The Federal Reserve has announced that it intends to pursue a low interest rate policy not only now, but for years to come. The CNBC cheerleaders mindlessly applaud the Fed for pursuing such a policy. Let’s play devil’s advocate and examine the heretical position that low interest rates are destroying the US economy. Let’s look at two classes of investors and examine the unintended consequences of a low interest rate policy.
You retired from a large company sometime in 2005 at age 65 with a final salary of $125k with stay at home spouse. Your lump sum pension, 401k and personal savings have allowed you to accumulate $2m in investable assets. With interest rates at 6 percent you plan on $120k in income plus a maximum social security benefit of approximately $27k. In other words, you can relax and look forward to a financially secure retirement with your assets generating $150 k per year of income. But after the financial crash, we are in “Bernanke World” where interest rates on 3 month T-bills drop to .1 percent. Our new retiree shops around and finds 12 month CD rates of .90 percent. Suddenly, $150k annual income drops to approximately $50k of income including social security payments. Our retired couple has gone from a life of 3-4 great vacations, visits to the grandchildren and dining out several times a week to barely being able to afford housing, food and supplemental medical insurance.
A couple of observations about the plight of our hypothetical couple: the standard response heard in the media is that our couple can just go back into the workforce. What workforce would that be? Statistics demonstrate that one of the hardest hit groups in this recession is workers over 50. What employer is clamoring for our now 69-year old couple to re-enter the workforce? It seems there are just so many Wal-Mart greeter positions. They are not particularly high paying positions, at least not enough to make up our hypothetical $100k income shortfall. Further, my guess is that applicants significantly outpace available jobs.
Where is the political support for our couple? Where is the vaunted AARP? Where is the AARP’s famed lobbying machine to make the case that bankers (and quite undeserving ones at that) are being favored over thrifty, hardworking retirees? Where is the Congressional response to the plight of our couple?
Other investor constituencies negatively affected by low interest rates are defined benefit pension funds (the classic pension benefit) and insurance companies. These groups have a basic goal of matching long term liabilities, e.g. pension payments, annuity payments and life insurance payouts with long term assets that will out earn these liabilities. This is a pretty simple business model with the insurance company or pension fund keeping the excess earning in the form of a profit or a surplus. In the case of a pension fund this surplus or reduce future funding costs for the sponsor, i.e., a company, university or governmental entity. Insurance companies and pension funds live in an actuarial world of an assumed return on assets. Insurance companies were guaranteeing that annuities written in the past several decades would earn in excess of 4, 5 or 6 percent. Pension funds projected that earning on assets would be between 7 to 9 percent. These aggressive projections moved ever upwards as the 25-year long bull market gave a false sense of confidence to actuaries and financial executives. Both the pension and insurance company projected earnings levels are now confronting the reality of a low interest rate world.
In a low interest rate world this patented formula is virtually destroyed. Bridled by fiduciary concerns limiting risk taking, there is a large potential shortfall between projected and actual earnings. The ramifications are enormous. Insurance company earnings will be negatively impacted, corporate sponsors of defined benefit pension plans will be negatively impacted as companies by law will be required to make additional contributions affecting net income and cash flows and states and municipalities will be required to increase taxes to meet funding shortfalls. The Federal Reserve is forcing fiduciaries to take even greater risk to try to catch up with past underperformance. The autumn 2008 debacle in the financial markets does not auger well for increased risk taking at this point in the economic cycle.
I do not purport to know what the real rate of interest should be, but neither does the Federal Reserve. I do know that artificially pegging an interest rate at an artificially low number has numerous unintended consequences, two of which are described above. Driving investors to greater level of risk taking has never ended well. Get the Federal Reserve out of the equation and let the free market decide the level of interest rates.
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Tags: AARP, Federal Reserve, interest rates, pensions, unintended consequences
