“To do whatever it takes” was Mario Draghi’s mantra in the summer of 2012 in his quest to keep the euro from falling apart. In January of this year, Super Mario adopted a similar no-holds-barred approach to tackling deflation and stagnation: a EUR 60 billion-a-month Quantitative Easing program which has seen interest rates plummet.
However, as yields have sunk, concerns have risen about the collateral damage QE is causing. Worries are not limited to asset bubbles and distortions in bond or repo markets. Apprehension has also grown in recent months about the negative impact of record-low yields on the solvency of pension funds and life insurers and how this in turn could undermine financial stability, demand, and the very goals QE aims to achieve.
The risk to pension funds and insurers has grown as these institutions are increasingly being hit on both sides of their balance sheets: low yields have simultaneously increased the value of their liabilities –the future pension pay-outs to clients –and hollowed out their investment income from bonds, which make up 40% (pension funds) to 70% (life insurers) of their total assets.
The effects are unmistakable: in the Netherlands, home to some of the world’s largest pension funds, the solvency ratios of 4 of the 5 largest providers have fallen below minimum legal requirements. They now must submit recovery plans to the central bank, along with over 150 other Dutch funds whose funding ratios also dipped because of the low yields.
Life insurers, particularly in Germany, face similar difficulties.
The problems are unlikely to subside anytime soon: S&P recently calculated that European defined benefit pensions are likely to see their funding ratios fall substantially as liabilities increase by 11-18% over the coming years. Similarly, the Dutch Pension Federation has predicted that solvency ratios of funds will fall by between 10 and 15 percentage points between now and 2020.
Moreover, as the OECD warned recently, weakening balance sheets may fuel a “search-for-yield” among pension funds and insurers; a practice other types of investors have already engaged in. Such behavior is particularly likely among defined-benefit or guaranteed-rates schemes, whose pay-out obligations are fixed.
The wider economic impact
Europe’s tepid economic recovery has to have been caused by a lack of investment, to a larger extent.
The solvency concerns surrounding pension funds and insurers –among the largest investors in the EU economy –are unlikely to help boost investment. Initiatives such as the new EU investment plan (EFSI) can also become the unintended victims of low rates.
EFSI aims to funnel EUR 316 billion euros into riskier investment projects and its success largely depends on institutional investors. With solvency at risk, it will be harder for insurers and pension funds to participate, especially in the riskiest projects, as regulatory requirements restrict additional risk-taking when solvency ratios are weak.
The consequences for consumption are also worrying. One way in which the effects of low rates have been mitigated is by making pension and insurance contracts “more flexible,” shifting investment risk onto pension participants and insurees. Indeed, EIOPA’s 2014 stress-test showed that many life insurers are reducing guaranteed rates on benefits. Many pension funds have also moved toward defined contribution schemes.
Providing clients with fewer guarantees regarding the level of benefits they will receive, while potentially improving providers’ solvency levels, means that interest-rate risks are in fact borne by those clients. As Draghi himself recently acknowledged, this shift may undermine the very purpose of QE –to strengthen demand and increase inflation.
After all, one of the main channels of monetary policy (and QE) is the “wealth channel.”
Low yields have boosted the value of European assets, shares, and real estate. These price rises should help make consumers feel “richer” –inducing them to consume more. However, as insurers and pension funds pass investment risk on to their customers, those saving for retirement (particularly those nearing the retirement age, a rapidly growing demographic in Europe) will find that the shortfall in investment income caused by low rates leaves them with insufficient retirement income.
Instead of increasing their consumption, they will have to make up the shortfall, either by paying more in pension or insurance premiums –Dutch pension funds indeed expect a real premium increase of around 5% over the next few years –or by increasing their saving levels. Either way, consumption levels will be reduced; the opposite of what QE is meant to achieve.
A second look
Mr. Draghi has thus far shrugged off these concerns, stating that abandoning QE would be even worse for pension funds, insurers, and the Eurozone economy.
Other supervisors across Europe, however, have woken up to the dangers of persistently low interest rates: last month, the European financial supervisory authorities (ESAs) in a joint report rated low yields among the greatest threats to financial stability.
The French supervisor ACPR recently announced a beefed-up stress test of the effects of low interest rates on insurers and the OECD has called for more supervisory flexibility. Dutch and Irish supervisors have heeded the warnings and given pension funds more time to restore their finances, thereby avoiding large-scale benefit cuts or premium rises, at least for now.
The growing concerns have also finally prompted the European authority charged with keeping track of risk build-up in the financial system, the European Systemic Risk Board –chaired by Mr. Draghi himself –to evaluate QE’s effects on the financial and economic system.
Although its report and recommendations are not due until next year, it is becoming increasingly clear to more and more observers and policy-makers that when it comes to QE, the unintended consequences of Draghi’s “whatever it takes” approach require a serious second look.