A typical pension fund might hold
around 40% bonds and 60% equities,6 and the illustrative figures below assume such a mix.
To begin with, consider a scheme that started off 2007 in balance. To keep the picture
simple, I will assume that the liabilities are discounted by the gilt yield, so that the valuation of
liabilities moves with this yield; any changes in longevity and the like are ignored so as to
focus on the implications of asset price movements. In practice, of course, for accounting
purposes many pension fund sponsors use an investment-grade corporate bond rate to
discount their liabilities; an annex shows what things look like in this case.
Chart 4 shows how the deficit of this fund evolves, decomposed into the cumulative
contributions of the liabilities (green bars) and assets, comprising equities (red bars) and
bonds (blue bars). Note that the deficit rises as high as 30% of initial liabilities in early 2009,
reflecting the sharp fall in equity prices during the worst of the financial crisis and subsequent
recession. The deficit then falls back as equity prices rally strongly. It then re-emerges in late
2011 and early 2012, reflecting the fall in gilt yields coupled with the more modest
movements in equity prices during this episode.
Now consider what the picture might have looked like if the MPC had not undertaken any
QE. In constructing this counterfactual experiment, I take the estimates of the asset-price
impact for QE1 from the work that I discussed earlier, namely that it reduced gilt yields by a
percentage point and raised equity prices by 20%, and then simply pro-rate those effects for
QE2. I emphasise again that these are only estimates of the effect of QE and are subject to
considerable uncertainty, so the results of this exercise should be treated as illustrative
rather than definitive.
Chart 5 shows the result. The value of liabilities (green bars) is lower from early 2009
onwards, which on its own pushes the fund towards surplus, but working against that there is
now much less of a recovery in equities, while the value of bond holdings is also lower. The
overall path of the deficit is very similar, as can be seen more clearly in Chart 6, which just
shows the two deficits together. So the bottom line is that QE is broadly neutral for a fund
that starts in balance, with the overall movement in assets broadly matching the movement in
liabilities.
Not all funds, however, started 2007 in balance. Indeed, the Purple Book, published by the
Pension Protection Fund and the Pensions Regulator, suggests that the average pension
fund deficit was equal to about 30% of total liabilities, calculated on a full buy-out basis. The
consequence of this is to shrink the red and blue bars in Charts 4 and 5 by 30% (the time
profiles are otherwise the same), reflecting the shortage of assets to meet such a fund's
obligations. The implications for the deficit, with and without QE, are shown in Chart 7. Now
QE widens the deficit from the start of our purchases in early 2009 onwards, and by the end
of the period has raised it by about 10% of initial liabilities. This is, by the way, of the same
order as some calculations of the impact of QE produced by the Pension Corporation late
last year.7
There are a couple of conclusions I want to draw from this. The first is that while the change
in the deficit is certainly not trivial for a substantially underfunded scheme, the impact of
QE is nevertheless small compared to the movement in the deficit associated with other
factors, such as the collapse in equity prices as a result of the financial crisis and the
recession. In particular, it would be an error to attribute the deterioration in pension deficits
since the start of the crisis solely to the impact of QE.
The second observation is that QE does not inherently raise pension deficits. It all depends
on the initial position of the fund, with the movements in liabilities and assets likely to be
broadly comparable when a scheme is fully funded. But the more a scheme is underfunded
(overfunded) to begin with, the more it will find its deficit (surplus) increased. This is entirely
intuitive. By reducing yields, QE increases the cost of purchasing a given future stream of
income. So if a fund starts off relatively "asset poor", the sponsors will now find it more costly
to acquire the assets necessary to match its future obligations.
A corollary of this is that the cost of provisioning against additional pension entitlements
being accumulated by currently serving staff unambiguously rises. That does mean that the
effective cost of employing labour, when their pension costs are also included, also rises.8
This is certainly an unwanted side effect of QE. But it needs to be balanced against the
higher activity and business profits resulting from QE, as well as the fact that wage growth
has recently been exceptionally weak, which work in the opposite direction.
Given that pension funds have for the most part seen deficits widen in recent years, whether
it be as a result of the crisis and recession or the result of QE, how should sponsors and
trustees respond? It makes little sense to rush to close a deficit that is likely to prove
temporary. But if a deficit is likely to persist, then corrective action is required, initially to
prevent it continuing to expand and ultimately to close it, though that adjustment could, quite
reasonably, be spread out over time. This is all recognised by the Pensions Regulator.
