Rates of "Return"

Having just concluded a long driving trip, I was reminded again just how helpful the technology under the hood of today’s automobiles can be: the warning lights when you’ve still got enough gas left to find a gas station, the low tire pressure light that tells you of a slow leak before you have a flat tire, the binging that lets you know you’ve left your headlights on (again), and my personal favorite, the klaxon-like bell that alerts you that your parking brake is still engaged (since that red “brake” light on the dashboard clearly wasn’t sufficient notice).

Before such warning signs were standard features, I’ve had the decidedly unpleasant experience of running out of gas in the middle of nowhere, finding myself driving on (two) flat tires, and—many years ago—I’m pretty sure I was responsible for ruining the brakes on my Dad’s car simply because I didn’t realize that the smell of burning rubber was coming from the car I was driving.

For some time now, the Federal Reserve has held short-term interest rates near zero in an effort to support an economic recovery—and has, in fact, announced its intention to maintain that policy until such time as the recovery seems to have taken hold. However, as many retirees and workers have discovered, those historically low interest rates are crimping their retirement savings—and a new study by the Employee Benefit Research Institute (EBR)¹ quantifies the impact of a sustained low-interest rate environment on America’s retirement readiness.

Using EBRI’s unique Retirement Security Projection Model® (RSPM), we found that more than a quarter of Baby Boomers and Gen Xers who would have had adequate retirement income under an assumption that historical average market returns would prevail are instead simulated to end up running short of money in retirement if today’s historically low interest rates are assumed to be a permanent condition (assuming retirement income/wealth is assumed to cover 100 percent of simulated retirement expense²).

Not that everyone is affected to the same degree. In fact, the analysis reveals that the potential impact varies by income levels: The low-yield-rate environment appears to have a limited impact on retirement income adequacy for those in the lowest preretirement income quartile, since they have relatively small levels of defined contribution and IRA assets and since they rely more heavily on Social Security income in retirement. However, the research found there is a very significant impact for the top three income quartiles.³

The research found that the impact is lessened if the current low rates are temporary, but that its impact can be magnified by years of future eligibility for participation in a defined contribution plan. For example, moving from the historical-return assumption to a zero-real-interest-rate assumption results in an 11 percentage-point decrease in simulated retirement readiness for Gen Xers who have one to nine years of future eligibility, but that gap widens to a 15 percentage-point decrease in retirement readiness for those with 10 or more years of future eligibility.

In recent days, word that the Federal Reserve sees an end to its current policies has brought some volatility to the stock market. While several sectors of the economy have benefitted from the U.S. Federal Reserve holding short-term interest rates near zero to support a recovery, there are warning signs in the EBRI analysis about longer-term consequences that policy makers should also consider—and implications for retirement readiness should historical averages return.

Nevin E. Adams, JD

¹ The full report is published in the June 2013 EBRI Notes, “What a Sustained Low-yield Rate Environment Means for Retirement Income Adequacy: Results From the 2013 EBRI Retirement Security Projection Model,®” online here.

² When 80 percent of simulated retirement expenses must be covered, only 5‒8 percent are simulated to run short of money.

³ This is in sharp contrast to a recent report by the Center for Retirement Research at Boston College that claimed that the lower interest rates had only a minor impact for ALL income categories. However, as we have noted previously, CRR’s National Retirement Risk Index, on which the conclusions are based, continues to assume that all retirees annuitize all of their defined contribution and IRA balances; continues to ignore the impact of long-term care and nursing home costs or assumes that they are insured against by everyone; and also seems to rely on an outdated perspective of 401(k)-plan designs and savings trends, essentially ignoring the impact of automatic enrollment, auto-escalation of contributions, and the diversification impact of qualified default investment alternatives. Additionally, given the way their model assumes assets accumulate during the preretirement period, the change in interest rates has NO impact on accumulations at retirement age. See “Rely Able?”