The Pervasive Effect Of Low Interest Rates On Financial Planning

Posted by Michael Kitces on Monday, October 1st, 11:06 am, 2012 in General Planning

The ongoing low interest rate environment in the US has created many challenges in recent years, as the struggle to find yield and return drives planners and investors away from bonds and towards other options for higher returns, from equities to so-called "alternative" asset classes - in turn driving up those prices and reducing dividend yields and prospective future appreciation. Nonetheless, many returns on alternatives are still appealing given an alternative of near-zero interest rates on fixed income! Yet the reality is that low interest rates, as they continue to persist, are beginning to have other effects beyond just the impact to investors. Insurance companies have been forced to raise prices on some types of insurance, or leave the marketplace entirely, as the returns are simply too low to manage risk and generate a reasonable profit. Pension plans continue a slow grind of underperforming their long-term actuarial assumptions, creating a larger and larger deficit that must ultimately be resolved as well. And while many planners have been trying to focus their clients on the risks of what happens to bonds if rates rise, recent research suggests that in fact the greatest surprise of the coming decade could be that rates continue to remain low as the US economy deals with its massive public and private debt levels - which in turn means many of these low interest rate challenges could still be in the early phase!

The inspiration for today's blog post was a recent trip I took to Sydney, Australia, for a speaking engagement. While there, I observed that it's not uncommon for banks to offer 1-year CDs in the range 3.5% - 4.5% range; while this is actually a significant decline from when I was there in 2011 (when rates near 6% were not uncommon!), it is still dramatically higher than the not-even-1% rates available from most banks in the US.

Yet while the most obvious effect of low interest rates here in the US is the lower interest income received - which has been especially problematic for today's retirees - I was struck in reflecting how much else in the US financial services world has been distorted by our extended period of ultra-low interest rates.

Investment Markets

Given low interest rates, those who rely upon investments to generate some return to achieve various financial goals are inevitably left deploying their money elsewhere in search of yield or total return. In point of fact, at the most basic level this is the purpose of low interest rate monetary policy - to drive dollars into other segments of the economy with the hopes of stimulating activity, such as driving dollars to equities to help companies raise capital for growth and expansion.

To some effect, this goal is clearly being achieved, as investors and planners alike focus on both investing more and more in "alternative" asset classes to obtain higher returns, and investing in equities despite a meager 2% dividend yield from the S&P 500. Although we have found many ways to rationalize investing in equities despite their low yields, it doesn't change the fact that the returns are modest by historical standards. Think of it this way: how many investors would take money out of equities if they could get "merely" 4% from a 1-year bank CD, or the 6% available in Australia last year (with even higher yields for longer terms)? I suspect the answer is "a lot" to put it mildly. What keeps Australian investors in equities despite these rates? Because in Australia, you can actually buy quality "blue chip" companies with 5% - 7% cash dividends, plus earn an additional tax credit available to Australian investors who buy domestic equities, leading to a total after-tax yield on stocks of about 6% - 9%. What a difference - US investors buy 2% yielding domestic stocks because it's better than 0.5% CDs, while Australian investors buy 6%-9% yielding domestic stocks because it's better than 4% CDs. I couldn't help but walk away thinking about how distorted our markets have become in the search for return.

Insurance Products

Unfortunately, the problems that arise from the lack of yield and return in the US is not limited to retail investors. Institutions have begun to suffer as well.

For instance, the fundamental business of insurance is to collect premiums, invest them for a period of time, and then pay out a portion of the money in claims, while earning a small profit margin along the way. Yet when interest rates are so low, insurance companies are forced to collect more in premiums to fund future benefits (since they can't bridge the gap with investment growth), and in some cases the prospective return on premiums is so low there isn't even room left for the company to retain a margin for both risk and profits; the end result is that insurers are changing or eliminating many lines of insurance.

As noted previously in this blog, the low interest rate environment has already helped to drive a number of long-term care insurance companies out of the marketplace entirely, and all of the remaining companies now charge dramatically more to offer what coverage they do. Estimates from the AALTCI suggest that every 1% decline in interest rates has driven up the cost of long-term care insurance premiums by 10%-15% over the past decade. Various policy options have been curtailed as well; it is likely that by the end of the year, lifetime benefits and limited-pay policies will no longer be available at all.

