With annuity rates near record lows, these are tough times for people about to retire. But things might not remain so bad. There are good reasons to believe that annuity rates will rise over the next few years.
One of these is that the quantitative easing (QE) which has reduced gilt yields, and thus annuity rates, might be reversed. Spencer Dale, a member of the monetary policy committee, hinted at this in a speech last month, saying that "we need to sell a huge amount of gilts back to private sector investors" - although he added that the time to do so "may well be some way off".
Bank of England economists estimate that the first £200bn of QE reduced gilt yields by a full percentage point. This suggests that reversing all of the £375bn of QE already undertaken could add almost 1.9 percentage points to gilt yields and thus annuity rates.
QE, however, is not the only reason why gilt yields are low. But the other reasons why they are low could also fade away.
One of these is that investors have sought a safe haven because they have been worried about the riskiness and growth prospects of equities. If appetite for risk recovers, therefore, gilt yields should rise. We can roughly quantify this. Since January 2001, there has been a strong correlation (0.67 in weekly data) between the price-earnings ratio on non-financial shares and the 10-year gilt yield; low PE ratios are accompanied by low gilt yields. This relationship implies that a rise of one unit in the PE ratio is accompanied, on average, by a rise of 0.15 percentage point in the 10-year gilt yield. If the PE ratio returns to around 14, therefore - below what it was in 2007 - we could see a half point added to annuity rates.
Another reason why gilt yields have been low is that there has been what Federal Reserve chairman Ben Bernanke has called a "global savings glut". This, he says, "played an important role in lowering Treasury yields". Because gilts are close substitutes for Treasuries, it also reduced gilt yields. However, one major cause of this glut should abate - namely, China's huge savings ratio. Dennis Yang of the Chinese University of Hong Kong expects this to fall partly because an ageing population will run down the savings it has built up, and partly because the creation of a welfare state and better functioning credit markets will reduce the need for households and companies to have huge precautionary savings.
The process could be accelerated by a policy shift, aimed at moving the economy away from heavy investment and towards consumer-led growth. Michael Pettis of Peking University says: "We may be seeing for the first time the beginning of China's urgently needed economic rebalancing, in which China reduces its overreliance on investment in favour of consumption."
This could eventually spell an end to the so-called Bretton Woods II arrangement, whereby China ran large trade surpluses - a trade surplus is generally the counterpart of high domestic saving - and reinvested them into US Treasuries. That would reduce demand for western government bonds which would raise gilt yields and annuity rates.
What's more, as demand for western government bonds declines, the supply of them could increase. The US's Congressional Budget Office has warned that, on present policies, government debt is on an "explosive path", because huge numbers of retiring baby boomers will cause increased spending on healthcare and social security. Unless things change radically, it has warned, "large budget deficits and growing debt would reduce national saving, leading to higher interest rates". This would drive up UK interest rates, too, even if fiscal austerity here succeeds in reducing our government debt. Such is the downside of government bonds being close substitutes for each other.
Something else could also reduce national saving. In the last few years, UK companies (and western ones generally) have been net lenders; their retained profits have exceeded their capital spending. This has helped reduce gilt yields not so much directly, but because it has meant there's been little issuance of shares or corporate bonds, which means investors' cash has - for want of alternatives - been directed towards gilts. If companies do rediscover investment opportunities, this net lending should decline, again putting upward pressure on gilt yields.
There are, therefore, good reasons to expect gilt yields and annuity rates to rise over coming years. Such a view is not an eccentric one, for two reasons.
First, the market expects gilt yields to rise - which is just another way of saying that the yield curve is upward sloping. Put it this way. Seven-year gilts now yield 0.96 per cent. Why would anyone want to hold these when they could hold a 14-year gilt which yields 1.96 per cent? In theory, the answer is that they expect to be able to reinvest the seven-year gilt at such a high yield that, over the 14-year period, the return on two seven-year gilts held consecutively equals that 1.96 per cent. This would be the case if investors expect seven-year gilts to yield 3 per cent in seven years' time.
Secondly, higher gilt yields would represent a return to normality. Until the late 1990s, long-dated index-linked gilts yielded over 2 per cent, and sometimes over 4 per cent. And that was probably a long-term 'natural' level; between the 1870s and 1950s (generally a time of near-zero inflation expectations) undated gilts yielded between 2 and 5 per cent. What's unusual in a historical context is their present near-zero levels.
Now, none of this is any comfort to those of you in or just approaching retirement. The forces for higher yields will operate over years rather than weeks. But this could be great news for those of us anticipating retiring in five or 10 years' time. Perhaps we can look forward to better incomes than today's retirees. And perhaps this means we don't need to worry so much about saving for that retirement.
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Chris blogs at http://stumblingandmumbling.typepad.com