When the Fed cut its main policy rate from 1.5% to essentially zero 2 weeks ago, it returned us to the weird world of negative real rates that flip a lot of the market and conventional incentives on their head. Although the Fed only really can control the short term rates, they are doing the best they can, armed with consistent low inflation expectations, to lower the entire yield curve as much as they can for the time being.

It isn’t just short term borrowers and grandma with her bank CD that care about short term rates. When the entire yield curve falls to what is essentially negative territory after accounting for inflation, it could change things as far flung as traditional retirement advice.

The Conservative Portfolio

Take for example the conventional wisdom that as you approach retirement, you should allocate more and more of your portfolio towards bonds. Each person has a different risk tolerance and a different capacity to withstand volatility, so the proportion of the portfolio devoted to fixed income securities varies, but the point is you want something counter cyclical to draw on when stocks are not doing so well, such as well, right now.

As hedge fund manager Garth Freisen pointed out recently though, if the 10 year treasury is hovering around 1% yield and the average inflation target is 2% annually, why would any rationale investor want to put their money in something that loses 1% in real value every year? This is especially true if you are 65 and intending to live another 20 years.

Risk versus reward is at the heart of what drives returns for retirees and how they make their investing decisions. Most people understand that in order to become rich, you will likely have to take some risks. However, once you do have a lot of money, it also gives you the freedom to take even more risk because you can afford the losses. What ends up happening, and one reason there may be so much inequality today, it’s that the rich mostly end up reaping the rewards from taking those risks and then end up becoming even richer as a result. You can visualize this below in household net worth levels divided into segments.

Source: Federal Reserve

The richest 1% of American households in terms of net worth own 50% of the stock market while the top 10% own 84% of the stock market. You can see how the performance of the stock market is very similar to the growth of the net worth of the top 10% of households, with declines after the Great Recession and a climbing right back up to the end of 2018. There seems to be a pretty strong correlation between the stock market and the wealth gap.

So far the financial industry and political response to this has been one of two choices: either give low income people more government handouts and encourage saving or punish the rich by taxing their wealth heavily to even the playing field, or some combination of these.

Zero Rates May Change the Math of Retirement

A recent economic study however, is upending the logic that we need to encourage low income people to save more. As I read through it, the paper gave me a better understanding of the theory that is behind retirement advice and why low interest rates may change the story for middle class and lower income households.

On a basic level it’s important to understand the concept of utility. Utility is a theoretical measurement of the satisfaction received from consuming a good or service. Economists don’t need to quantify utility to be able know whether it will be greater or smaller. This is a key attribute because we can’t measure the satisfaction of buying a car, we can say that for most people, the satisfaction they get from getting 2 cars is greater than the satisfaction they get from getting 1 car. The concept of utility only needs to specify that having more is better for the purposes of this exercise.

Utility is at the heart of traditional investing as well. Most people get more satisfaction or utility from consuming a good or service now. To delay that gratification, they have to be compensated for it. The compensation when it comes to money is that you can invest it in say, a bond that yields 5% annually and 20 years later you will be able to consume much more than you could have consumed if you spent the money right now.

That theory works well if the rate of growth on your investment is high enough to grow your money, but that isn’t our reality now when it comes to bonds.

A Theoretical Case

The authors of the study, economists from Stanford and George Mason, derived a model that looks at a person who is 55 and has not accumulated any retirement savings. They assume that person will suddenly start to save diligently and retire by 67. They assume at that time the person will have accumulated 434% of their annual income for retirement. They then look at what would be the optical utility maximizing spending behavior of this person if they were very low income, low income and middle class and their findings were interesting.

To put some tangible numbers to their models, I went by the fact that they used the Social Security Administration (SSA) average wage index, which for an American worker was $52,145.80 in 2018. Based on this figure, the definition of income levels was as follows for the study:

Very Low – $13,036.45

Low – $23,465.61

Moderate – $52,145.80

From these, we know that the annual social security payments for these workers will be:

Annual Social Security Payments at 67:

Very Low – $9,777.34

Low – $12,671.42

Moderate – $21,119.04

Furthermore, the authors gave 4 different scenarios for the future of the retired when she was 67:

1. A baseline scenario where there is a 3% interest rate for fixed income investments;
2. A scenario where the retiree is not able to buy an annuity to guarantee income;
3. A scenario where they can buy an annuity but interest rates are 0% and;
4. A scenario where they cannot buy an annuity and the rates are 0%.

Annuities are important to the math here because they offer guaranteed income which increases that current utility we are looking for. The results of the optimal spending in these scenarios are seen below:

Source: NBER

In all but the 3% interest case, the optimal behavior is to actually spend more, early in retirement and run out of money at some point relying only on social security. The rationale being that we actually may not need as much as we think when we are older because of health issues which may keep us in the house and not spending as much. This tends to fly in the face of all advice saying we cannot and should not rely on social security while in retirement. Wealth managers treat this scenario like a death sentence if you have to bear it.

A Realistic Look at the Scenario

Although the outcome is surprising and I suspect is close to what many people with little or no retirement savings may actually experience, there are a few issues I have with this model when it comes to the real world.

1. The Saving – the authors assume that this person, who hasn’t saved for all of their lives can suddenly reverse course and accumulate 434% of their annual income in 12 years. For the average income case, this equates to saving up $174,166.97. I determined this would require a savings rate of at least about 20% of income, depending on the interest rate. It would also require constant investment with no big hiccups or mistakes. I don’t believe someone older with poor savings habits will be likely to all of the sudden become a perfect saver and rational investor, it just isn’t consistent with the psychology of non-savers.
2. The Income – Although the focus is on utility, I think in the very low income bracket, a person surviving off of social security alone would not be able to survive. Rather, they would need subsidization of other needs such as housing or mobility, likely by way of help from family. The people that I know that are in situations like this rely heavily on adult children to take care of them in old age.
3. The Life Spans – These lives would likely be shortened by not being able to receive the proper care. Having owned a retirement home, I have seen how fast someone can deteriorate without proper attention. It literally is the difference between living years more or weeks more of your life. Unfortunately, most low income people do not get the attention they deserve in old age, especially those that are attended to by non-family members most of the day. Nursing homes tend to be a business, and the less you pay, the lower quality service you get. It may not be fair, but it’s a fact of life. This is again another reason many retirees may depend on adult children for care.

The Message

The conclusion I come to after reading this is that it will likely give a false sense of security to those people who think they can just save later. Saving and investing is a habit developed over time, not something you just turn on one day. It requires discipline and mental skill to both rationally invest and psychologically defer consumption. The study does not capture all the dynamics of a poor retiree but is nonetheless and interesting exercise and does beg the question of how we should be advising people in the world of zero interest rates.

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