The biggest issue here is not the principles involved, but rather the likely future evolution of
yields and asset prices. Here I think it is worth stepping back from recent developments to
consider the behaviour of yields over a longer horizon. Chart 8 shows the nominal and real
yields on UK and US government debt over the past twenty years. Though yields have
dipped recently, the most striking feature of this chart is the general downward trend that was
evident for some years even before the financial crisis.
The causes of this downward trend are still not well understood. Some have pointed to a
global "savings glut" associated with unusually high levels of savings in some emerging
economies,9 especially China, which have been more than enough to finance the high levels
of investment there. That was reflected in downward pressure on global safe interest rates,
as well as the pattern of current account imbalances. While the Chinese surplus has fallen in
recent years, reflecting in part efforts to stimulate domestic demand, that has been offset by
a widening in the surplus of the major oil producers as increased revenues resulting from
high oil prices are largely saved rather than spent. While one might expect the Chinese
economy to continue to rebalance towards greater reliance on domestic demand and lower
savings, that process is likely to take many years to play out, so an early reversal of that
factor holding down yields seems unlikely.
Another possibility is a shortage of high-quality safe assets,10 with countries like China
accumulating reserves particularly in the form of US Treasuries. That in turn will also have
increased the demand for substitutes, including the government debt of other advanced
economies. But recent events in the euro area have highlighted the fact that the debt of
some sovereigns is not as safe as market participants thought. That has led to increased
demand for the debt of those sovereigns that are still regarded as safe, including that of the
United Kingdom. How long such a "safe-haven discount" persists depends not only on what
happens in this country but also what happens abroad: the demand for one country's bonds
as a safe haven depends in part on how risky those of other countries are thought to be.
Since the financial crisis and subsequent recession, another factor likely to have contributed
to depressing yields is the sharp decline in investment, prompted by the deterioration in the
outlook and heightened uncertainty. To date the recovery has been painfully slow, with
negligible growth in the United Kingdom over the past year and a half. And though there is
some variation in the pace of recovery across countries, in general growth has been weaker
than after a normal cyclical downturn. In part that reflects the fact that recoveries after
financial crises tend to be weaker and more drawn out as balance sheets are repaired, but
also it probably reflects the exceptional uncertainty in the aftermath of the financial crisis. It is
consequently hard to know when the animal spirits of businesses, and with it the propensity
to invest, are likely to revive.
Certainly the impact of QE on yields should ultimately reverse when the economic
environment improves and we start to sell the gilts back to the market in order to withdraw
the present exceptional monetary stimulus. Unfortunately, with the present heightened
uncertainty associated with the problems in the euro area, the likely future date for us to
commence selling gilts has receded somewhat. And if conditions do deteriorate significantly,
we may need to re-start the programme of purchases. Indeed, as the minutes released
earlier today reveal, the decision at our May meeting not to extend the programme was
already quite finely balanced. So, in conclusion, while there are reasons to expect yields to
return towards historically more normal levels at some stage, it is difficult to know when that
will be and how quickly it will occur.
There is no doubt that this is a challenging time for pension funds and their sponsors. Low
yields reduce the scope for harnessing the magic of compound interest to provide generous
future pensions at a moderate current cost. It may be tempting to conclude that the current
abnormally low yields are primarily a consequence of QE, and that the right approach is just
to look through the associated rise in deficits. But I hope that what I have said today has
persuaded you that this may not, in fact, be the most prudent course to take. Pension funds
and their sponsors may, I am afraid, have to contend with low yields for some considerable
time yet.
Thank you!
ANNEX:
EFFECT OF DISCOUNTING BY A CORPORATE BOND RATE
Accounting standard FRS17 dictates that pension fund liabilities should be discounted by an
investment-grade (AA) corporate bond rate, rather than the gilt yield. During the period of the
financial crisis that may, however, provide a misleading impression of the position of pension
funds. Corporate bond yields carry a premium over gilt yields in part because of the risk of
default. Discounting the flow of future pension liabilities by a corporate bond rate only makes
sense if the fund is no longer required to meet those liabilities in the states of the world
where the bond defaults. But this is not generally the case: broadly speaking, the fund needs
to meet its liabilities whatever happens.
