Low interest rates make saving nearly mission impossible

PARIS — While borrowers rejoice at the ultra low and even negative interest rates in Europe, savers fret and life insurance companies and pension funds face what is virtually a mission impossible.

Despite a spike in sovereign bond yields in the past couple of weeks, levels still remain ultra-low. The rate of return to investors on benchmark 10-year German and French bonds has stayed below one per cent in recent months and the yields on long-term Swiss debt even went negative.

Sovereign bonds are very important for long-term investors as they are a safe investment that allows them to lock into guaranteed returns.

For life insurance companies and pension funds which are investing the savings of others, the safety of sovereign bonds has led regulators to require them to place certain percentages of their investments in bonds.

But the unprecedented rock bottom interest rates are posing a problem as many life insurance polices offer guaranteed interest higher than current bond yields.

Last year in France, life insurance contracts paid on average 2.5 per cent.

Life insurance companies can temporarily dig into investment funds to continue to pay high rates and attract investors, but this is a strategy experts said cannot continue if rates remain low.

"This drop in rates and the uncertainty that has accompanied it is affecting life insurance returns," said Claude Chassain, an actuarial expert at Deloitte.

The level of interest rates has been worrying the industry for months, and analysts and ratings agencies are concerned about the industry.

"Low interest rates in the euro area pose substantial challenges to the life insurance industry," said International Monetary Fund (IMF) staff in a blog post earlier this month.

"Mid-sized insurers with guaranteed returns and long-dated liabilities that are not matched by similarly long-dated assets face a particularly high and rising risk of failure," they added. 

Collateral damage  

German insurers, which offer much higher guaranteed returns than their French counterparts, have been particularly critical of the European Central Bank's (ECB) ultra-low interest rate policy, and its 1.1-trillion-euro ($1.2-trillion) bond buying stimulus programme that has driven down bond yields.

"The problem with German insurers is that not long ago they guaranteed returns on [products] like long-term euro contracts. These yields must be respected every year, even as rates fall," explains Chassain.

According to Karsten Eichmann, president of German insurer Gothaer, that situation has left companies like his caught in an agonising pinch.

"The insurance sector in Germany is currently facing a considerable degree of damage, in the order of several billion, provoked by the ECB's policy of very low rates," Eichmann wrote in the Sueddeutsche Zeitung in early May.

The result, he noted, is "it is clear that in an environment of rates close to zero, life insurance becomes a money-losing activity in all its forms".

Pension funds are also sounding the alarm.

PensionsEurope, the trade organisation for European pension institutions, warned regulators in a report in late April that "pension funds can not be considered collateral damage of the ECB's [quantitative easing policy] when the problem involves retirement savings of millions of Europeans".

Chassain says low interest rates like those currently in place are destined to make life difficult for any insurer with long-term guarantees on return.

"In the United Kingdom, pension funds abandoned fixed-yield agreements quite a while ago in favour of fixed-contribution schemes that allow them to take economic conditions into account at the time [the client] retires," Chassain says.

For insurance companies, the strategy is to invest in high-risk assets like corporate bonds, stocks and infrastructure projects. Meanwhile, most also encourage clients towards options that do not guarantee savings invested, such as unit-linked plans.

That same trend has already taken hold in Japan, where interest rates have remained low for quite some time. 

Insurers have restructured their portfolios to reduce investments with fixed rates of return and replaced those with plans tied to demographic risk, such as term life insurance or provident funds, Chassain says.

In France, payments into unit-linked plans increased 38 per cent in the first quarter of 2015 compared to the same three-month period the previous year.

Historically low interest rates in the euro area are also  becoming an increasing headache for companies forced to set aside billions in extra cash to meet their pension obligations to employees.

The ECB's ultra-easy monetary policy, with record low interest rates and unprecedented bond purchase programmes, has contributed greatly to the decline in yields on bond markets.

That is not good news for the in-house schemes that many companies offer employees to help top up their state pensions.

Like banks and insurers all across the eurozone, these corporate pension funds usually rely on adequate yields or interest rates to help increase and maximise their clients' investments.

But with interest rates in the euro area around the lowest they have ever been, pension funds are finding it difficult to meet those demands.

The corporate pension scheme is particularly well-established and popular in Germany. Around 17.8 million Germans had signed up to a corporate scheme at the end of 2013, or 60 per cent of people in jobs required to pay social insurance contributions, according to data compiled by the Federal Labour Ministry.

Given the low yields, companies are having to dig deeper into their own financial reserves to fulfil their pension obligations.

German flag carrier Lufthansa, for example, set aside an additional 2.5 billion euros ($2.8 billion) in pension provisions for 2014 in order to meet the returns of 6 to 7 per cent it had guaranteed its employees. That burden was one of the factors that drove profits down to just 55 million euros last year.

Power giant E ON set aside an additional 2.2 billion euros in pension provisions last year and carmaker Daimler an extra 2.9 billion euros.

According to a study by consultants Towers Watson, the companies that make up the blue-chip DAX 30 stock index saw their pension obligations jump by 25 per cent to 372 billion euros last year.

"The ECB's policy of low interest rates is having a strong effect on the financing situation for corporate pension schemes in German companies," Towers Watson said.

British companies are facing similar problems, including several on London's FTSE 100 index of blue-chip stocks.

According to JLT, a pension and benefits consultancy, "a number of FTSE 100 companies will be forced to increase their cash contributions to their defined benefits pensions schemes in 2015".

JLT calculated that the total deficit in FTSE 100 pension schemes at the end of last year amounted to £80 billion (110 billion euros, $125 billion) wider than a year earlier.

Dilemma  

This places companies in a dilemma between safeguarding their own financial reserves while still offering attractive pension packages to their workforce as demand for top-up schemes increases in the face of dwindling state pensions.

"Employees' expectations with regard to corporate pension schemes will continue to rise. Adequate pension provisions will play a key role for companies looking to hire and keep hold of skilled employees," said Thomas Jasper at Towers Watson.

"In order to remain attractive as an employer, companies need to offer attractive pension schemes while at the same time managing costs and risks," he added.

German airline Lufthansa, for one, is currently looking to re-think its retirement system for employees.

"The risks and costs of the existing pension system are jeopardising the airline's future sustainability," argued Lufthansa's personnel chief Bettina Volkens, insisting that pension provisions for all groups of employees needed to be reorganised.

But talks on the issue with unions are deadlocked.

Lufthansa's pilots, for example, have staged a series of walkouts over the past year in protest over management plans to scrap an arrangement under which pilots can retire at 55 and receive up to 60 per cent of their pay until they reach the statutory retirement age of 65.

Nevertheless, despite the challenges many companies are facing with their corporate pension schemes, the government is looking at how such programmes can be extended even further to small-and mid-sized companies.

With state pensions now averaging less than 800 euros per month, private sector employees are being encouraged to take every action to buy additional pension coverage.