Forget cash, or even politics, the real obstacles which may make negative interest rates unworkable in some larger economies are pension and insurance obligations.
Negative rates reduce investment returns in nominal terms, a problem which ultimately could threaten the solvency of pension funds and others who must generate a certain amount of money by a certain date.
Defined benefit pension plans don’t, as a rule, have any provision which says that the saver will get less if deflation makes money worth more. Instead, they typically promise a certain dollar payout based on the saver’s final salary.
Similarly, life insurance contracts don’t usually have an out for deflation. You die, they pay out the face value of the policy. That’s the deal.
That means there are huge pools of money out there, managed by pension funds or insurance companies, which must make a certain minimum nominal return in order to be able to meet their obligations. As interest rates sink towards zero, that gets tougher and tougher.
If they go below zero and stay there for an extended period, it may become impossible.
Thus far central banks in Denmark, the eurozone, Sweden, Switzerland and Japan have all introduced some form of negative rates, and everywhere for more or less the same reasons.
The hope is that by making financing cheap they can induce more investment, thus breaking the now long-running cycle of ever lower inflation, or even falling prices.
As interest rates have dropped in recent years, pension funds and insurers have reacted pretty much as hoped: they’ve moved money from government debt to credit and equities, driving down spreads and making borrowing cheaper. But as rates fall further, investors who must meet a fixed hurdle may start to demand a higher spread above base. Having taken on more risk, many may find themselves unable to make sufficient return without flouting risk-taking regulations.
Barclays, as part of its 2016 Equity/Gilt Study of investment returns, describes what happens eventually should rates continue to decline:
“At that point, pensions and insurers are insolvent and need to turn to their regulator or the state either for capital injections or for contractual relief from their nominal liabilities,” according to the study.
“Pensions and insurers entering regulatory protection or receivership are unlikely to be allowed to take on further risk, and likely will be forced to actively de-risk, sending credit spreads and the equity risk premium sharply higher as the financial system’s marginal buyers turn to sellers.”
Who is hurt, who foots the bill?
That sounds like a nightmare: not only are poor savers, who vote, looking at reduced benefits or default on monies owed them, but markets are hurt as pension funds and insurance companies suddenly demand more return, driving down the price of riskier securities like equities and credit.
Some will argue that negative rates will work, and that after a short period, order will be restored and pension funds will be replenished.
That’s not the message from a Bank of England Staff Working Paper from December, which found that demographic changes and other forces may drive the global neutral real rate of interest to 1 percent or slightly below over the medium to long run.
With interest rates at 1% or less globally, there is room for negative interest rates in some developed markets given that emerging economies usually have higher rates.
Remember too that government and market interest rates are an important input into how pension fund viability is judged. The lower the rate, the more money a fund needs now to be considered fully funded.
The first-ever Europe-wide stress test of pension fund viability, released in January, found that falling interest rates were a key vulnerability in a variety of scenarios which might threaten their ability to meet promises.
The audit and tests, carried out by the European Insurance and Occupational Pensions Authority (EIOPA), found the possibility of defined-benefit schemes finding themselves €750bn under water in two different scenarios.
Negative rates may also ultimately cause a rift in the euro zone between counties like the Netherlands, where pension savings are about 150% of GDP, and those like Germany and Italy, where they only are about equal to 1% of annual output, according to OECD data. It would certainly be a large consideration in the US, should the Federal Reserve ever want to take rates below zero, as US pension savings are about 80 percent of GDP.
If you think low savings rates are politically unpopular, just wait until we see pension and insurance promises broken.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
