Friday, May 27, 2016

The Federal Reserve's War on Retirement and Pensions

In spite of the minor interest rate hike last December, interest rates in the US remain at historically low levels. This is not a natural phenomenon, and it is not caused by the "free market". Rather, it's a direct and deliberate result of the Federal Reserve's monetary policy, and its effects on the broader economy are rarely appreciated. It's bad for banks, which few people are likely to have sympathy for. It encourages government deficits by lowering the costs of government borrowing. And similarly, it encourages everyone else in the economy, from corporations to students, to take on more debt than they otherwise would.

But while all these things are important, the most destructive impact of artificially low interest rates is that it destroys the ability to save and invest. And, like most central planning policies that are designed to stimulate the economy, the people hit hardest by low interest rates are invariably the people who can least afford it--in this case, the middle class, the working class, and the elderly. Many pensions around the country are deep underwater on the verge of bankruptcy in the coming years, and elderly income insecurity and poverty are on the rise. These are real problems, and they are likely to come to a boiling point soon. But to address them, we need to first understand how they came to be. And the answer isn't greed or unbridled capitalism; it's one of the most significant distortions of the market system that exists in the economy today--artificially low interest rates.

How It Works
When the Federal Reserve decides to lower interest rates, it has the effect of shifting all interest rates down across the board. This occurs because all US banks have to be part of the Federal Reserve System. If the Fed lowers the main interest rate they control by 1%, we can expect other interest rates in the economy to shift down by about the same amount.

Banks will be willing to offer corporations loans at lower rates, and this in turn means that corporate bonds offered to the public will go for lower rates. Similarly, as banks start offering lower interest rates to borrowers (the banks' source of income), they will also shift down the already low rates they pay their depositors on savings (the banks' expense), to preserve a consistent spread. And generally, the Federal Reserve will also make purchases of the US Treasury Bonds (loans to the Government) to help drive down rates there as well. All of this has the practical effect of depressing interest rates across the whole economy for borrowers and savers alike, in bonds, loans, and deposits.

In this low-interest rate environment, however, individuals are still going to want to save about the same amount of money for retirement. Or if they're already retired, they need to continue making a decent return on their existing savings to maintain their standard of living. Prior to interest rates being cut, this might have been possible with a high-yield certificate of deposit, a basic savings account, or investments in government or corporate bonds. But as interest rates shift down, all of these options become less attractive. For example, consider how much lower 10-year Treasury yields have become over time, falling from over 6% at the turn of the millennium, to a mere 1.8% today. While it may seem small, that's a massive difference. At 6%, investors could earn a respectable return that was all-but risk-free. Today, the same security would barely outpace official inflation (and would be unlikely to keep up with real inflation if rent, healthcare were tossed into the mix).

The end result, then, is that individuals can no longer afford to keep their investments in safe assets, because they don't earn enough to be worthwhile. Now they have to look for riskier assets that have a chance to generate higher returns. (Riskier investments always tend to carry the promise of higher returns, because they have to compensate investors for the risk. This is why poor people or those with bad credit will generally have to borrow money at higher interest rates--to compensate the bank for taking a risk on them.)

At first, the riskier investments may be stocks. But then, as everybody pours into stocks, the earning potential here falls as well--the price of stocks will be driven up (for example, from $20 to $40 per share) even though the underlying profits will remain the same (say, $1.00 per share). In this example, that would mean the effective yield for anyone that buys at $40 would be $1 / $40 = 2.5%, where as it used to be $1 / $20 = 5%.* As more people pour into stocks, which are already somewhat risky, the return is driven down. This necessarily causes people to find the next, even riskier asset to continue trying to get a higher return. And the cycle repeats itself, with people becoming more and more exposed to risk as it progresses, while still struggling to earn a decent return. This process is referred to as chasing yield, and it only gets triggered in a down interest rate environment.

It's worth noting here that nothing I've suggested so far is controversial. Different economists disagree whether low-interest rates are a good thing (with most mainstream / Keynesian types generally believing they are indeed), but the yield-chasing behavior follows naturally from the incentives it creates.

And this is why the Fed's low-interest policies are effectively a war on retirement and the elderly. People plan to save a certain amount of money in order to live comfortably in retirement--but this plan necessarily assumes they will be able to earn a decent return. The low-interest rate policies diminishes the prospect for earning a healthy return and thereby plunges numerous elderly people into an income insecure situation.

A Practical Example
To see exactly how much more difficult it would be to retire under this low-interest rate environment, it's useful to see some real numbers. Back when I was in high school, I was obsessed with money to a completely absurd degree (circa 2006-2007 especially). And in particular, I was really focused on being able to have enough money to retire early. At the time, you could get an online savings account that paid 5% interest. And since I lived in the fantastically affordable city of Boise, Idaho, I figured I could live quite comfortably off of just $50k a year. To do that, I needed to save about $1,000,000. It's a big number of course, but it's not an insurmountable one. And then I could live off basically risk-free interest income forever.

Fast forward to today, and I'm not nearly as obsessed. That's a good thing for many reasons, but one of them is that being focused on money or retiring today would be incredibly depressing. If you're lucky, and willing to lock your money away for some time, you might be able to get a certificate of deposit around 2%. Assuming costs of living are the same, that means I'd now have to save 250% as much as before ($2.5 million) to achieve the same standard of living I had planned on.

