Increased uncertainty around Brexit could lead to a prolonged period of low economic growth like that experienced by Japan. Charlotte Moore looks at what this will mean and how it can be prevented.
- The expectation is that UK interest rates will remain low into the medium term
- The economy needs to be stimulated to avoid a similar fate to that of Japan
- The flexibility within the UK economy means it is possible to avoid such a fate
Before the referendum, concerns about Europe resembling Japan were confined to the other side of the channel. But the decision to leave the European Union has increased the likelihood that a similar contagion could grip the UK.
While the continued uncertainty surrounding Brexit makes it hard to predict the full economic ramifications of this decision, some clarity has emerged.
Despite recent data being more positive than anticipated, economists still predict lower growth than before the referendum. Hermes Investment Management's chief executive Saker Nusseibeh says: "The uncertainty created by Brexit has dented the UK's potential for growth."
The Bank of England has already acted to provide support to the economy, cutting the base rate to 0.25% from 0.5% and unveiling a new programme of quantitative easing. While these moves are expected to cushion the impact of Brexit, they cannot completely offset its impact.
Before the vote on the European Union, the UK economic outlook was materially different. Unemployment had fallen from over 8% after the global financial crisis to 4.9%, which is close to historic lows of 4.7%.
Mercer Investments head of asset allocation Rupert Watson says: "This low level of unemployment would have led to wage inflation which could have triggered an interest rate rise."
If economic growth is lower, however, it is likely unemployment numbers will increase and wage growth will not pick up as much as had been anticipated so interest rates will remain lower.
As uncertainty over the full impact of Brexit could last at least five years and possibly more than a decade, interest rates could stay lower for much longer than had been expected. The UK could mimic Japan where the central bank has kept interest rates low for decades in an effort to stimulate economic growth.
LCP partner Alex Waite, says: "The Bank of England is falling into the same trap as the Bank of Japan - we've already had low interest rates for eight years and it looks like this will now extend into the medium term."
It's likely the UK will find this long period of low cost borrowing just as an unproductive as Japan. Waite says: "Ultra loose monetary policy perpetuates the existing endemic nervousness in financial markets."
This policy creates the opposite behavioural response than it intends. Rather than encouraging pension schemes to take risk, it stimulates more cautious behaviour.
Waite says: "A scheme trustee thinks: 'If the Bank of England needs to stimulate the economy, I'm even more nervous about risk and financial markets.'"
This has parallels with Japan. Waite says: "Despite the central bank keeping interest rates low for the past 20 years, economic growth has remained elusive." The UK is in danger of falling into the same policy trap, he warns.
But this is not the only way that the UK could start to resemble Japan. There is another important reason that Japan has found it hard to stimulate economic growth - its population is ageing yet it has no immigration.
Immigration was a key factor for many voters who opted to leave the European Union. While the government's precise stance is far from clear, it looks likely that the UK will aim to curb immigration in the future.
If immigration is strongly curbed, this could have a serious impact both on economic growth and the viability of state pensions. Aon Hewitt head of global asset allocation Tapan Datta, says: "Slower immigration will mean a faster ageing of the UK population."
Even at current immigration levels, there will be a decline in the dependency ratio, which measures the number of workers to pensioners. The ratio of the 45 to 59 age cohort to the 60 to 74 cohort was 1.4 in 2009. By 2030, the Office for National Statistics projects this ratio will be closer to 1.
The proportion of the population aged over 75 is also forecast to increase rapidly. In 1980, this age group made up only 5% of the UK's population. By 2020, this proportion will have doubled to 10% and by 2030 this increases to 12%.
Datta says: "If, after Brexit, there is less immigration these statistics will happen more quickly." In other words, the dependency ratio will deteriorate more rapidly and the proportion of the population aged over 75 will increase more quickly.
A lower dependency ratio means fewer tax earners have to support a higher number of state pensioners. That means government will have to choose between higher taxes or cutting the state pension benefits.
But finding high tax revenues might be difficult because of the impact of lower immigration on economic growth.
