Not drowning but waving? Summary of findings UK April 2013 IN BRIEF n The purchasing of Gilts through the Bank of England s Quantitative Easing programme has pushed yields to an even lower level than justified by the economic environment n The funding position of UK pension schemes was adversely impacted, with funding solvency reduced by up to 16 percentage points n However, the effects of Quantitative Easing are transitory. Outside the period of buying by the Bank of England, yields appear to return to reflecting the prevailing economic environment. As such, the long term impact on pension schemes will be dictated by the decisions made during periods of abnormally low yields, including contribution schedules, rather than an ongoing depressive effect. INTRODUCTION 1 Over the last few years, central banks have made increasing use of unconventional monetary policy to stimulate economic growth. While growth has been the motivation for this policy, pension schemes have also been seriously affected. Pension liabilities are driven by Gilt yields: if yields are pushed down, liabilities and, potentially, contributions are forced up. While there might also be a beneficial impact on assets, it is far from clear what the net effect on pension scheme solvency might be. The nature and duration of pension schemes mean that their reaction to changes in bond yields is not necessarily straightforward. The impact of QE on both nominal and real rates must be assessed and understood for the full term of the yield curves. To explore this question, we have built a model of yields, and the results are interesting. 1 This report provides a summary of findings from our analysis. For a more detailed treatment, please see the associated white paper, Not drowning by waving? FOR INSTITUTIONAL AND PROFESSSIONAL CLIENTS ONLY NOT FOR RETAIL USE OR DISTRIBUTION.
Not drowning but waving? Summary of findings On the face of it, the impact of quantitative easing (QE) has been immense. At the height of the first round of QE (QE1), we estimate that the impact on bond yields both through the increases in liabilities and the offsetting rise in bonds pushed pension scheme deficits as much as GBP 150 billion above the levels that would have been seen without QE. The impact of QE on pension schemes is not just an issue of historical interest. Transitory effects on rates can have long lasting effects on contributions, as these are often fixed for three years following a valuation and since the greatest distortion occurred on 30 September 2009, contributions assessed as at this date could have been similarly elevated. There may even be further bond repurchases as recently as February 2013, one third of the Bank of England s Monetary Policy Committee voted to expand the programme of QE 2, so the potential impact on pension schemes is as relevant as ever. What is QE? QE is a form of unconventional monetary policy. It is a technique used by the Bank of England and other central banks to stimulate growth by reducing the cost of capital for companies. This essentially means pushing yields downwards and asset values upwards. As well as being beneficial to companies, the support for asset values benefits investors. In broad terms, QE in the UK is implemented by the Bank of England increasing the money supply by creating electronic money, and using the proceeds to buy securities from financial institutions through its Asset Purchase Facility (APF). The securities bought have been almost overwhelmingly government bonds: at the end of 2012, the Bank of England held GBP 375 billion in Gilts, while it holds only GBP 25 million in corporate bonds and no commercial paper at all. The Bank of England has purchased Gilts of virtually all terms from three years upwards. It has tried to ensure that it holds no more than 70% of any issue, in order to maintain liquidity in the market, and while it has purchased a proportion of all but one issue 3, it has concentrated on the medium-term (seven to fifteen year) market: it holds around 40% of the securities here, as compared with 35% of the short- and long-term Gilt markets. 4 The impact of QE: a counterfactual analysis In our analysis, we concentrate on the impact of QE on bond yields. To do this, we use a counterfactual model. The principle here is to build a financial model that describes the movement of bond yields before the introduction of QE (the training period ), and use this model to show how yields would have behaved if QE had not been introduced (the projection period ). The training period we use for Gilts is February 1993 to December 2008, and the projection period is January 2009 to December 2012. EXHIBIT 1: THE IMPACT OF QE ON THE TEN-YEAR GILT YIELD AND BASIS Redemption yield and Basis (basis points) 1000 900 800 700 600 500 400 300 200 100 0-100 -200 Inflation report (telegraphed QE) The broad picture for conventional Gilts is shown in Exhibit 1. The apparent impact here is clear: Gilt yields at the ten-year term started falling behind the rising counterfactual yield as soon as QE was telegraphed in the Bank of England s inflation report. Yields remained at these relatively depressed levels for much of QE1 with the difference peaking at 162 basis points. Importantly, however, as soon as QE1 ceased, ten-year yields moved to be broadly in line with the yields predicted by the counterfactual model, and stayed there until around the time that QE2 was implemented. Here, the difference between actual and predicted yields was as high as 199 basis points at one point. The difference has since reduced following the end of QE, but at the end of 2012 yields still appeared to be 109 basis points lower than they should have been according to the counterfactual model. QE1 QE 2 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Date BoE purchases 10-year Gilt (smoothed) 10-year Gilt (counterfactual) Announcements 10-year basis. The basis represents difference between the counterfactual and actual Gilts yields." 2 Not drowning but waving? Summary of findings
