Medium- and long-term interest rates have declined 75-100 basis points since the beginning of the year. That decline, if it persists, will significantly increase the “cost of retirement,” not just for defined benefit plan sponsors (see our recent article Interest rates 2019 – DB funding strategy) but also for defined contribution plan participants.
In this article we discuss in detail the challenges that declining interest rates present for DC plan participants.
The effect of changes in interest rates on a 401(k) plan participant’s retirement income is not at all intuitive. A critical first premise – which may not hold for all 401(k) savers – is that the purpose of 401(k) savings is to provide income in retirement. If you assume that the participant’s retirement income need is “inelastic” – that is, that the participant has no flexibility about his retirement needs – then declines in interest rates translate (more or less directly) into an increase in the current “cost” of retirement savings.
We illustrate this in two ways – with a story and with a chart.
Here’s the story: Assume that there is a store where you can buy retirement income, and there is a participant who needs $1,000 of retirement income 30 years from now. The participant goes to the store and sees that she can buy that future-$1,000 for just $265. Which is convenient, because that is exactly what she has in her account. (In financial terms, the participant can buy a 30-year corporate “strip” that will (literally) pay her exactly $1,000 in 30 years.)
Before buying, however, the participant talks to a friend who tells her she can make more in the stock market.
“But won’t that make the $1,000 more expensive next year, because there’ll be one less year – it will then be income 29 years from now, right?”
“Yes, you’ll lose one year of interest.” But her friend assures her, “Interest rates are super-low right now, around 4%. You’ll make way more than that in the market.”
So instead of just buying the income she needs, she invests in an S&P 500 index fund and makes 26% on her investment in one year – so that at the end of the year she has $335.
Full of optimism, the participant goes back to the retirement store to buy that $1,000 in future retirement income, figuring that she’ll have money left over for a nice dinner out (or to put towards that cruise she wants to take).
When the participant gets to the store, however, she finds that the cost of $1,000 29 years from now has – because of declines in interest rates – gone up to $370. (That is, the cost of that 29-year corporate strip is now $370.) So that, in fact, she no longer has enough to buy the future-$1,000 she needs.
Here’s the chart: The story we just related is, more or less, what happened in 2019. The following chart shows the change this year in the cost of $1,000 30 years from now. The participant had an opening account balance that was exactly equal to the cost a 30-year strip at the beginning of the year.
And – even after making more than 25% on her money – she’s $37 short at the end of the year.
A lot of stock market gains simply reflect declines in valuation interest rates
Economist (and former director of the National Economic Council for President Obama) Lawrence Summers recently observed: “Wealth can go up because future income streams go up … or wealth can go up because the discount factor goes down. … The Shiller Price Earnings Ratio is 76% more than its post-war average. That would explain all of the increase in wealth relative to income.” (Remarks of Lawrence Summers, Would a “Wealth Tax” Help Combat Inequality? A Debate with Saez, Summers, and Mankiw, Peterson Institute for International Economics, October 18, 2019.)
In a very real sense, much of the “gains” that participants have seen in the value of their 401(k) accounts in the last two decades has been offset by this increase in the cost of future retirement income. Many observers (including, e.g., Mr. Summers) have pointed out that that is no accident. That as the discount rate goes down, stock values go up, with no effect on “permanent income.” As in our story, the amount of income needed – $1,000 30 years from now – has not changed. What has changed – with the decline in interest rates – is how much it costs.
The need for an employer-based retirement income solution
We conclude our discussion below with a consideration of actions that sponsors can take to help participants address this challenge, including helping participants develop an understanding of their own “retirement outcomes” and of alternative strategies – saving more, working longer, or adjusting expectations.
We want to, at the top, highlight one innovative strategy that may help reduce the cost of retirement income, that we at October Three are committed to – providing an employer-based retirement income solution.
It’s possible for a participant to self-insure against longevity risk – and that may in certain circumstances, e.g., where the participant intends to leave a legacy, be the best strategy. But for most participants, dependent on their retirement savings for retirement income, an annuity will provide the best solution to their retirement income challenge.
