September 2008 was the month the financial crisis exploded into the global financial meltdown that arguably, the world is still dealing with today.
Last time we looked at what caused the crash, here we’ll examine some of the ways that it has affected your pensions and savings.
Quantitative Easing – the £375 billion elephant in the room
To help stimulate the economy, the Bank of England took the decision to slash interest rates. Between April 2008 and March 2009, the interest rate plummeted from 5.0% to its current historical low of 0.5%, where it remains today. The point came when the Bank of England didn’t feel it could cut interest rates any further, but needed to do something more to stimulate the economy – enter Quantitative Easing (QE).
QE both is and isn’t printing money. Confused? Under QE, the Bank of England bought gilts (government bonds) from other banks with new, digitally-created money. The broad idea was that banks would use this new money to lend to businesses and buy shares and corporate bonds, stimulating the economy.
However, in a sense QE didn’t actually increase the amount of money in circulation. Although there was more money around (that extra £375 billion the Bank of England created out of thin air) it was used to buy an equal amount of government bonds, which sat there doing little or nothing on its balance sheet (or if you like, in its vaults).
The important difference between QE and printing money is that QE is in theory reversible – the Bank of England can either resell those gilts back on the market and ‘delete’ the money it makes, or let them expire when they reach maturity date, effectively cancelling them out.
In total, the Bank of England bought £375 billion of assets from banks between March 2009 and July 2012, adding this amount of new money to the economy. The Bank of England estimates that QE added 1.5% to 2% to the UK’s GDP.
Pension fund accounting – a huge liability
To understand the impact of QE and the stock market crash on pension funds, we have to take a quick detour into the complex world of pension fund accounting for UK defined benefit schemes, usually known outside the pensions industry as final salary schemes – we’ll try to keep it as simple as possible.
Every three years, pension schemes file their accounts, comparing the value of their investments against what they expect to have to pay out in pensions in the future. These values are based on the prices available in the markets when the accounts are due to be filed, so a big rise or fall in prices can have a huge impact on the overall financial health of the scheme.
In March 2009, when many schemes filed their valuations, the FTSE 100 stock index was at one of its lowest points since the crisis hit – around 4000 points, down from around 6000 points in March 2006 – which meant their investments were suddenly worth a lot less.
On the other side of the accounts, to work out what the current total ‘cost’ is of all those future pension promises (which is incredibly complex in itself), schemes use bond yields, or the effective interest rate that bonds pay out. But one of the major effects of QE has been to drastically lower bond yields, making that current ‘cost’ much more expensive.
You can think about it like this: if you’re trying to save up for something then it will take longer to reach your goal with a bank account paying interest of 2% than one earning 10%.
A funding black hole
Because the value of their investments had fallen so much, while the future cost of what they had to pay out had risen thanks to QE, it suddenly appeared to be much more expensive to run a pension scheme. According to the Pension Protection Fund (PPF), which pays pensions on behalf of bankrupt firms, schemes had a combined funding shortfall of £188.5 billion at the end of April 2009, down from surplus of £51 billion a year earlier - or a swing of around £240 billion in about 12 months (Source: BBC).
Plugging these funding gaps (by law, companies have to put plans and steps in place to do this over a period of time) used up a lot of money that companies could have used to pay profits to shareholders, hire more people or invest – companies in the FTSE 100 paid in about £17.5 billion in 2009. This extra expense is one of the reasons why companies have been closing their defined benefit pension schemes in droves (Source: BBC).
Of course, the impact of the financial crisis affected more than just defined benefit schemes. Retirees buying annuities have been particularly badly affected, as annuity rates are set based on the returns available from bonds. Whereas a typical annuity could have provided an income of close to £8,000 a year in summer 2008, as of August 2015 this stood at £5,847 and hit an all time low of £5,373 in January 2013 (Source: Sharing Pensions).
Members of defined contribution schemes were also similarly affected by lower share values and, if they were close to retirement, lower government and corporate bond yields. And as the financial crisis provoked the closure of defined benefit schemes, more workers have become members of defined contribution pensions, moving the burden of investment risk from companies and the scheme membership as a whole to being entirely held by the individual.
This article has been commissioned by retiresavvy and any opinions voiced are the author's own.