The Bank of England have increased the Official Interest Rate to 0.75%, a rise of 0.5%. This takes interest rates up to their highest official level in 13 years.
Prior to the financial crisis of 2008 - 2011, interest rates regularly exceeded 4%, but the economic malaise that descended on the UK economy since has never given the Bank the room to increase rates without reducing demand and spending GDP growth into negative territory.
This desire to avoid a recession has handcuffed the Monetary Policy Committee in each meeting that has taken place during the recent decade of abnormally low rates.
But now, the new threat of inflation is finally forcing the hand of the MPC to take action, in spite of the risks to economic growth. Inflation could reach 10%, was the stark message within the announcement of the rate rise, spending shockwaves through financial media as consumers blinked at how an inflation rate that had rarely risen above 2% for the last ten years could possibly hit double-digits.
It’s notable that several members of the MPC pushed for a 0.75% raise, which would have taken the rate to 1%. This shows that there is an appetite for future rate increases and that stamping down on inflation is the primary objective of the Bank rather than fuelling economic expansion.
In this article, we will summarise how this seismic shift will affect British pension plans through an analysis of investment management. An equities-based retirement portfolio has enjoyed considerable headwinds from the period of low-interest rates, but this could be about to change.
Bond prices will fall
As expectations change surrounding future interest rates, the prices of bonds will react, negatively. With the returns on cash deposits expected to rise to 2-3% over the next couple of years, the incentive to overpay for a government bond evaporates.
Bond prices will continue to creep downward so that the effective yield of a bond maintains its parity with returns on bank and savings accounts.
Equities will come under pressure
Equities are affected by conflicting factors when responding to interest rate changes.
On the one hand, shares are valued by discounting all future expected dividends to today's date, using a discount rate that partly reflects the risk of the investment and partly reflects the general interest rate environment. The higher interest rates are, the more heavily those cash flows are discounted by the valuation model. Therefore, share prices experience downward pressure.
On the other hand, we need to recognise that interest rates are rising in response to out-of-control inflation. Inflation incurred by companies is generally passed on in the shape of higher prices, meaning that the revenues, costs and therefore profits inflate too. Of course, this depends on the commercial position of the individual companies in question, but this gifts equities with the ability to ‘float upward’ with inflation.
Annuity rates will increase
Annuities are a financial product that pensioners can buy with a lump sum of cash and in return, they are given a guaranteed monthly payment for the rest of their lives.
The returns offered by annuities have been frankly poor for the last decade because the returns are created by low-risk, low-yielding investments such as government bonds which have consistently provided yields of less than 2%.
A turnaround in the headline rate of interest will lead to higher bond yields and will turbocharge the returns that annuities can offer.
Overall, a pension that is invested in a bond-heavy portfolio will likely experience negative returns in the short term. These will offset the gains enjoyed in the last ten years as bond prices rose in response to rock-bottom rates, so if you’ve been invested for a long period, this may help you understand and digest these changes.
If you’re on the cusp of retiring, the news of higher rates is probably good news because you should be able to soon lock into a higher annuity rate or receive a better return on new cash or bond investments made.