For me, that's not a big deal. I'm in my twenties, and it's easy for me to adapt to that new reality (and eventually, interest rates will go back up). But imagine how hard this would be if you were nearing retirement age around the time of the financial crisis, when interest rates officially fell off a cliff. People could have already met their goals, only to see the goalposts get abruptly moved out beyond their worst fears. Then they might gamble on high-risk investments to try to catch up, and the end result may be that they fall even more behind.

Pensions As Collateral Damage
In many ways, pension funds, public or private, face a lot of the same challenges as the average saver does in a low-rate environment. They likely have more robust resources to research markets and find decent investments. But at the end of the day, they're still stuck chasing yield like everyone else. They're also likely to be based on somewhat aggressive return assumptions to begin with.

You needn't know the nuances of pension accounting to understand this discussion, but the basic idea is this. Employers contribute money to pension plans and bake in certain assumptions about how much that money will grow over time. Meanwhile, employees are earning more pension benefits over time, and if those benefits include medical coverage, the cost of their lifetime benefits will rise over time. By comparing projected lifetime expenses of the pension (based on how much people are expected to earn, how long they'll live, etc.) and lifetime assets / returns of the pension, we can determine whether a pension is adequately funded or not. If the pension is not adequately funded (projected expenses exceed projected revenues), we would say it's underwater. For instance, using this calculation, the Social Security system is deeply underwater currently. That doesn't mean it will go broke tomorrow, but it means, if nothing changes, things will break down eventually.

Right now, many US pension funds find themselves in an underwater position. Indeed, the pension for the Teamsters Union is so underfunded that it recently filed for de facto bankruptcy protection (to try to cut the benefits it's supposed to pay to its members), though its petition was denied. These trends are also a direct result of low-interest rate policy. Pensions take money from employers on the assumption they'll make (for example) 6% a year. Then if they only make 2% a year, the fund becomes underfunded until they manage to catch up. So they chase yields and expose all of their pensioners to more risk and uncertainty in the process. But they have no other options.

We can actually see this chasing yield phenomenon emerge over time. A recent piece at Zero Hedge, shows how the pension of the International Red Cross, has gradually shifted to more and more risky and uncertain assets as the years have rolled by in a historically low rate environment.** Where they once owned mostly standard, well-understood securities like stocks, bonds, and US Treasuries, now their portfolio has shifted toward more complicated, illiquid investments to try to increase returns. They don't really have a choice, but the consequences for their pensioners could be substantial.

In the face of these looming disasters, Senator and presidential candidate Bernie Sanders, proposed a bill that would apparently require the federal government to provide more assistance (that is, bailout) to underfunded pension funds to protect the workers. But a more pragmatic and sustainable solution is to begin by asking why so many pension funds are failing in the first place. And the answer is that the Federal Reserve's interest rate policies made it so.

Why Keep Interest Rates Low?
Given all the calamities associated with artificially low interest rates, you might be wondering exactly why they've become the dominant policy. The best answer seems to lie in economists' and politicians' unholy focus on gross domestic product (GDP) as a metric of overall economic health. To you and me, GDP is completely meaningless. Other than academic curiosity, it obviously doesn't matter to me what the total net value of all goods and products produced in the US was over a given year. I care whether I have a good job, whether my company still has customers, and whether I can still buy the things I need at reasonable prices. But to economists that love statistical aggregates, GDP is the gold standard, if you'll pardon the expression.

The trouble is that it's really easy to mess with. To be counted in GDP, goods and services basically have to be sold to an end-user, and government spending counts as part of that. Thus, in some ways, it's basically a measure of total spending. And if all we're measuring is spending, it's easy to see how low-interest rates help that goal. Low-interest rates decrease incentives to save money (as discussed) and make it easier for me to borrow extra money and spend that. It also makes it easier for the government to borrow and spend more money. Therefore, it should be no surprise at all that lowering interest rates can have the effect of increasing GDP. However, it should be equally obvious that this is not an automatic social good.

To see this, we just need to ask the following question. Which is likely to be more important for economic health: The amount of money spent in any given year or quarter (i.e. GDP) in total, or whether people have a reasonable ability to save and invest for their future? That is not a hard question. But unfortunately, most economists and politicians have agreed on the wrong answer for years.

Summing Up
It's entirely appropriate for people to be concerned about the plight of the working class and the elderly as the economy continues to struggle along. Many people see expanding the role of government as a means to help address these problems, while people like me would be deeply skeptical of the incentives for government to do things correctly. But before we debate the potential for government to do more to help these people, we should begin by considering the ways that current policies are actively sabotaging them. Artificially low interest rates should be near the top of that list. It's also a great example of an issue where partisanship can be cast aside. Whether you lean left, right, or libertarian, the case against manipulated interest rates, as outlined here, should be compelling.

*In effect, this model assumes that the company pays out all its profits as dividends. That's unlikely to be the case in reality. But since theoretically, the value of a stock is really based on its underlying earnings and earnings potential, this is a good enough calculation for our present purposes.

**Not at all important, but I can't stand when people put an "an" before a word beginning in "hi-". Anyway, I'm aware that this is not technically correct, and I've decided prevailing grammar rules just got this one wrong, and I don't abide by it.


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