100-Year Bonds: Pension Destroyers?

I’m going to go a little UK-centric in this article, so if you’ve ever worked in the UK, this could be very important; if not, I hope you find it informative.

It’s time for the UK’s 2012 budget this week (Wednesday 21^st March), where the Chancellor of the Exchequer, George Osborne, will lay out the Government’s plans for the UK economy and public finances for the year ahead.

Whilst that possibly may not be the most exciting sentence you’ve read this week, what the budget contains could have a big impact on the personal finances of anyone who has a pension in the UK.

How so? Well, one thing that the Chancellor is expected to announce is that he is considering issuing Government bonds (commonly known as “gilts”) with a term of 100 years. (This may still sound incredibly uninteresting, but stick with me…).

Normally, the maximum duration for Government issued bonds is about 30 years – so this is quite a leap. The main reason this is being considered is because it is incredibly cheap for the Government to borrow money at the moment – depending on how you calculate it, you could argue that it’s free.

Because of the global financial crisis, many investors have run for cover, and are desperately seeking “safe” places to store their wealth – and rightly or wrongly, many have decided that lending money to AAA rated governments is the best thing to do.

As a result, the “yields” (return/interest) on these bonds have fallen to incredibly low levels – which is simply a result of supply and demand. As demand goes up, so does the price – and because the returns are fixed in monetary terms, any increase in purchase price has the effect of reducing the amount of return in percentage terms.

As I write this (Tuesday evening, Jakarta time), the current yields for UK government bonds are all less than 0.5% for terms of 2 years or less; less than 1% for 4 years or less; less than 2% for 8 years or less, and only 3.47% for the 30-year bonds.

Now it doesn’t take a genius to work out that when inflation is running at 3.4% (based on the latest figures which were published earlier today), if you’re only making a 2% return, you’re losing money. Similarly, if you can borrow money at less than the rate of inflation, then you’re in profit (as long as you do something useful with it).

And the average rate that the government has had to pay (calculated using 10-year bonds) over the last 25 years is 6.28% - the highest during that time being 12.84% (22 years ago) and the lowest being 1.97% (two months ago). So it should come as no surprise that the Government sees an opportunity to drastically reduce average borrowing rates for a very long time.

But if it is an opportunity for the Government to save money, then surely it’s a bad idea for investors to buy the bonds? Why would you invest in something which gives a fixed return, at probably the worst time to do it?

In short: You wouldn’t. That would be slightly crazy. If you buy a 100-year bond, paying a return of less than the average rate of inflation, you are almost certainly going to lose money, almost every year, for 100 years.

The last time the UK issued 100-year bonds was nearly 100 years ago, to help pay for World War One. It has been calculated that anyone who bought those bonds at that time (and held them until now) would have by now lost 98% of their investment, in real terms.

So how can this possibly be a threat to anyone with a pension in the UK? Surely no pension company would be crazy enough to buy them? That’s what you would think.

But there’s an important thing to remember here – governments are powerful. And governments, through regulation, can put enough pressure on professional money managers to make them do things which may not be a sensible thing to do in purely financial terms – but which benefit the government.

If that sounds too much like a conspiracy theory, consider the vast amount of government bonds which have been bought in the last few months by European Banks (enough to prop up several European governments).

In the UK itself, only 8 years ago, Standard Life (a major life insurance company) was forced to sell half of its portfolio of shares and buy UK Government bonds with it - £7.5billion worth – all in the name of “solvency rules”.

And it would be relatively easy to do – simply tell the regulatory authorities to view the new 100-year bonds as “ultra-safe”, and on a risk-weighted basis this would allow the pension firms a little more freedom to hold riskier assets – as long as they held some of the wealth-destroying 100-year bonds.

So, if you have a pension in the UK, frozen or otherwise, now is definitely the time to get it out (if you haven’t done it already). If you don’t, there’s a very high chance that you’ll be indirectly buying one of the worst investments of the century (although not as bad as the one highlighted in last weeks’ blog) via your pension.

In case you weren’t aware, you can get it out – quickly and cheaply – whether it’s a private pension, a company pension, a final salary scheme, or whatever. And as a bonus, it won’t have tax deducted from it when it pays out either.

So I’d strongly suggest that if you have a pension in the UK, even if it’s from years ago, get in touch – I’ll help you find out how it’s doing, explain what your options are, and show you how you can make the most money from it.

It could be worth a small fortune…