I originally wrote this article in May 2011. I think that it remains relevant today: feel free to disagree (or agree) in the comments below.
Suppose you were told that you would live to 120. What would you do today? (If you’re already 120, pick a bigger number.)
Further assume that you aren’t a member of a defined benefit pension plan. Defined benefit plans promise to pay benefits for your life. Those funding the plan might not be thrilled to hear about your longevity: they’d be paying for it. Short of profiting from the information – switching to an employer with a defined benefit pension plan or purchasing a lifetime annuity – you’d face some difficult planning. How could you save enough money to support yourself in retirement?
Presumably, your answer would be a combination of save more now and retire later. If you are already retired, the choices would be spend less now and return to work. In either event, you may also invest in riskier assets. With some doubt in your capacity to work into your 80s or 90s, and a lot of doubt in the outcome of riskier assets, most responses should rely heavily on austerity. Your austerity might not thrill your barber or your favourite coffee shop. But, it shouldn’t have much effect on them and negligible effect more broadly.
What if you aren’t alone?
If everyone else got the exact same news, we’d face the same challenge simultaneously. We’d come to similar conclusions as above: save more/spend less, work longer and, possibly, invest riskier. With us all spending less today, currencies would face deflationary pressures. We’d experience a decline in disposable income chasing a similar amount of today’s economic output. The price, in dollars, of buying a share of economic output would face downward pressure. Put another way, a large increase in money supply could be handled without inflation pressures if it was saved. Global saving and de-leveraging, the same things practically, push prices down.
Governments could respond by increasing retirement ages, to the extent it can be sold politically and we could handle productive work into our later years. This would mitigate some of the spending decline. Retirement age changes, however, are unlikely to be bold enough to decrease most of the reliance on austerity.
Too much money
If we all knew that we’d be living to 120, we’d maintain and build up a lot more capital than today.
Capital growth would outpace economic growth. As this happens the returns from a unit of capital would decrease. Returns from capital ultimately come from economic output. Of course, capital growth leads to economic growth. But, there are diminishing returns. Long-term bond yields provide evidence for recent decreases in returns on capital. In the last 20 years, rich government long-term bond yields, both real and nominal, declined to record lows. The last 10 years of this interest rate decrease happened while government debt levels increased substantially.
The last 10 years of this change should be perplexing:
– Supply of these bonds went up
– The financials supporting the bonds deteriorated
– But, prices kept increasing
Either there are fewer other investment opportunities, risk appetites changed dramatically or there is a growing supply of money. The first two options are offered as a narrative a fair amount but do they hold much water?
– The world is larger and capital moves easier than ever before. Investment opportunities appear to be higher than lower.
– Pension plans, significant market participants, have seen risk appetites increase as yields from less risky assets have increased. “Flight to quality” and other such narratives are trading terms that barely apply to pension plans.
Risky assets adjust, too. Corporate bond yields have declined in line with government bond yields. Riskier assets like equities and real estate have seen declines in return outlooks.
Longevity and investment returns
When only you were going to reach age 120, only you would be saving more money. Capital markets needn’t be affected. But, when everybody’s heading to age 120, everybody needs to save more money. The resulting increase in capital leads to decreased returns on capital. Unfortunately, this means that we won’t be able to rely on investment returns as much as we think. Right now, retirement income relies heavily on investment returns. Return expectations are heavily influenced by past returns. So, we would need to save more money still, putting further strain on returns.
The more money saved, or not spent, the more pressure on deflation. So, low long-term interest rates have a deflationary component, which will grow in proportion to the size of retirement savings.
Are we becoming Japanese?
While the example above is extreme, we are experiencing small versions of it every year. We are living longer. Retirement savings are getting much bigger and will continue to grow. They matter. Japan is older, lives longer and is richer, relative to its income, than other developed countries. They’ve faced low asset returns, rock bottom bond yields and deflationary pressures over the past two decades. Japan’s Central Bank used traditional and some non-traditional methods to spur on inflation and economic growth. They didn’t work.
The rest of the rich world looks to be now catching up. This is troubling. The implications of further decreased bond yields and low inflation bordering on deflation are profound, particularly for retirement savings.
In upcoming blog posts we’ll continue to explore areas for pensions to invest in a prolonged low interest rate reality.