In normal times, this does not matter very much as the spread of investment-grade bonds
over gilt yields is pretty small and does not vary very much. But during the peak of the crisis,
the spread - even for investment-grade bonds - rose significantly (Chart A). Consequently,
when standard accounting conventions are followed an additional factor needs to be added
to Charts 4 and 5, reflecting the impact of changes in the corporate bond spread. That is
shown by the mauve bars in Charts B and C respectively; the profiles of the other
components of the deficit are unchanged. The main consequence of this is that the value of
liabilities falls markedly during the period up to early 2009, indeed so much so that it
counteracts the loss in asset value due to the fall in equity prices and pushes the fund into
surplus. But it would be unwise for the sponsors and trustees of a pension fund to take
comfort from this, given that the fall in the value of liabilities was merely an artefact of an
increased probability of default on corporate bonds!
Reworking the analysis of the text does not, however, affect the main conclusions regarding
the impact of QE. Charts D and E are the equivalents of Charts 6 and 7, showing the
calculated deficits with and without QE for a fully funded and a 30% underfunded pension
scheme respectively. As before, QE makes little difference in the case of a fully funded
scheme, but moves it towards deficit in the case of a significantly underfunded one.
Chart 1: Stock of conventional gilts
£ billions
900
Private sector holdings
800
MPC purchases
700
600
500
400
300
200
100
0
Chart 2: Gilt yields and equity prices
Index
Per cent
4000 6
QE2
QE1
3500
5
3000
4
2500
2000 3
1500
2
15-year gilt yield (right-hand scale)
1000
FTSE All-Share (left-hand scale)
1
500
0 0
07 08 09 10 11 12
Chart 3: Changes in gilt yields & purchases around 9/2/2012
Chart 4: Simulated fund deficit (100% funded in 2007)
% of fund's
initial liabilities
Cumulative changes in liabilities
50
Cumulative changes in equities (inverted)
Cumulative changes in fixed income (inverted)
40
Deficit
30
20
10
0
-10
Start of QE1 Start of QE2
-20
07 08 09 10 11 12
Chart 5: Simulated fund deficit (100% funded in 2007), ex QE
% of fund's
initial liabilities
Cumulative changes in liabilities
50
Cumulative changes in equities (inverted)
Cumulative changes in fixed income (inverted)
40
Deficit
30
20
10
0
-10
Start of QE2
Start of QE1
-20
Chart 6: Deficits with and without QE (100% funded in 2007)
% of fund's initial liabilities
40
QE2
QE1
30
20
10
0
Including quantitative easing
Excluding quantitative easing
-10
07 08 09 10 11 12
Chart 7: Deficits with and without QE (70% funded in 2007)
% of fund's initial liabilities
60
QE1 QE2
50
40
30
Including quantitative easing
20
Excluding quantitative easing
10
Chart 8: International 10-year sovereign bond yields
Per cent
UK nominal yield UK real yield
12
US nominal yield US real yield
10
8
6
4
2
0
-2
1992 1997 2002 2007 2012
Chart A: Gilt yields and corporate bond yields
Per cent
9
8
7
6
5
4
3
AA sterling corporate bond yield
2
15-year gilt yield
1
0
Chart B: Simulated fund deficit (100% funded in 2007,
liabilities discounted by AA corporate bond yield)
% of fund's
initial liabilities
40
Start of QE2
Start of QE1
30
20
10
0
-10
-20
-30
Impact of corporate bond spread on liabilities
Cumulative changes in liabilities due to gilts -40
Cumulative changes in equities (inverted)
-50
Cumulative changes in fixed income (inverted)
07 08 09 10 11 12
Chart C: Simulated fund deficit (100% funded in 2007,
liabilities discounted by AA corporate bond yield), ex QE
% of fund's
initial liabilities
Start of QE1 40
Start of QE2
30
20
10
0
-10
-20
-30
Impact of corporate bond spread on liabilities
Cumulative changes in liabilities due to gilts
-40
Cumulative changes in equities (inverted)
-50
Cumulative changes in fixed income (inverted)
Chart D: Deficits with and without QE (100% funded in 2007,
liabilities discounted by AA corporate bond yield)
% of fund's initial liabilities
40
Including quantitative easing
30
Excluding quantitative easing
20
10
0
QE1 QE2
-10
-20
07 08 09 10 11 12
Chart E: Deficits with and without QE (70% funded in 2007,
liabilities discounted by AA corporate bond yield)
% of fund's initial liabilities
60
QE1 QE2
50
40
30
20
10
Including quantitative easing
Excluding quantitative easing
0