AJ Bell press comment – 2 November 2022
Ahead of this week’s Bank of England Monetary Policy Committee (MPC) interest rates decision, AJ Bell experts outline some of the key impacts of rising rates on household finances, including pensions, mortgages, borrowing and investing.
They cover the impact of rising rates on:
Tom Selby, head of retirement policy considers the impact on pensions, including annuity rates, annuity hedging investment strategies, and defined benefit pensions:
Annuities
“The rising cost of borrowing – specifically UK government bond, or gilt, yields – impacts on millions of people’s pensions. When gilt yields rise, the annuity rate insurance companies can offer rises too. While clearly gilt yields have been extremely volatile since the disastrous mini-budget, the trend over the past year has very much been upwards.
“This is bad news for those buying a home or remortgaging (as it feeds through to higher borrowing costs), but good news for anyone planning to turn a portion of their pension pot into a guaranteed income for life by purchasing an annuity.
“Annuity rates have increased by 40-50% this year, meaning for many people they will be a consideration today in a way they probably haven’t been for the past decade or so.
“To give you an idea of what you can get for your money, a £100,000 fund might buy a healthy 65-year-old a single-life, level annuity paying around £7,684 a year*. However, anyone wanting inflation protection or to leave money behind to loved ones when they die will need to accept a significantly lower starting income.”
Annuity hedging funds
“Falling government bond prices (and rising yields) presents a specific problem for people invested in ‘annuity hedging’ funds who no longer plan to buy an annuity. These funds automatically move investors funds into bonds and cash as they approach their chosen retirement date.
“The logic is that bond prices and annuity rates move in opposite directions, creating a hedging effect as you approach retirement.
“However, most people now choose to stay invested while taking a flexible income via drawdown, meaning there is a risk hundreds of thousands of investors have sleepwalked into eye-watering investment losses.”
Defined benefit (DB) pensions
“Funded defined benefit (DB) pension schemes are also impacted by gilt yields. Generally speaking, when gilt yields go up – as has happened in 2022 – the value of liabilities goes down. All else being equal, this should mean scheme deficits drop as well.
“Of course, the very rapid rises in gilt yields we saw recently caused big problems for the Bank of England, with the gilt sell-off precipitated by the mini-budget risking being exacerbated by a further sell-off to pay margin calls on ‘liability driven investment’, or LDI, strategies. These strategies are meant to hedge against interest rate risk.
“It’s important to emphasise that while DB pensions were caught up in this crisis, there was no direct threat to people’s retirement incomes. This is because it is the solvency of the employer that is the key factor when determining the strength of a DB promise.
“And even where an employer goes bust, the Pension Protection Fund (PPF) provides a valuable safety net, so members should still get back most of their promised pension.
*Annuity rates sourced from the MoneyHelper annuity calculator on 25 October 2022
Laura Suter, AJ Bell head of personal finance, explains how interest rates effect savers and borrowers:
Cash savings
“Savers are the big winners of a rising interest rate environment, as the Bank of England increases rates the interest rates offered on cash accounts will rise too. However, savers always have to shop around to get the best rates. If you leave you money in an old savings account, your bank might increase your rates slightly but you’ll be getting far less interest than the market-leading account. Also, rates will rarely rise as high as the cost of borrowing. Banks make their profits on the difference between the interest they charge people for borrowing money and the interest they hand out to savers – this is also why rates on savings accounts tend to go up at a slower pace than borrowing costs in a rising interest rate environment.”
Fixed rate savings
“Fixed rate savings accounts will usually pay you a higher interest rate than easy-access, as the bank will pay a premium in return for knowing that it will have your savings for longer. But if interest rates are still rising you need to be a bit cautious about locking away your savings, as you could miss out on future rate rises.”
Mortgages
“Generally the interest rate charged on new mortgages rises as the Base Rate increases. However, you’ll often find that mortgage rates rise before Base Rate has increased. Mortgages are priced based on a number of different factors, including competition in the market but also the cost of the money mortgage companies borrow to then lend out to borrowers – whether that’s from savers’ deposits or the wholesale market.
“Anyone on tracker or variable rate mortgages will see their mortgage cost increase when base rate rises. This is because a tracker mortgage is designed to rise and fall in line with the Base Rate, with a premium on top. So you might have a tracker of Base Rate plus 1%, meaning that if Base Rate is 2% you’ll be paying 3%. Once a Base Rate rise happens, these rates will often rise overnight to reflect that.
“A Standard Variable Rate (also called a reversion rate) is the highest rate from a mortgage lender and is what you’ll fall onto once your fixed rate deal is up. These generally go up as Base Rate rises, but not as quickly as with a tracker rate. The mortgage lender will decide whether to increase these rates and will give notice before they do.”
Consumer credit
“The cost of debt rises as the Bank of England hikes interest rates. This means that if you’re not locked into a deal already you’ll likely see the cost of any credit card or loans increase. However, companies factor other things into their decision on whether to raise their interest rates, such as competition in the market or whether they want more of a certain type of borrower. For this reason rates won’t rise directly in step with Base Rate.”
Overdrafts
“Intervention by the regulator in the overdraft market a few years ago means that overdraft interest now works slightly differently, and means you might not see a big hike in the cost of your overdraft once Base Rate rises. A move to scrap the variety of fees for authorised and unauthorised overdrafts resulted in most banks setting standard 40% interest rate for overdraft borrowing. This is determined more by competition (or lack of) in the market than Base Rate. Anyone with a 0% arranged overdraft won’t see any change in their costs so long as that 0% deal remains.”
Russ Mould, AJ Bell investment director, explains the relationship with share prices:
Shares
“The return available on cash, and by extension the risk-free rate available on government benchmark bonds, sets the reference point by which the attractiveness or otherwise of all asset classes will be judged.
“For much of the past decade, bullish investors have argued that share prices should rise because record-low interest rates and record low government bond yields, meaning that ‘There Is No Alternative’ (TINA). To try and get any sort of return on their cash, they have had to look to different and more risky assets.
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because. The last time the UK defaulted was 1672 and as such as the ten-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“Any other alternative investment carries more risk so the investor should demand more from them - investment-grade corporate bonds should yield more than government bonds because companies can and do go bust, for example.
“The returns demanded by an investor to compensate themselves for the additional risks involved will therefore, in theory, move relative to the gilt yield.
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly-issued gilts, which will have to come with a higher yield to attract buyers.
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase.
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and also perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade (and especially in 2020 to 2021). The problem now for holders of this sort of company is that the opposite effect is kicking in, at least for now.”