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Investment View: Interesting times

Are low interest rates always a good thing? They certainly did not appear to be in Japan. Rising interest rates and the prospect of real dividends from Japanese companies are indicative of a return to health for the Japanese economy and they have been accompanied by a resurgence in the stock-market.

In the US, the cut in base rates helped revitalise a flagging economy. Belief that the latest round of rate tightening will soon come to an end is encouraging equity investors.

Back at home, the low real yield on long-term government paper has caused the governor of the Bank of England to sound a caution. But yields continued to trend down. The move is of significant importance to all manner of investors.

One of the conundrums is why should pension deficits increase when both bond and equity markets perform strongly? The answer lies in the way that these deficits are calculated. Pension liabilities are based on the cost of providing an annuity. Annuity rates are determined by the level of long-term interest rates. If long-term rates are low, the cost of providing the annuity rises and so does the cost of funding a DB scheme.

All this can turn out to be self-perpetuating. If liability-matching requires pension funds to buy long-dated gilts, then demand from the industry can push prices up and depress yields. More gilts then need to be bought, with predictable results. Unless the basis of calculation is changed, there seems no way out of this upward spiral, until all final-salary schemes have been replaced by DC pensions.

In the meantime, we have an asset class which no self-respecting value manager would buy but which looks unlikely to revert to a level at which yields could be considered attractive, at least in the short term. This suggests the whole basis of valuing the liabilities inherent in a pension scheme should be overhauled but that does not look likely . The real worry is the fact that longer-term returns appear so parsimonious. It all makes equities look that little bit more attractive but that will not help the pension fund managers.

Equity investors saw a return to more buoyant conditions last week. That brings me back to the problem of how to match pension fund liabilities. The best investment must be one that addresses the inflation risk and delivers returns relevant to the needs of future pensioners. Since this relates to the likely salary levels of those about to retire, a security linked to, say, growth in the economy might do the trick, except that calcula-ting that would be well-nigh impossible.

It looks increasingly as though schemes that are deficient in funding will have to turn to asset classes offering the best prospects of superior long-term returns – like equities. Shades of the 1980s and 1990s, perhaps?


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