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Pension liabilities

Philip Bowring

THURSDAY, JANUARY 26, 2006
DAVOS, Switzerland A remarkable if obscure event last week highlighted the potentially colossal impact on the global economy of the collision of two forces: the pension needs of aging populations throughout the developed world and the collapse of long-term interest rates. Pensions do not feature in the long list of subjects to be discussed at the World Economic Forum in Davos this week, but they ought to.
 
The event last week was the fall in the rate of return of 50-year inflation-indexed British government bonds to under 0.4 percent. That is far worse than anything even Japanese savers have experienced - the inflation adjusted on yen bonds was never below 1 percent.
 
The British bond bubble is exceptional and caused in part by regulations that force pension fund trustees to seek safety more than yield. But it is also part of a global phenomenon. For example, yields on 20-year U.S. Treasury inflation-protected bonds are 1.9 percent and those on French, Canadian and other equivalents are lower. Conventional bond yields are close to record lows almost everywhere, including emerging and higher risk markets such as Russia and Argentina.
 
So why should this be a problem? Are not low interest rates good for economies, stimulating consumption and encouraging investment? Unfortunately, not always - particularly when pension schemes in many companies and countries are already inadequate to meet future obligations.
 
In the case of Britain, the fall in long-term rates over the past year has added $30 billion to the existing pension fund deficits. In the United States, many funds already had overly optimistic of rates of return on funds. For the time being, a pick-up in some equity markets may be delaying a day of reckoning. But funds assuming an annual return of 8 percent to 9 percent, when 10-year treasuries yield half that and corporate dividend yields are under 2 percent, will face a crisis if yields do not rise.
 
Low long-term interest rates are having or will have very serious negative consequences that outweigh temporary apparent benefits:
 
The more aware corporations become of the further growth in their unfunded pension liabilities, the less willing will they be to invest surplus cash in new ventures. It will go to shore up the funds. In the United States, the weak corporate investment response to very healthy profits suggests this is happening already.
 
As in Japan, low interest rates have minimal impact on willingness to consume. Instead they make it seemingly painless for the government to borrow heavily for investment in schemes and bridges to nowhere.
 
Low long-term interest rates encourage asset bubbles of all sorts. The world may not be in an equity bubble but many parts of it have been enjoying property bubbles - and now the bond bubble. That gives central banks, fearful of bubbles bursting, reason to delay return to more normal rates.
 
Low rates of return from bond and equity markets encourage a shift into nonconventional assets such as hedge funds and private equity. These promise higher returns but their lack of transparency and high leverage promise more train wrecks ahead.
 
Annuity yields are so low that pensioners will be forced to rely on the state for welfare.
 
It has become fashionable in the West to see "excess Asian savings" as the main cause of low bond yields. Yes, there is scope for China, South Korea, Japan and parts of Southeast Asia to spend more and save less. There is a trend in that direction already - and, in time, oil exporters now accumulating vast surpluses will also spend more of their new wealth.
 
None of this can adequately explain, however, why real interest rates in the United States can be at record lows while household saving is nonexistent and the government deficit enormous. Or why British rates are so low despite record levels of household debt and a rising government deficit.
 
A more plausible explanation is the extraordinarily rapid pace of money supply growth almost everywhere - in Europe, Australia and even Japan as well as in the lead money printer, the United States. Rapid expansion of reserve currencies has quickly been followed by monetary surges in Asia and Latin America.
 
Of course there are other influences. In the information technology era, growth may be less capital-intensive than during the era of steel. And global demographic change is adding to savings and reducing growth in demand for new houses and factories.
 
But the major central bankers and finance ministers should stop either blaming the Asians or just musing over the causes of low rates. Individually and severally, they are supposed to be in control of money creation, credit growth and the supply of long-term public debt.
 
The problems of aging and pensions were already challenging enough. Current attempts to buy short-term expansion with artificially low interest rates can only make the long-term problems greater than ever.
 
Davos: please discuss.
 
 
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