Interest rates are low, folks. This isn’t news — they’ve been in the gutter for the last eight years. But the near-zero rate environment is changing the traditional preconceptions we’ve had about investing and retirement planning altogether.
And it’s killing the American saver.
Good things can certainly come of low interest rates — cheap money encourages individuals and businesses to borrow and invest in new projects, spurring economic growth. There’s an ugly downside to low rates, too.
Who this hurts and how. Savers, “conservative investors, retirees, and those that are close to retirement have very few investment options that provide any meaningful return on investment without taking irresponsible risk,” says Greg Charleston, senior managing director of Conway MacKenzie.
[Read: 4 Ways to Protect Your Retirement.]
Indeed, low-risk, reliable income-producing investments like the 10-year Treasury have been a cornerstone of retirement planning since time immemorial, and for good reason. As you get older you want to focus on:
— Preservation of capital instead of growth
— Streams of income before capital appreciation
— Low-volatility versus high volatility
— Overall: less risk and more predictability
The 10-year Treasury, however, essentially pays nothing today.
The 10-year yield is at just 1.8 percent, almost exactly in line with inflation, which registered at 1.7 percent in August. That’s a historically miserable spread for savers, people investing for retirement and retirees themselves. The average 10-year Treasury yield since 1958 has been 6.17 percent, while the average inflation rate over the last 50 years is 3.5 percent.
In other words, the average real rate of return for government bonds has plunged from roughly 2.7 percent to 0.1 percent — let’s be honest, zilch — in recent years. For most savers and investors, that’s simply financially unacceptable.
Not only does this zero-yield age mean the obvious for savers — less interest income — it’s also coincided with two other megatrends that, when combined, change the way we think about planning for retirement entirely.
First, people are living longer than ever. In 2014, the average life expectancy in the U.S. at birth was 78.8 years, the highest in history.
Second, health care is also more expensive than ever; Uncle Sam estimates that medical costs will exceed $10,000 per person for the first time ever in 2016.
This unfortunate triumvirate of factors means that “saving for retirement” may be an antiquated phrase. If you’re not investing for retirement you’re falling behind. For older investors who need regular income instead of capital appreciation, that means finding riskier investments with higher yields than T-bonds.
“Reaching for yield has led risk-averse investors to move along the risk spectrum and to invest in high-yield bonds and equities. For most people with long time horizons, accepting the risk in junk bonds and equities is likely prudent,” says Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania. But for those nearing or in retirement, “the short-term volatility in these asset classes is problematic.”
In its quest to fix the economy, the Federal Reserve has punished the risk-averse, who now must take more risk at precisely the wrong time in their lives if they want to earn enough income to beat inflation by any meaningful margin.
Other casualties of low interest rates. Former Dallas Fed Vice President Harvey Rosenblum, now professor of business economics at the SMU Cox School of Business, says that low rates aren’t just toxic to savers. They can also hit the broader economy.
“Savers cannot spend their interest income; there is none to spend. Moreover, they must save at a higher clip to reach their saving goals because there is no magic from compound interest. The more you have to save to reach the goal, the less you can consume, and economic growth slows down,” he says.
“The FOMC has been forced to mark down its forecasts for growth for five successive years, but has not asked whether low interest rates are the problem instead of the solution,” Rosenblum says.
[See: 7 Dividend ETFs for the Income-Minded Investor.]
Despite tepid economic growth, the stock market hit all-time highs in 2016. The price-earnings ratio of the Dow Jones industrial average is currently 20, up from 16.4 a year ago. Investors are paying 22 percent more per dollar of blue-chip earnings than they were a year ago.
So, if low rates are hurting savers and by extension the economy — while simultaneously contributing to frothy stock market prices that may not be sustainable — why not raise rates?
The truth is that with the slow recovery and pitifully low inflation, the Fed worries that raising rates could actually risk deflation — which is seen as a disastrous outcome. Japan’s deflationary environment, which discourages spending, has been stuck in neutral for two decades now. Raising rates could also strengthen the dollar, further weakening the earnings of U.S. multinationals and making American exports less attractive to foreign trade partners.
Still, the case for raising rates — if even gradually — is strengthening. Baby boomers are retiring, and they need safe sources of disposable income. A rate increase would also help the profitability of banks, and encourage them to make more loans. Many market-watchers expect Janet Yellen & Co. to raise rates at the Fed’s December meeting, the first after the presidential election.
Until then. In the meantime, what’s the saver to do? The next rate hike likely won’t be big, only modestly boosting interest income for retirement investors.
Blue-chip stocks are one course of action, although they aren’t for the faint of heart. Even household names like Coca-Cola Co. (ticker: KO), Microsoft Corp. ( MSFT) and Johnson & Johnson ( JNJ) can lose a quarter of their value in any given year. Stocks are risky.
Real estate investment trusts and annuities are both options as well, but neither one is very attractive in a rising interest rate environment.
Lastly, investors can simply buy higher-risk bonds.
“There are two main ways to obtain more yield within bonds, and both can increase volatility. Savers can invest in longer maturity bonds, which currently yield more, but also have much greater sensitivity to interest rates should rates rise,” says Steve Lowe, senior portfolio manager at Thrivent Financial. “Also, savers could take credit risk in bonds such as corporate bonds. Credit risk is the risk a company defaults. Default risks are relatively low in investment-grade bonds, but rise substantially for high-yield bonds, which are rated below investment grade.”
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
If savers and investors, out of necessity, change strategies to reach for yield, Lowe has a warning: “There is always a trade-off between yield, or potential return, and risk.”
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Death of the Saver: How Low Interest Rates Are Punishing the Risk-Averse originally appeared on usnews.com
