Tom Gill

Which temperature would characterise best current interest rates? Certainly not one that feels as comfortably warm. Current interest rates are so low that one would not expect people to put any money on their saving accounts. Probably, it is the low transaction costs due to the ICT revolution or something like that which explains why people still save. Interest rates do not leave us cold either. The low interest rates involve an increased risk of (high) inflation, an increased risk of public finances becoming unsustainable and an increased risk that the next financial crisis will be as painful as the one that the world is now trying to escape.

Temperature and interest rates do have something in common (or should I say ‘were thought to have something in common’?) until recently. That is that they can reach levels that are astronomically high, but cannot fall under a certain minimum. For temperature, this is the -273 degrees Celsius (0 Kelvin) bound. As for the interest rate, it is the zero bound. The latter has a simple reason: if the interest rate were negative, no one would save any longer, since even storing your bills and coins in an old sock would yield a higher rate of return. However, central banks have now succeeded in bringing interest rates below the zero bound. In particular, the ECB reduced the interest rate it offers on the deposit facility  at which financial institutions can put their money overnight  to zero in July 2012. The interest rate stayed at that level for about two years until the ECB, in June 2014, lowered this interest rate to a negative 10 basis points; in September, the interest rate was further decreased to -20 basis points.

Expectations are that this situation may last for some time

Expectations are that this situation may last for some time. The ECB only recently started her QE operations, which it plans to continue until the middle of next year. Consumer confidence has increased, but consumption growth is still fairly low. There are clear signs of economic recovery, but developments  economic as well as political  could easily spoil the show. On a longer term, the ageing of the population will continue to repress the demand for new investment, again a factor that contributes to low or falling interest rates. On the other hand, should European monetary policies succeed in restoring economic growth and price inflation, interest rates may start to rise again within a couple of years. Few dare to speculate on that scenario, however.

An exercise of calculating the implicit debt is then useless

Negative interest rates are also interesting from a mathematical point of view. Take the implicit debt of the government, the debt that you cannot find in the statistics but which will become visible when the future unfolds. This implicit debt is calculated by adding up the present values of future primary government deficits. These deficits may remain high for a very long time. Still, the implicit debt is finite, due to discounting. Indeed, discounting renders the calculation of the implicit public debt an exercise in convergent series. But what if the interest rate used in the calculation is negative? The series is no longer convergent, but divergent. An exercise of calculating the implicit debt is then useless. It would yield infinity as the outcome, irrespective the countries or government policies that are being analysed.

Does this mathematical curiosity also apply to pension funds? After all, like the government, pension funds also face an implicit debt, now based on future pension liabilities. There are two important differences, however. The first is that the implicit debt that pension funds calculate to find their funding ratio, is based on a finite number of pension liabilities. Only the liabilities of existing members are included, not those of members who may become participants in the future. Second, the interest rate used by pension funds is much higher than that used by the ECB. To be sure, it has fallen to a level that is sufficiently low to become the talk of the day in the pension industry  actually, for a number of years now. But the perspective of discounting future pension liabilities with negative interest rates looks much more exotic than that of negative interest rates on public debt.

Only if interest rates will start to increase again considerably in the coming years, the switch towards defined ambition might be avoided

Still, there is a very different effect that freezing cold interest rates have on pension funds. That concerns what I like to call the price of guaranteed benefits. By guarantees I mean the case where pension funds tell their members that their pensions will attain a certain level, except in the unlikely event that… You see that this is not a guarantee in the literal sense. We have seen of lot of debate in the Netherlands about the question whether or not we should reform our pension schemes to a sort of defined ambition schemes, which would be the opposite of a defined benefit scheme. Defined ambition schemes would yield a higher return at the price of a higher degree of risk. Presumably, because of these two opposing effects, the debate never ended. But the low interest rates bring in a new element. They make it increasingly expensive for pension funds to continue offering pension guarantees. They make it more likely that pension funds will make the step towards defined ambition schemes. Only if interest rates will start to increase again considerably in the coming years, the switch towards defined ambition might be avoided.

The ECB’s QE policies are heavily debated for their possible effects on inflation and economic growth. They have equally interesting implications on other aspects of economic life however: the mathematics of calculating implicit public debts and funding ratios of pension funds. Just one little footnote: they might command pension funds to transform their defined benefit schemes into defined ambition schemes. To be continued.