Are low interest rates the problem, not the solution?

18 February 2016

Adrian Boulding - Retirement Strategy Director at Dunstan Thomas

All of us involved in producing illustrations for pension scheme members have both a statutory duty, demanded of us by Statutory Money Purchase Illustrations (SMPI) rules, as well as a fiduciary responsibility to ensure that we use both prescribed and sensible growth projections.

However the prolonged period of low interest rates being dictated by The Bank of England, gives us something of a challenge. Cash funds are earning next to nothing, and in some cases are delivering negative returns after charges are taken into account. Equity markets have enjoyed quite a bull run as they recovered from the 2008/9 crash, but now seem to have run into choppy waters. Should we project forwards assuming that customers will earn no interest and achieve no growth on their savings? Surely not, that’s just too awful to contemplate!

We can understand something of what’s been going on by following the money trail. The Bank of England has been doing two things: it’s been keeping short term interest rates low and using its newly printed QE money to buy gilts off other investors, driving down the long term rates as well.

So there is lots of money available for companies to grow their businesses, and they can get it at unbelievably low cost. At the risk of upsetting the CEO’s of all major companies, we should have realised that all this free money would lead to over-production. Milk prices have fallen because we make too much milk. And the same for steel. And also for oil and gas, where all that money spent on developing fracking technology has resulted in an oil glut that has collapsed the oil price and means the port of Aberdeen is now clogged with oil rigs towed back to shore as nobody wants the North Sea oil they were supposed to pump out.

Simplistically, we might think that falling prices are good news for the consumer. It’s certainly nice to have to spend less to refill the petrol tank at the end of the week. But the longer term consequences of this overproduction are not nice, and they came home to me on reading Shell’s recently published annual results.

Shell’s return on capital employed during 2015 was just 1.9%. As an investor, I find that’s shockingly low. My tracker fund certainly holds Shell, and maybe my active managers do too. If all equities earned that, and we produced pension illustrations showing growth funds earning 1.9% and cash funds earning nothing, well I think customers would pretty soon stop saving!

There is no end to this in sight. The Bank of England’s Monetary Policy Committee has just voted 9-0 to keep interest rates on hold. And their Inflation Report notes that investment by business has been “significantly faster”

It’s time we called for higher interest rates. Only a higher cost of capital will make companies stop and think whether what they are investing in is really needed. Cheap capital means that all sorts of weak projects get approved, producing output that isn’t needed, further depressing prices. That sort of behaviour by companies is destroying investors’ money

Maybe the Bank of England have got it wrong. Their ultra-low interest rates are not solving a problem, they are the problem! It’s time to increase rates, in baby steps, to get us back to normal rates of return and enable us to generate pensions illustrations that show a decent rate of return and a fair reward for those doing the right thing and saving for their future.

Adrian Boulding is Retirement Strategy Director at Dunstan Thomas.

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