Watson says: "Immigration is an important driver of economic growth." With much lower levels of migrant workers, the proportion of the population that is working becomes smaller making it harder to keep expanding the economy.
He continues: "Most of the European migrants have been young and of working age who help to bolster economic growth and contribute to tax revenues."
Impact on schemes
If the UK's economic growth rate starts to resemble that of Japan, it creates problems not only for state-funded pension benefits but also for occupational pension schemes.
Some effects have already been felt by defined benefit schemes. The impact of QE and looser monetary policy has caused the value of pension liabilities to balloon.
This is not the only negative effect of the peculiar economic environment. It also seriously distorts the models used to determine how a pension scheme should match its liabilities, allocate its assets and calculate future liabilities.
Nusseibeh says: "Under these conditions these historic norms at best look seriously stretched and, at worst, incorrect."
Expected investment returns have been significantly eroded. Nusseibeh says: "It's impossible for a pension scheme to find bond yields of greater than 1%."
Under hedged DB schemes should give up on the dream that bond yields will rescue them. Datta says: "Pension schemes should relinquish the dwindling hope that interest rates will normalise."
Both equity and alternative asset returns are also lacklustre. "Even if a scheme allocates a significant proportion of its portfolio to equities and private equity, returns over the next five to ten years will not be much more than 4%," adds Nusseibeh.
This presents significant challenges for DB schemes, many of which are struggling to close funding gaps. Nusseibeh says: "If pension schemes accept that investment returns will be much lower than anticipated, the only real solution would be to ask the company sponsor for greater contributions."
But companies are likely to be less than enthusiastic about further cash contributions in times of economic hardship. Nusseibeh says: "This could prevent companies from making additional capital investment which in turn could further dent economic growth."
The low economic growth that could result from the Japanification of the UK will also have an impact on defined contribution pensions.
While auto-enrolment has made significant progress in improving the likelihood that more people will have a better retirement, contributions levels are currently low and need to be increased.
The government has been reluctant to increase contribution levels more rapidly as many employees have seen little improvement in their wages, in the years since the global financial crisis.
Increasing contribution levels is less about incentivising employees and more about affordability. Datta says: "Most employees simply cannot afford to save much more."
If economic growth remains lower for longer, then affordability will remain an issue and the government may well be reluctant to enforce higher contribution levels as they could believe it would be perceived as a tax.
But before becoming too gloomy, it's worth remembering while there are serious risks that the UK economy could start to resemble Japan's, there are a number of important differences that could prevent this from happening.
Not only has Japan's economy been bedevilled with very low interest rates, anaemic economic growth rates and an ageing population, it has also suffered from significant deflation.
Watson says: "Even if the UK economy were to slip into deflation, remaining there would be a choice." The prolonged period of Japanese deflation was due to policy errors as much as structural economic issues.
"As long as the Bank of England does whatever it takes to prevent this from happening, the UK should avoid this fate," he says.
Prudential Portfolio Management Group senior economist Leila Butt adds: "The Bank of England is more credible and more systematic in the way it communicates its decisions than the Bank of Japan."
As well as the UK's central bank being better able to avoid Japan's policy errors, the UK's flexible and dynamic economy should enable it to maintain economic growth.
Butt says: "A lack of regulation makes the UK labour market one of the most flexible in the world." This is in stark contrast to Japan.
The rigidity of the Japanese market has created a dual system. There is a labour force on permanent contracts, which benefits from good wages and a degree of job security, and a temporary one with shorter-term contracts.
Butt says: "In Japan, the temporary labour force is 30% to 40% of the total workforce and it has kept a lid on overall wage inflation, which has kept interest rates low."
In the UK in contrast, the labour market is much more flexible, which means that, while zero-term contracts exist, they are less than 5% of the of the labour market. This enables wage inflation to happen more easily, helps to anchor inflation expectations, and would prevent deflation from persisting, if it were to occur.
This flexibility will be important in the uncertain times ahead. Butt says: "The UK's dynamism and flexibility will enable it to adapt to a post-Brexit world."
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