Currently, most DC participants must purchase annuities in the retail market. Most would agree that that market is less than perfect and carries a number of regulatory burdens (including limits on investments), that make retail annuities relatively expensive. These issues may explain why only a small percentage of DC participants buy annuities.
But … most employers have – at hand – a pool of participants that they can spread this longevity risk over, and the ability to manage, at scale, that risk and the associated investments. Indeed, the private retirement plan industry was founded on the premise that private employers could do a better job providing retirement benefits directly to their employees than purchasing them from a carrier.
We believe – in an era of increasing retirement income costs – that it is critical to exploit this opportunity to lower costs by developing such an employer-based solution to the DC retirement income challenge.
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In what follows, we begin by discussing the complicated issue of interest rate risk in DC plans. We then discuss the effect of recent interest rate declines on DC plan participants and conclude with a discussion of how sponsors may be able to help their plan participants deal with this challenge.
Retirement savings generally presents three significant risks – interest rate risk, asset risk, and mortality/longevity risk. In a DB plan, generally, the effect on “financing retirement” of asset and mortality/longevity risk is relatively intuitive. And, while the effect of interest rate risk is more complicated, for DB plans the effect is made explicit by federal minimum funding/PBGC variable rate premium and applicable financial disclosure rules.
When a sponsor switches from a DB retirement program to an account-based DC program, all three of these risks are transferred to participants. Again, the effect of the transfer of asset and mortality/longevity risk is relatively intuitive. And sponsors and policymakers have made efforts to improve participant decision-making in light of this transfer: improving participant asset allocation decisions through, e.g., education and defaults, and raising awareness and providing tools for understanding and (to a lesser extent) managing longevity risk.
But in this DB-to-DC transaction what, exactly, happens to interest rate risk? The answer to that question – the topic of this article – is more obscure. Participants aren’t subject to those federal minimum funding/PBGC variable rate premium and financial disclosure rules. So how does interest rate risk show up for them “in real life?”
The double function of interest rates
A major cause of confusion here is that interest rates serve a double function:
On the one hand, interest rates are used to value claims on future income. Thus, for instance, interest rates (e.g., yields on high-quality corporate bonds) are used to value participant liabilities in a DB plans.
On the other hand, they represent a return on an investment, typically, a credit transaction, such as a loan or a bond. As such, interest rates define, generally, the return on a “safe” investment.
As a result of this double function, declines in interest rates can send signals that point in different directions.
Declines in interest rates can result in an increase in the value of assets-on-the-books
Declines in interest rates are often associated with increases in asset values. This year, for instance, the S&P 500 is up nearly 26%.
The logic of this can be most easily seen with respect to a bond. If you own a bond that pays 4% interest, and interest rates go down to 3%, that 4% bond will be significantly more valuable after that decline.
The effect of an interest rate decline on stocks is more complicated. Generally, an equity security represents a claim on future corporate profits. If those profits are, after the interest rate decline, expected to be the same as they were before the decline, the value of the stock will generally go up (more or less) in the same way that the value of the bond went up. Things are more complicated here, though, because an interest rate decline may also be correlated with an economic slowdown and (possibly) reduced corporate profits.
These effects typically translate into an increase in the value of “assets-on-the-books,” e.g., assets that a 401(k) plan participant already holds in her account.
Declines in interest rates increase the cost of retirement income
A corollary of the foregoing is that a decline in interest rates makes income-producing assets more expensive. One version of this is that (to state the obvious), stocks and bonds are more expensive – hence this year’s increase in, e.g., the value of the S&P 500.
This effect is of acute significance for an individual, e.g., a 401(k) plan participant, saving for retirement, because, when interest rates decrease, retirement income – via an annuity or simply a conservative, income-producing securities portfolio – gets more expensive.
An easy way to see this is that a decline in interest rates translates relatively straightforwardly into an increase in the cost of an annuity.