Similarly, insurers have also been reducing their offerings for no-lapse guaranteed Universal Life policies, another product whose margins for risk and profit are greatly impacted by the low interest rate environment. Although the products are not gone altogether, they are offered by far fewer carriers, and have significantly higher premium requirements when coverage is still available.

Pension Plans

Another area where low interest rates have created new challenges is in the world of pension plans. Because the fundamental framework of pension plans requires the plan sponsor to make contributions to the plan to fill any shortfalls, the ongoing low interest rate and low return environment is making it almost impossible for pensions to earn the returns they need. After all, with a long-term return assumption of "merely" 7%, when the 10-year Treasury barely earns 1.5%, equities would need to return 12.5%/year for the next decade (which at a 2% dividend yield requires over 10%/year in appreciation alone!)! To say the least, these returns seem somewhat unlikely and unsustainable; if/when/as they fail to manifest, businesses are forced to allocate a portion of their cash flows to retirement plan contributions instead of other business uses.

As a result, many large companies have been seeking to terminate their pension plans entirely, and convert to alternative retirement plan options that do not put such cash flow pressures on the business, and/or that entirely shift the responsibility of shortfalls to workers (who can choose to contribute more or work longer on their own). In addition, several legislative changes in recent years have also tried to relieve the funding pressures on businesses to contribute to their pension plans - although unfortunately, if the low returns persist, the shortfalls will just increase until a final reckoning occurs.

In the case of small businesses, the low return environment is actually a double-edged sword. On the one hand, persistent low returns means small business need to be warned that estimated contributions (based on standard actuarial assumptions) may in reality underestimate what required contributions will really be as the low return environment plays out. On the other hand, for small business owners with a lot of excess cash flow, this may actually be good news - it means they can contribute even more to their pension plans on a tax-deductible basis, although they won't necessarily know exactly how much the contribution will be until the returns do (or rather, don't) occur.

But the bottom line is that unfortunately, one of the indirect unintended consequences of persistent low interest rates is that businesses with pension plans may need to take advantage of low rates by borrowing, just to fund their pension plan shortfalls that occur as a result of the same low interest rates!

Is The End In Sight?

Low rates rates will not persist forever, and at some point will normalize. Nonetheless, it's not necessarily clear how soon the adjustment will happen. While many financial planners have preached the rising risks of rising interest rates for many years, the fact remains that since the financial crisis and the dramatic monetary interventions that occurred, rates have only gone lower, not higher. Recent research by Reinhart, Reinhart, and Rogoff on debt overhangs suggests that the problems could in fact extend far longer; the average duration of debt overhangs is approximately 23 years, and in roughly half of those scenarios real interest rates persisted at below-average levels throughout most/all of the episode.

Thus, while on the one hand planners must prepare clients for the risks and opportunities of rising interest rates in the future, it's also worth noting that some of the problematic effects discussed here could actually continue to play out in the form of low interest rates for a remarkably (and unexpectedly?) long time to come!

So what do you think? How have low interest rates impacted your clients and your planning? Are you seeing other areas of planning impacted by low interest rates, besides investment attitudes, insurance products, and pension plans? Are you planning for higher interest rates? Have you done any planning for the risk of persistently low interest rates? What would your clients be doing differently right now if interest rates were at more "normal" levels?


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  • Robert Wasilewski

    Typically I would put the fixed income allocation into AGG to match the Barclay's Aggregate Index and forget about it. Today with AGG loaded with low yielding/high duration Treasuries because of the deficit/Fed monetizing the debt policy I have to be more creative and use some junk bonds, overload investment grade bank notes, emerging market debt etc. Not too difficult to get 2.5% - 3% yield with minimal risk IMHO.
    Still, a basic low cost, well diversified basic allocation of 65% stocks/35% bonds is up over 11% year to date and was up last year. See:
    http://rwinvesting.blogspot.com/2012/10/year-to-date-performance.html

    So low rates not a problem from my perspective.

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  • Joyanta

    Simply brilliant article.
    I am actually scheduled to see my pension adviser and will be asking about some of these thoughts.

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