EXHIBIT 2: THE IMPACT OF QE ON THE TEN-YEAR INDEX-LINKED GILT YIELD AND BASIS Redemption yield and basis (basis points) 500 400 300 200 100 0-100 -200 Inflation report (telegraphed QE) Date BoE purchases 10-year Gilt (smoothed) 10-year Gilt (counterfactual) Announcements 10-year basis Despite the Bank of England buying only conventional Gilts, QE appears to have affected index-linked Gilts in exactly the same way, as shown in Exhibit 2. After the spike in real yields in November 2008 resulting from a brief but severe fear of deflation QE made its presence felt. During both QE1 and QE2, real yields were depressed by up to 155 basis points and at the end of 2012, this apparent mispricing largely persisted, falling only to 144 basis points. However, the impact on yields was not constant across the yield curve. As Tables 1 and 2 show, the impact on long dated yields was less pronounced, and less likely to persist beyond the end of QE2. TABLE 1: DIFFERENCE BETWEEN COUNTERFACTUAL AND SMOOTHED OBSERVED GILT YIELDS Country 5 Year 10 Year 20 Year Maximum basis during QE1 145 162 137 Maximum basis during QE2 237 199 103 Basis in December 2012 123 109 45 QE1 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 QE 2 2 Bank of England (February, 2013), Minutes of the Monetary Policy Committee Meeting, 6 and 7 February 2013 3 The 1 ¼% Gilt maturing in 2018 was not purchased due to its limited liquidity 4 Full details of the Bank of England s actions are available on the bank s website, www.bankofengland.co.uk TABLE 2: DIFFERENCE BETWEEN COUNTERFACTUAL AND SMOOTHED OBSERVED INDEX-LINKED GILT YIELDS Country 5 year 10 year 20 year Maximum basis during QE1 195 155 120 Maximum basis during QE2 224 155 72 Basis in December 2012 198 144 61 The impact of QE on pension schemes Tracking the various yield curves over time, we are able to see how UK pension scheme funding liabilities would have moved both allowing for QE and under the counterfactual scenario. To do this, we directly account for any beneficial impact falling interest rates may have had on pension assets, as well as the detrimental impact in increasing liabilities. This analysis, presented in Exhibit 3, shows that even allowing for the impact on bond values, QE1 had a significant impact on funding solvency, reducing solvency by up to 16 percentage points. In monetary terms, this is equivalent to an increase of around GBP 150 billion in the aggregate deficit of UK pension schemes. Importantly, this point of maximum divergence occurred on 30 September 2009, so any pension schemes carrying out valuations with this effective date would have seen their funding solvency depressed by a substantial degree and there is a risk that this impact could have flowed through to give higher contribution rates. EXHIBIT 3: ESTIMATED ACTUAL AND COUNTERFACTUAL FUNDING SOLVENCY Funding solvency (%) 140 120 100 80 60 40 20 0 Dec 2007 Apr 2008 Inflation report (telegraphed QE) Aug 2008 QE1 BoE Purchases Actual Dec 2008 Apr 2009 Aug 2009 Dec 2009 Apr 2010 Counterfactual Announcements QE2 Aug 2010 Date Dec 2010 Apr 2011 Aug 2011 Dec 2011 Apr 2012 Aug 2012 Dec 2012 J.P. MORGAN ASSET MANAGEMENT 3
Not drowning but waving? Summary of findings In contrast, QE2 had a much more moderate effect, though funding levels still appear to be depressed. However, by the end of 2012 funding solvency for both the actual and counterfactual models is broadly similar. It is interesting to see how pension schemes would have fared between the end of QE1 and the start of QE2. It appears that in this period, pension schemes were actually better off than they would otherwise have been. Conclusion Our study reveals that QE has clearly had an effect on conventional and index-linked Gilt yields. Not only that, but it appears that pension scheme solvency was also depressed significantly, with the inflation in bond values doing little to offset the increase in liabilities. It could be that some of this deficit was offset by an increase in the values of risk assets, but even the widely-quoted figure of a 20% boost to equities would not have cleared the deficits in QE1. The overall position appears to be that QE has artificially inflated liability values for the purpose of funding, and this has accelerated or is likely to accelerate the payment of deficit recovery contributions in many cases. The analysis also suggests that the effect on solvency was temporary. Too stringent a funding requirement could well result in excessive contributions being paid and, more importantly, in companies being forced into distress. Finally, it is important to look to the future. It is clear that QE has depressed Gilt yields. This suggests that unwinding QE could inflate Gilt yields. Care will need to be taken to make any unwinding as controlled as possible. QE has had a major impact on pension schemes, and it is important to keep pension schemes in mind when QE is on the agenda in future For further discussion of this topic, please see the associated white paper, Not drowning but waving? 4 Not drowning but waving? Summary of findings
Authors Paul Sweeting, managing director, is European head of J.P. Morgan Asset Management s Strategy Group, based in London. An employee since 2011, he is responsible for providing institutional clients with tailored advice, analysis and education about various aspects of asset allocation, risk management and investment strategies. Paul published a book called Financial Enterprise Risk Management in 2011. Before joining the firm, he held a full time post at the University of Kent as professor of Actuarial Science, a role he continues to hold on a part-time basis. Prior to this, he worked at Munich Reinsurance and at Fidelity Investments, where he was director of Research at their Retirement Institute. Paul holds a Bachelor s degree in Economics from the University of Bristol, a Master s degree in Actuarial Science from Cass Business School and a Doctoral degree in Finance, also from the University of Bristol. He is a fellow of the Institute of Actuaries, of the Royal Statistical Society and of the Chartered Institute for Securities and Investment, and a CFA charterholder. Alex Christie, vice president, is a member of the Strategy Group. An employee since 2008, his background is in pure mathematics. Prior to joining J.P. Morgan, he worked at the European Commission and he is the author of a book on mathematical linguistics. He studied pure mathematics at the Université Henri Poincaré, in France, and he studied Economics at the University of Oxford and at the London School of Economics in the UK. He holds two Master s Degrees and the title of Ingénieur-Maître. Edward Gladwyn, is a member of J.P. Morgan Asset Management s Strategy Group, based in London. An employee since 2011, he is responsible for delivering customised research, analytics and solutions to institutional clients about various aspects of asset allocation, risk management and investment strategies. Prior to joining J.P. Morgan, he worked at KPMG as a risk consultant, focusing on regulatory risk issues for banks and other financial institutions. He studied Economics at Durham University and has passed all three levels of the CFA curriculum.
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