Case 8
No accounting for inflation

The 'real interest rate' is the actual or nominal interest rate minus the inflation rate over the corresponding period. Positive real interest rates imply that, properly measured, savers earn a reward and borrowers pay a cost. Negative real interest rates mean that nominal interest rates are insufficient to compensate for inflation. Savers lose out, and borrowers are benefit!

If people care ultimately about the quantity of goods and services they can afford, only inflation-adjusted measures are relevant. This applies as much to interest rates as to anything else. Yet many people fail to understand this, or fall into common traps.

At present, much of the public discussion about private pensions is simply wrong. Maybe you think you are too young to find this an interesting example. Your parents will probably disagree, and you should start to master the analysis yourself pretty soon. People investing in private pensions used to be told that returns were high - perhaps 10 per cent a year. Now interest rates are much lower, perhaps only 5 per cent. So the newspapers are full of articles moaning about poor returns on private pensions in the future.

However, doorstep sellers of private pensions had not been drawing attention to the fact that 10 per cent a year was previously not a high real return when inflation averaged around 10 per cent. Nor do they emphasise that a nominal return of 5 per cent from now on may not be that different in real terms provided future inflation stays low. Since many countries have handed over monetary policy to independent central banks, this may well be the case.

Another reason people are so easily misled is the way pensions are eventually paid out. Whatever funds have been accumulated in a private fund by the retirement date, these are then used to buy an annuity - a contract that pays out a constant nominal amount each year for the remainder of the person's life. Suppose the fund is £100000. When inflation is high and nominal interest rates are say 10 per cent, perhaps the fund pays £12000 a year to the retired person (if they lived for ever, it could pay £10000 or 10 percent; since the person will die, it can also use up the capital and pay a bit more).

£12000 seems a lot the first year, but having lived for 12 further years, the person is still only getting £12000 a year even though the price level has trebled because of 10 years of inflation since retirement. Inflation makes the real value of the annuity's income in later years become low, in exchange for which the real value in early years can be very high. If the person lives 20 years beyond retirement, the real value of the pension may become very small indeed.

If there was no inflation and nominal interest rates were much lower, the same initial fund of £100000 might buy an annuity of say only £3000 per annum. The first year this is less generous than when interest rates were higher, but now the real value stays constant because there is no inflation. After a few years, this contract is paying out more in real terms than the £12000 eroded by years of high inflation.

Many sellers of pensions, and most journalists who write about them, get this all wrong. They tell people that the low-inflation, low-interest-rate scenario is now hurting people because the nominal value of the annuity has been reduced. This just shows that they don't know how to think about the problem in the first place.

Lower inflation allows nominal annuities to pay their true real returns in a manner more evenly spread out over the person's retirement. High inflation effectively skews the real payout into the early years. Controlling for this difference, the other key thing is the level of real interest rates in general. Higher real interest rates allow savers to et a better total return in real terms.

When inflation is rising, real interest rates are often quite low. When inflation is falling, real interest rates are often abnormally high (since tough monetary policy and high interest rates is often the way that inflation is brought down again). But there is no simple relationship between the level of inflation and the level of real interest rates (because inflation on average is usually reflected appropriately in nominal interest rates).

The weekend we wrote this case study, yet another UK Sunday newspapers wrote an article that analysed pensions and interest rates incorrectly. We could have said the same most previous weekends as well. Try turning to the Money or Personal Finance section of your weekend newspaper, and see if they are doing any better. Meanwhile, insurance companies such as Legal & General are responding to the widespread belief that rates of return on pensions are now low. In spring 2000, L&G announced a new 'with profits' pension that replaces the constant-income annuity with a fund whose real value rises over time as its stock market portfolio rises (see L&G's Pension website).