The current low-yield environment creates a major challenge for people who have to save for retirement. At the same time, in many countries, political efforts to limit public pension obligations increase the need for retirement savings. This makes the current low-yield environment especially harmful and raises questions about the efficiency of the pension reforms. Furthermore, there are indications that the combination of low interest rates and a greater reliance on retirement savings contributes to economic inequality. It will be important to address the growing inequality problem, and insurance can significantly contribute to this goal.
Why are interest rates so low?
Simply speaking, nominal interest rates should equal inflation plus the real growth rate of the economy. The latter could again be divided into productivity growth, which influences the output per person working, plus the growth rate of the labor force. In principle, monetary policy should not interfere with this relationship, as it is looking at these variables as well (e.g. by following the Taylor Rule). However, there is of course some leeway leading to relatively tight (higher interest rates) or expansive (lower interest rates) monetary policy.
Hence, we have four main factors influencing interest rates: inflation, productivity growth, growth of the labor force and monetary policy. Inflation has declined in most advanced economies over the past 40 years and is at a very low level. In spite of the digital revolution, productivity growth rates have been rather low over the past years. Due to low fertility rates, the growth rate of the labor force has significantly declined over the past decades in most advanced economies and has turned even negative in some. Finally, monetary policy has become very expansive to support the slow recovery in many economies. Hence, all the driving factors have worked in the same direction, leading to the current low-yield environment.
Given that the demographic trend of declining labor force growth rates is expected to continue and that higher inflation would not help to increase real returns, the only — albeit limited — hope for higher interest rates is a reversal of the productivity trend as well as a normalization of monetary policy.
Impact on retirement funding
Besides the low fertility rates, there is an additional major demographic development: an increasing life expectancy. This implies that we are living longer in retirement, and this in turn implies that we have to transfer more money from work life to retirement to keep appropriate living standards. There are basically two ways to do this: via a (public) pay-as-you-go system or via (private or occupational) retirement savings.
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In a pay-as-you-go system, people in working life transfer a fraction of their income to the people living in retirement. In return, they get a fraction of the next generation’s labo- force income when they are in retirement themselves. Hence, the implicit return on the pay-as-you-go contributions is influenced by the growth rate of the individual labor income (inflation plus productivity growth) and the growth rate of the total labor force.
As we can see, the implicit return on the pay-as-you-go contribution is harmed by the same factors as the return on retirement savings (i.e. the interest rate). However, it is not affected by the very expansive monetary policy, which is only lowering the return on retirement savings. Hence, pay-as-you-go pensions should become relatively more attractive.
Nevertheless, most pension reforms lead to a decreasing relevance of public pay-as-you-go pensions. One reason for this might be that politicians fear that a pronounced increase in social security taxes would not be opportune for their political future. It is important to note, however, that as a result people will have lower public pensions and therefore have to put the dollar they are not investing in the one system (the pay-as-you-go system) into the other system (retirement savings). Whether people are happy with this depends on the relative returns on the two systems. Due to the expansive monetary policy, it is far from given that the retirement savings offer the higher return.
When people have to save for retirement, they are directly affected by low interest rates. Let’s look at a young household that saves $1.000 per year for retirement, which starts in 40 years. At an interest rate of 2%, the household would have a bit more than $60,000 available at the start of retirement. At an interest rate of 0% (currently, real rates are rather negative) it would be only $40,000. Hence, the household would have to increase its annual savings by 50% to $1,500 to still end up with the $60,000.
However, not everyone is affected by the low interest rates to the same degree. For comparison, we look at an older household that is saving $1,000 for five years. For this household, a reduction of interest rates from 2% to 0% translates into a reduction of the end sum from $5,300 to $5,000. Hence, this older household would not have to increase annual savings by 50% but only by 6%.
For the young household, one way to compensate the strong impact of the low interest rates would be to increase risk taking. Stocks, for example, typically have an excess return of about 5%. This implies that in the current 0% interest rate environment, the young household would not end up with $40,000 but with more than $125,000! Even though there has never been a long period where stocks fared worse than bonds, many people shy away from taking on financial risk and are still looking for guarantees. Richard Thaler associates this with behavioral biases that could be overcome with the right nudges. However, it is also true that richer people tend to be better able to live with income fluctuations and therefore to take on financial risks.
There is another reason why richer people might be better able to live with the declined interest rates: By definition, they already have wealth and therefore profit from the increase in asset prices that comes with decreasing interest rates. This capital gain is especially strong for long-term assets like very long-term bonds, real estate and stocks. As a result, for people with substantial wealth, the net effect of decreasing interest rates might well be positive.
Richer people also profit relative to poorer from the shift from the public pay-as-you-go system to a greater reliance on retirement savings. First, public pay-as-you-go pensions often include some redistribution from people with a higher lifetime income to people with a lower income. This redistribution is typically not part of private retirement savings.
Second, public pay-as-you-go pensions often provide insurance against some biometric risks that are not necessarily insured in private retirement saving products. One major risk is the individual longevity risk, i.e. the risk that a household outlives its savings. If people are rich enough, they never outlive their wealth but rather pass substantial amounts to their inheritor. However, this applies to far from everyone. Another biometric risk is the disability to work and to earn the labor income that is necessary to save enough for retirement. While richer people also have a disability risk, the financial consequences might be (relatively) smaller as they often also have capital income that is not (or less) affected by the disability. Others, however, risk outliving their savings even before reaching retirement age and falling into poverty due to disability.
What should be done?
As we have seen, the expansive monetary policy in combination with the shift from a public pay-as-you-go system toward a greater reliance on retirement savings affects people differently and will likely foster inequality. What can we do to address this social problem?
First, it is important that central banks are aware of and consider the effects of their monetary policy decisions on retirement savings and inequality. In fact, there are also indications that the relationship works in both ways and that inequality also affects the monetary transmission channel as well as financial stability. As a result, several central banks have already started to analyze the relationship between monetary policy and inequality.
Second, policy makers should reconsider the efficiency of shifting the focus of retirement funding from a pay-as-you-go system toward a pre-funded system based on savings. Retirement savings will always be an important pillar of retirement funding and a crucial funding source for long-term investments in an economy. However, there are limits to the efficiency of more savings, and we have to be aware that savings are affected by the same demographic factors that harm pay-as-you-go pensions. To make public pensions more sustainable, policy makers should rather aim to broaden the basis of contributors and to increase flexibility of labor markets and the retirement age.
Third, individuals should reconsider which risks they want to take and which not. Retirement saving products with a guaranteed interest rate are still very popular. However, by choosing guarantee products, people substantially reduce the return on their savings even though the long-term nature of their retirement savings would put them in a good position to take the risk themselves. Biometric risks, in contrast, are difficult to take individually but lend themselves to risk pooling. Yet many individuals do not appropriately buy insurance protection against biometric risks like disability or longevity.
What does this mean for insurers?
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By pooling individual risks, insurers not only support wellbeing of risk-averse individuals but also reduce inequality in a society. The degree to which insurers are fulfilling this valuable role depends, however, on the products they are selling to their customers.
When it comes to retirement savings products, it is important that products include protection against biometric risks and not protection against financial risks. Given that insurance regulation aggravates the provision of financial guarantees, supply does not seem to be the problem in this regard. It is rather the demand side that for some reason prefers buying protection against financial risks to products that insure biometric risks.
It will be important to increase our understanding of why this is the case and how we could overcome this bias. Further research is needed although behavioral economics already provides some first insights in this regard. Nudges to overcome the described behavioral biases are, for example, increasing the availability of risk information, limiting the number of alternative products and having appropriate default options.