Whether interest rates rise sooner or later is not really an issue to concern people in itself. U.S. interest rates will probably rise more than they will here in Europe, but they will stay comparatively – and surprisingly – low everywhere. The biggest risk is that they remain very low. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways.
The biggest area of concern lies in the pensions industry. The Office for National Statistics announced back in 2012 that total UK pension liabilities amounted to just over £7 trillion, with almost £5 trillion being unfunded.
According to Niels Jensen, chief investment officer of investment consultancy, Absolute Return Partners, well informed sources tell him that UK unfunded pension liabilities are fast approaching £10 trillion, or over five times GDP. "Put another way, £10 trillion translate into approx. £375,000 per UK household in future pension liabilities; a whopping number that makes pretty much all other problems look like a walk in the park. The fact that most unfunded pension liabilities in the UK are linked to state pensions only make matters worse; there is in reality only one place to find the money – the taxpayer’s pockets," he says.
It's not just a problem for the UK. In the U.S., where Defined Benefit schemes do not account for a particularly large part of the pensions industry, federal unfunded pension liabilities now exceed $127 trillion (it is not a misprint). One can only imagine what that implies for the U.S. tax payer.
German pension funds’ funded status, already low after years of falling interest rates, took another dive in 2014, and German companies have been forced to set aside billions of euros for their struggling pension funds.
Some countries have begun to take action. Sweden, Denmark and the Netherlands have all permitted the local pension industry to use a fixed discount factor of 4.2%, and in the U.S. the regulator now allows the industry to use the average rate over the last 25 years when discounting future liabilities back to a present value.
Given the magnitude of unfunded pension liabilities in the Anglo-Saxon world, something will simply have to give. Political leaders in most countries prefer not to talk openly about it, which is (sort of) understandable, given that it is not the most obvious vote winner one can think of.
However, the fact that UK Prime Minister, David Cameron appointed one of the leading UK experts on pensions – and one with no previous ties to the Conservative Party - as a pension minister when his government was reshuffled earlier this year, is an indication that they are finally beginning to take the problem seriously.
"So what could happen?" Mr Jensens asks. "An across-the-board haircut? An extension of the retirement age? A mandatory conversion of Defined Benefit schemes to less risky Defined Contribution schemes? (Less risky – at least from the employer’s point of view.) Something else? I have no idea, but something is almost certain to happen. Otherwise entire countries could be forced to default on their pension liabilities, which is in nobody’s interest."
Changing the discount factor is only the beginning of something much bigger to come but changing the discount factor is akin to financial engineering anyway. "No fundamental problems are resolved this way. The best of all worlds would obviously be a material rise in interest rates without a corresponding rise in the debt service burden, and without it having a negative impact on equity prices. One can only dream," concludes Jensen.
UK private sector pension schemes could find their aggregate liabilities increase by as much as £62bn if an interest rate rise fails to materialise one year after market expectations, research by JLT Employee Benefits has revealed. If the pension consultancy firm’s predictions are correct, employers might have to find an extra £2m on average to top up their pension contributions.