In recent years a great deal of attention has been paid to ultra-low interest rates impacting the financial position of pension funds. Central banks’ quantitative easing programs have often been cited as drivers. Aegon Asset Management’s Investment Solutions Center has investigated the causes of this decline in interest rates, in particular real interest rates.
Real interest rate estimates are important
Just as for estimates of future returns on asset classes, estimates of future (real) interest rates are subject to considerable uncertainty. Because interest rate levels are a key parameter in many quantitative analyses, it is important for a well-considered decision to factor in both the estimated expected path of interest rates and the uncertainties inherent in these estimates.
Real interest rates are important for estimating bond yields as well as determining how pension liabilities will evolve. They are also important in estimating annuity factors for defined contribution pension schemes. Expected returns on other asset classes are also often derived through estimated risk premia above bond yields. In these instances, absolute levels are therefore also influenced by real interest rate levels.
All these expectations and uncertainties are brought together in Asset-Liability Management (ALM) exercises. For defined contribution schemes, in particular, projections are made that look several decades into the future. Best estimates of future interest rate paths, and deviations from these paths, may be used in those analyses. Moreover, sensitivity analyses shed light on the consequences if the future pans out differently to current estimates. This way, balanced decisions can be taken.
Figure 1 shows the movements in Dutch 10-year real interest rates, based on nominal 10-year interest rates adjusted for Dutch inflation (CPI). The strong decline recorded since the late 1980s has had a significantly detrimental impact on the financial position of pension funds.
Figure 1: Development of real interest rates over the past four decades. Source: OECD (OECD, 2018) and Statistics Netherlands (CBS, Inflation: CPI, 2018).
A few explanations for the real interest rate decline
One oft-cited reason for the decline in interest rates is the impact of central banks' asset-purchasing programs. Although these have certainly contributed to current real interest rate levels, they do not represent the whole picture. After all, the decline in real rates began long before central banks began quantitative easing after the financial crisis.
Based on quantitative analyses, Rachel and Smith1, economists at the Bank of England, proposed a list of the key drivers that have influenced interest rates. They conclude that the global decline in interest rates has been caused, in particular, by economic trend growth, greater demand for savings (driven by demographic trends and inequality), and lower investment demand (driven by lower prices of capital goods and risk premia).
In addition to demographic variables (including the number of older people as a percentage of the total working population), our research has also looked at several macroeconomic parameters, such as sovereign debt and consumption growth.
Three ways to analyze trends in real interest rates
We have used three statistical analyses to investigate the factors with the greatest impact on Dutch real interest rates2. The first analysis incorporates the levels of the different factors. The second looks at the impact of changes in the different parameters. The third way is a combination of the first two and is based on the assumption that a long-term equilibrium exists. However, in the short term, they allow for, sometimes substantial, deviations from this equilibrium.
The numerical results of our research show that incorporating the different levels, in particular, provides a good description of the historical data. Key variables are the number of older people as a percentage of the working population, consumption growth, growth in gross domestic product, and government debt. The regression analysis explains 84% of the variance, meaning that it gives a good description of the data3. Using this model, a one per cent increase in government debt may lead to a 0.21 percentage point drop in the real interest rate, for example. A one per cent increase in consumption may lead to a 0.23 percentage point rise in the real interest rate. Both results are in line with what has been described in the financial literature.
Historical movements provide important insights
A proper estimate of the drivers of historical movements is key to generating insight. Additionally, it is important that the future development of each of these factors is estimated consistently. After all, historically observed trends will not necessarily continue in the same way in the future.
Real interest rates have declined substantially since the late 1980s. This has not only been the result of central bank policy but also of long-term demographic and macroeconomic factors.
Although any quantification of effects is subject to a large degree of uncertainty, it is important that we have an understanding of the potential effects of these factors. Estimates are particularly important because many policy choices are based on the level of real interest rates. Given the insights provided by the models that we have developed, a return to historical average real interest rate levels does not seem likely in the near future. Instead, real interest rates are likely to remain lower for a sustained period.
1 Rachel, L. and Smith, T.D.. Secular drivers of the global real interest rate, Bank of England Staff Working Paper no. 571.
2 These analyses have been done in cooperation with the University of Groningen for the Master of Finance thesis called "Determinants of the real long term interest rate in the Netherlands" by M. Brockmann (June 2017).
3 Data from 1971 to 2016, using multiple sources such as Netherlands Bureau for Economic Policy Analysis (CPB), World Bank, OECD and Statistics Netherlands (CBS).