Low Interest Rates Hurt Savers

September 30, 2016

 

This month two corporations successfully sold bonds with negative yields. That's a guaranteed cash loss for investors. What's going on? How does it affect you, the investor?

 

Hello, my name is Paul Carroll. I'm the CEO and founder of Efficient Wealth Management, a boutique wealth management firm based here in The Woodlands, Texas.

 

We're out of the second debate for the election. We're in the final leg of the election cycle. Unfortunately, one of the casualties of this and most elections, frankly, is reasoned debate — discussion of what are really serious issues that are affecting all of us. One of those critical issues is, why are interest rates so low, and what, if anything, can be done about it?

 

What is the impact of these low interest rates? We call it "zero-interest-rate policies" — it's what's coming out of the central banks of most of the Western world. It's good for national governments. National governments can literally print money and pay nothing for the privilege of doing so. In fact, many governments around the world, including the German government, are getting paid to issue debt. They're actually going to pay back less than they're borrowing. They have negative yields.

 

It's gotten to the point now that this "free money" is now available for some AAA credit writs, especially if they're selling euro bonds — we're talking French, German, large corporations. We're getting pretty close to this territory in the United States. It's good for those guys, but it's bad for savers. If you're a retiree and you're trying to live on a fixed income, especially if you have a conservative portfolio, you've already figured it out. Something's wrong. Some people call this "financial repression," but that implies there's a conspiracy to hurt savers. Really, no such conspiracy exists.

 

From the point of view of the pension plans throughout the country, this is a very big problem because outstanding liabilities are inversely related to interest rates. With the yields so low, corporate and public pensions are desperately underfunded. Most of these pensions, especially public pensions, are using assumed returns of 7.5% for the liabilities of the coming due, really, in the next 5 to 15 or 20 years. There really shouldn't be equity returns involved in this calculation.

 

When we look at the unfunded status and local pensions, there was a recent article in The Economist that suggested that, at best, they are 60% funded. I'll go out on a limb and say, "If and when there's a state income tax in Texas, it will be because of unfunded pension liabilities that are guaranteed by the state constitution." When pensions say they're 70% funded, they're using returns of 7% or 8%. But we bring those returns down to 2% to 4%, and they are desperately underfunded. Nationwide, the underfunding is up to $4 trillion.

 

To put that in context, the post-9/11 Iraq War — which was one of the longest military engagements, if not the longest, in American history — was a $1 trillion event. We're talking $4 trillion in unfunded liabilities. Definitely, low interest rates are affecting retirees — they're affecting savers, and they're affecting the security of future pensions in a significant, real manner — but why is this happening?

 

Short-term debt is easy to explain. It's cheap, in no small part due to central bank interventions and quantitative easing. Quantitative easing is done by buying short-term debt and putting cash into the system. But long-term nominal interest rates are low, and that means that from an expectations point of view, among other things, there is no expectation of inflation anytime in the next 10, maybe even 20 years.

 

There are two reasons why the real rate of return — that is, the rate of interest after inflation — is so low. In fact, after we strip out inflation in many, many markets, it's already negative. Those two reasons are very interesting and yet very different. The first reason is demographics. From the ages of 45 to 65, people are in their peak earning years and are most concerned about their retirement.

They're in their peak savings years. There are more savings than there is a place to put this money. You can go to many, many business events, and they're full of bankers looking for good credit because they've got more money than they know what to do with. This is playing out on the global field, though the baby boom is a little different in every country — Canada, the United States, Europe, Japan. There's a surfeit of savings and a shortage of investment opportunities, so the price of money is low, and the interest rates are the price of money.

 

There's another player in the game, an 800-pound gorilla called China. China has no safety net. Now, there may be some people who say, "That's the way it should be. Let people save." That's what's happening. In China, the middle and upper-middle class have a 40% savings rate. Such a high savings rate means that China, though a massive creditor, is still exporting savings to the rest of the world and further depressing interest rates. This isn't any kind of a conspiracy; this is just market economics at work.

 

That's the why, but when will this end? Because this is going to hurt. This is going to hurt retirees, it's going to hit, and it's really going to hurt state and local governments. Unfortunately, a couple of things have to happen for this to end. First, the demographic bubble has to pass. Sadly, that means if you're 70 and you're counting on interest rates to increase to help you, it's not going to happen in your lifetime. The demographic bubble has to pass so that the average age is one of drawing down assets, not maximum saving.

 

The second thing that has to happen within China — and this probably will happen, but won't happen overnight — is, they need a safety net. They need a social security system. They need medical care delivery of some sort that is more reliable than paying cash. Until they get that, until that need for a high savings rate is gone, their savings level will stay where it is today.

 

There is a third element. There is a fear of secular stagnation that is in no small part a function of the demographic changes in the Western world. As people age, as there are fewer young people to pay those bills, there's a fear that the drag in taxes and other expenses will slow the GDP growth of the Western world. We are seeing that today. We're also seeing some of the frustration in today's political cycle. That fear of secular stagnation is actually being exacerbated by these other elements, and that also has to be taken off the table.

 

To cut a long story short, this cycle of low interest rates, in my opinion, is going to be at least 10, maybe 20, possibly even 30 years. It's not going away anytime soon.

 

We wish you the best investing success.

 

Bodnar, Janet. "Savers Feel the Pain of Low Interest Rates." Kiplinger. http://www.kiplinger.com/article/saving/T037-C021-S002-savers-feel-the-pain-of-low-interest-rates.html. (Accessed Sept. 29, 2016).

 

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