On Wednesday night, I gave a talk at my old primary school, Johnstown National School in Dún Laoghaire. One of the many interesting questions from the parents of the pupils focused on pensions and what this early-middle-aged group could expect from them.
I am considering this question in more detail now as I fly to the States. The little map on my screen tells me that I am at 38,000 feet above Newfoundland, the vast territory uncharted until French Canadian trappers began to map it out. The question for your pension is whether we are now in similar territory.
In the old days, when short-term interest rates were around 5 per cent, the pension fund manager could simply buy a government bond yielding 6 per cent and go on holidays, sage in the knowledge that the government would pay him 6 per cent at the end of the year. If the stocks he also bought did reasonably well, he might be able to generate a sweet double-digit return on the pension without having to do much. In such an environment, inflation is likely to be running at around 3 per cent, but punters tended to look at the headline number. Back in the 1970s when I was at Johnstown National School, pensions would have been yielding double-digit headline returns due to high inflation.
However, since that time, inflation has been falling – and so too have interest rates.
But the interest rate is driven by more than just what is happening to inflation.
The rate of interest is set by the Central Bank in order to achieve certain things in the economy. If, for example, the economy is very weak and has just experienced a recession, the rate of interest will be cut dramatically to support demand by encouraging people to borrow.
Alternatively, if the economy is overheating and growing too quickly, the rate of interest will be increased to stop people spending too much, as a higher interest rate encourages people to save.
So the natural rate of interest is the one that would pertain if central banks were neither trying to cool down the economy nor trying to heat it up. Over the past 30 years, the ‘natural rate of interest’ has fallen from about 6 or 7 per cent to around 1.5 per cent in Britain, near zero for the US and below zero for the eurozone. These are very low levels of interest; you would normally associate these levels with recessions, but we are not in recession.
The US is growing strongly, unemployment is below 5 per cent and most indicators point to an economy that is in mature recovery – so much so that all the talk now is of the next rate rise, not cut. Britain is also growing, unemployment is also low and exports are robust post-Brexit. Only in the EU is the zero interest rate reflective of a truly convalescent economy.
So why are rates so low, and why is your pension costing you, rather than making you, money? The real reason for the decline in the natural interest rate is the forces that are affecting the supply and demand for funds. These include ageing. Old people save rather than spend. Slowing productivity growth is also a factor because as productivity slows, economies tend to invest less. There is also the China effect, which is the fall in the price of big investment goods. Big machines that used to cost companies so much in the old days, and demand lots of funds to do so, have fallen in price because they are now made more cheaply in China.
We have also seen a sharp decline in public investment for building schools, hospitals and roads. The fewer of these our societies build, the less money the state needs to borrow. Obviously, austerity amplified this process. Rising inequality plays its part because if more and more money that used to go to lots of people now goes to fewer and fewer people, the demand for cash will fall because fewer and fewer people can never spend as much – even if they try (and they do).
Taken together, these global factors imply that there is money sitting in bank accounts, rather than being used productively in the economy. This excess supply of savings is driving rates down.
But if everyone is saving, who is spending? And if everyone is saving and the return on ‘safe’ assets, like government bonds, has collapsed, what are fund managers doing with your money?
They are taking bigger and bigger risks to generate yield for you. This means they are buying products that promise higher returns. But in a low-interest environment, how can products generate higher return? They must entail more risk, because you can’t have higher return without taking more risk. This is the name of the game. The only way something that looks safe can generate more return for you is if it has lots of leverage, so you think you are buying more of something than you are because the leverage allows you to gain more exposure for your investment.
But be careful, because – as we experienced in the housing boom – leverage is a great man when things are going up, but when the market turns, leverage not only destroys your one investment, but leaves you owing lots of money too.
With financial markets at all-time highs and interest rates in the US on the way up, the risk of whiplash in some leveraged pension products sold over the past three years to unsuspecting punters is increasing by the day.
Be wary when a man in a Hugo Boss suit promises you over-the-odds returns on a pension product. And remember, he takes his fee first whether the investment goes up or down and, by the way, his fee is your money.