A more complicated version of this same effect can be seen when we consider that standard 401(k) glide paths provide for allocating a progressively increasing amount of a participant’s retirement savings to fixed income securities. As rates go down, the cost of those securities goes up. In these conditions, the typical participant is on the “losing side” of that deal, as – in an era of declining interest rates – he has to pay more and more to get the same retirement income.
Interest rate declines are a trend, not a fad
Below is a chart of the yield on high-quality corporate bonds for the last 100 years.
On this data, interest rates peaked in 1981 at around 15% and have since then declined to around 3%, a 1,200 basis point drop.
In a speech on “The Global Saving Glut and the U.S. Current Account Deficit” (2005) then Federal Reserve Governor Ben S. Bernanke attributed the “global savings gut” to (1) “the strong saving motive of rich countries with aging populations, which must make provision for an impending sharp increase in the number of retirees relative to the number of workers” and (2) “the recent metamorphosis of the developing world from a net user to a net supplier of funds to international capital markets.”
These trends – especially the first – do not appear to be reversing.
Takeaways for plan sponsors – helping participants meet the retirement income challenge
To repeat: a decline in interest rates makes income producing assets more expensive. For instance, when interest rates go down, annuities cost more. A 100-basis point decline in interest rates will (more or less) increase the cost of an annuity for a 65-year-old by about 11%, and much more for a younger participant (like the one in our “story”).
Critically, to state what may be obvious, even though the amount of retirement income a participant can buy with a dollar of savings has gone down dramatically this year, the cost of everything else – the goods and services that the retiree will, in the future, use that retirement income to buy – has gone up. (According to the DOL’s Bureau of Labor Statistics, the Consumer Price Index increased 1.7% over the year ending September 2019.)
Helping participants develop an understanding of their own “retirement outcome”
In a DC plan, the (negative) effect of interest rate declines on retirement income are (in the first instance at least) the participant’s problem. How can a sponsor help participants meet this challenge?
Consider lifetime income disclosure. Many sponsors already provide participants with “lifetime income disclosure” on annual or quarterly statements, explaining what a participant’s account balance may provide as retirement income. To the extent that a sponsor’s approach to this reflects changes in interest or annuity purchase rates, the recent interest rate declines will show up as reduced retirement income – perhaps offset by increases in asset values. This sort of communication permits participants to get a more accurate picture of what – based on their current savings – their retirement income will be. (We note there is a proposal in Congress that would mandate this sort of disclosure.)
Reevaluate the 4% drawdown rule. Many expect that, in addition to interest rates, returns generally will go down/remain low in the future. In this context, sponsors that provide information about drawdown strategies may want to consider whether the 4% drawdown rule-of-thumb is still appropriate, or for example, whether 3% is the “new” 4%.
Strategies to address the greater cost of retirement income
Consider encouraging greater savings. In an era of lower interest rates, sponsors may want to consider communicating the need to save more to meet retirement income targets, where a participant has saving/spending flexibility.
Consider whether communication/counseling about “Plan B” may be useful. Many participants may not be able to meet the increase in the cost of retirement income by simply diverting more of their pay to retirement savings. The standard Plan B is living on less or working longer. Participants – especially those relatively near retirement – may need help thinking through these alternatives and deciding what is their best option.
Consider alternatives that will improve participants’ “annuity deal.” The retail annuity market can, for a participant, be expensive and difficult to navigate. As we said at the top: sponsors may be able to provide alternatives, either directly – through a plan-provided annuity – or indirectly, by developing ways for participants to access the institutional market or raising awareness about the value of deferring Social Security benefits.
Retirement income policy
Lower interest rates exacerbate the retirement income challenge. It’s widely recognized that we do not have an adequate solution to DC payout – how to effectively turn an account into a stream of retirement income. We see that asset gains can be offset by the increasing cost of retirement income, driven by the ongoing decline in interest rates. Making the need for a better retirement income solution even more acute.
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Perhaps the biggest outstanding question is whether current interest rates represent a new normal or a temporary drop.
We will continue to follow this issue.