We’re now more than seven years into the era of “emergency” monetary policy, whereby interest rates around the globe (not just Japan) have been driven down to near-zero (or lower) levels.
The idea has been to boost economic growth and inflation. We haven’t seen much evidence of a huge impact on either.
But there’s one area where current monetary policy is starting to have a very obvious, and painful, impact – corporate pension deficits…
When monetary policy starts eating up your dividends
Earlier this week, plastics manufacturer Carclo warned that it might not be able to pay its final dividend. The dividend was scheduled to be paid on 7 October, but that now looks unlikely.
Unsurprisingly, the share price tanked. Investors hate it when dividends are cut. They hate it even more when they’re not expecting it.
So what’s the problem? Carclo has a defined-benefit pension scheme. In other words, it guarantees retired staff a certain level of income. How it funds that income is the company’s problem, not the retirees’.
(This is the opposite of the type of pension most of you still working in the private sector probably have. With a defined-contribution pension, you have no guarantees – you save up over the years, probably with a contribution from your employer, and when you retire, you get as much as your pot will produce, whatever that ends up being. The risk is on you, not the company or the taxpayer).
- So Carclo – like any other employer with a defined benefit scheme – has a big future liability in the form of its pension promises that it has to fund.
The other side of this problem is that, since the Brexit vote, yields on government and corporate debt have sunk even further (in other words, the price of government and corporate bonds has risen).
One reason for corporate bond yields dropping is that the Bank of England has promised to start buying corporate bonds as part of its latest batch of quantitative easing (QE), introduced by Mark Carney as a post-Brexit panic measure.
This is important, because corporate bond yields are used to value a company’s pension liabilities. If the yield falls, then the value of the liability rises (put simply, the lower the interest rate, the more money you need to save to generate the same return).
So as corporate bond yields have tumbled, the value of the pension deficit has risen. As Carclo put it: “If the corporate bond yield remains at its current low level then this will result in a significant increase in the group’s pension deficit as at September 30 2016.”
Hence the likely dividend cut.
The growing pension deficit problem
That’s annoying for Carclo shareholders. But it’s a major warning for lots of other shareholders too.
In total, the deficit for the country’s 6,000 private sector defined-benefit schemes has risen to £1trn in the six weeks following the Brexit vote, according to data from Hyman Robertson, quoted in the FT.
Meanwhile, Bob Scott of actuarial firm Lane Clark & Peacock tells the Financial Times: “Over August, the yields on high-quality corporate bonds have fallen dramatically from around 3% to 2%, and that will have increased pension liabilities by about 20%. This is going to be a real issue for companies looking to report their interim results in September.”
As Hargreaves Lansdown’s Tom McPhail noted: “Current monetary policy… is killing pension schemes, with disastrous consequences both for any employers sponsoring a final salary scheme and for any individuals looking to buy an annuity.”
We’ll be looking at this issue in more detail in the next issue of MoneyWeek magazine, out next Friday. But this is another threat to the dividend-paying capacity of Britain’s biggest companies.
It’s an issue that could potentially go away if interest rates rise, but clearly, that would bring a whole other set of concerns with it.
As for the effect on you as an individual, it’s both a threat to your dividend income and a risk for your long-term future. Assuming that it gets paid, a defined-benefit pension is a great perk. But most of us don’t have them.
In fact, you could argue that we defined-contribution pension holders have exactly the same problem as the companies involved here. If you’ve got plans to enjoy a certain level of income during retirement, then the further that expected returns fall, the more you have to save now to generate that level of income.
Conceptually, the only real difference here is that companies actually have to account for this deficit in some way. We don’t, which means – particularly if you are a decade or more from retirement – we tend to sweep the issue under the carpet and think that “something will come up”.
But the grim reality is that your personal pension deficit could be growing by the minute, and there’s no guarantee that this will change in the near future.
At the very least, take a look at your assumptions about your future income and the likely growth rate of your pension pot. If your projections are still based on 7% real returns a year or something similar, there’s a serious risk that you might be disappointed. Maybe think about how you should be addressing that.