In Part 1 of this series on the impact of central bank actions on the economy, I looked at the total size of the interference in the free market by the world's four major central banks; the Federal Reserve, the ECB, the Bank of England and the Bank of Japan. In Part 2, I looked at the three sectors of the economy that had a net positive benefit with the current ultra-low interest rate environment; central governments, non-financial corporations and banks. In part three of this series I will be looking at two sectors of the economy that experienced a net negative impact from the current no-interest environment:
1.) Insurance and Pensions
As a reminder, here is a graphic from the McKinsey report on redistribution that shows the winners and losers in our new interest rate reality:
Let's now take a more detailed look at the net QE losers thanks, in no small part, to Mr. Bernanke.
1.) Insurance and Pensions:
Let's start by looking at the impact of QE on the insurance sector. Life insurance companies around the world offer two types of savings products; variable-rate and guaranteed-rate policies. In much of Europe, guaranteed-rate policies are used by households as a savings vehicle for both general purposes and retirement with more than 80 percent of European life insurance premiums being written for plans of this type compared to only 45 percent in the United States. In the case of variable-rate policies, when interest rates drop, households bear to brunt of the drop in income since the amount of income received is linked directly to the change in the value of the investments chosen. The authors of the study included the risk of lower interest rates on variable-rate policies in their analysis of households. In the case of guaranteed-rate or fixed-rate policies, the insurance company offers a policyholder a fixed or minimum rate of return on the money that they have invested. In this case, the risk of lower interest rates is borne by the insurance company. As interest rates dropped, the income that insurance companies are receiving from their portfolios dropped in tandem, a situation that has become worse as the current low interest rate environment has lengthened. As insurance companies have seen their portfolios mature over the past five years, their old inventory of high-yielding bonds has been replaced with an inventory of low-yielding bonds. This means that there is great risk that the minimum return guaranteed to policyholders may, in fact, be higher than the rate of return on the insurance company's assets. In fact, the current German 10 year bund which is yielding 1.54 percent is higher than the 1.75 percent minimum rate of return being guaranteed to policyholders. Looking at Japan's experience with a prolonged period of ultra-low interest rates as shown here:
...we can see that the longer that interest rates remain low, the greater the chance that insurance companies could be forced to drastically change their product offerings or be forced out of business. In the case of Japan, insurance company pre-tax profits have dropped by 70 percent over the past decade and a half due to low interest rates.
Now let's take a brief look at the impact of QE on pension plans, particularly defined-benefit plans. These pension plans tend to invest in long-term assets to cover their future liabilities (the payments to pension plan members). As interest rates have dropped, there has been a decrease in the discount rate used by pension plans to measure the present value of future plan liabilities. The present value of liabilities has risen by 43 percent between 2007 and 2012 with low interest rates/low discount rate being responsible for 83 percent of that increase or a total funding gap of $817 billion. United States public sector plans have seen their funding gap increase by $450 billion over the same time period. Part of the shortfall in the funding of U.S. public sector pension plans can also be attributed to low interest rates; because these plans hold much of their assets in government bonds, low interest rates have seen their interest income drop by $19 billion between 2007 and 2012. Europe has also seen an increase in defined-benefit pension plan liabilities, rising by 31 percent between 2007 and 2012 with a majority of this due to a decrease in the discount rate related to low interest rates. Unlike the U.S., total European pension plan assets have grown, however, the 23 percent growth rate is still insufficient to prevent the funding gap from widening.
Households across the United States and Europe tend to be net savers with assets outweighing liabilities. Assets include all forms of savings including bank accounts and CDs/GICs, mutual funds, life insurance policies, annuities and retirement plans. Liabilities include both consumer and mortgage debt. The current ultra-low interest rate environment has reduced household income from assets by a greater amount than they have reduced debt service payments. Here is a chart showing the reduction in net interest income for households in the United States, the United Kingdom and Europe:
Here is a graphic showing the changes in annual household interest expenses and income in the United States for the period from 2007 to 2012:
On the chart, you will notice that the net losses in the United States are far higher than in either the United Kingdom or Europe. This can largely be attributed to the mortgage side of the equation; since interest payments on variable rate mortgage debt have declined with the drop in interest rates, mortgagees in Europe, where 70 percent of mortgages are variable, have resulted a smaller drop in net household interest income compared to the United States where only 20 percent of mortgages are variable.
Looking at the last number in the chart above gives us a sense of how households feel that they are faring in the current interest rate environment. Interest income losses attributable to both insurance and pension plans is largely invisible to households compared to losses attributable to lower returns on savings. When this aspect is considered, American households still have lost a great deal more in net interest income than their counterparts in both the U.K. and Europe.
One interesting note is that the loss of interest income has impacted various age groups far differently. Looking at the United States, we find that younger households, where the head of household is under the age of 45, tend to be net debtors and, as a result, benefit positively from low interest rates. Older households are generally net holders of interest earning assets and have lost interest income as shown on this graphic:
The oldest Americans, aged 75 and older, have seen their total income contract by $2700 or 6 percent due to lower interest rates compared to the youngest Americans, aged 35 and under, who have seen their total income increase by $1500 or 2.8 percent due to lower interest rates.
When all factors are considered, it is interesting to see that governments have, by a wide margin, been the biggest beneficiaries of our current ultra-low interest rate environment. Central bank policies have allowed governments to continue to ramp up debt levels as though there were no tomorrow. The biggest losers have been households, particularly older households where interest income used to provide a steady source of income. Such is no longer the case. On the upside, however, the experimental policies of Mr. Bernanke et al have allowed some households in some nations (i.e. Canada) to go on accumulating consumer debt at a record pace as shown here:
From this research, we can clearly seen that both governments, non-financial corporations, the banking sector and some households in some nations are setting themselves up for a major problem with even a small increase in interest rates. On the upside, at least pension plan managers and life insurers will find solace in a more normal interest rate environment, something that will benefit those of us who live on Main Street.