People talk about how even the darkest clouds can have silver linings. Today, let’s talk about the inverse of that – how even the brightest, most glittery silver linings can have clouds lurking nearby.
What I’m talking about is the downside of the amazingly low long-term interest rates that we’ve got in the U.S. these days.
On the surface, they’re a total blessing. But look beneath the surface and you can see all sorts of problems affecting pension funds; people trying to live off the interest on the savings they’ve accumulated over their lifetimes; and the future of Social Security.
Let me explain.
As I write this, 30-year U.S. Treasury bonds carry an interest yield of a tad over 2 percent, and corporations are lining up to sell billions of bucks of low-interest, long-term bonds before the debt markets come to their senses.
Those lower interest costs are great, right? They make it cheaper for the federal government to finance its trillion-dollar (and growing) budget deficits. They make it possible for companies to use low-cost money to expand (if they’re willing to risk doing that in the uncertain environment created by President Trump’s trade wars and general unpredictability) or buy other companies or buy back their own stock or just to keep around.
But there are problems associated with these ultra-low rates.
We’ll start with pension funds. The lower interest rates fall, the deeper the financial hole in which funds find themselves.
According to Piscataqua Research, a New Hampshire investment firm, by the end of next year, ultra-low yields will have added about $1.25 trillion to the funding deficit faced by the 127 public employee pension systems that Piscataqua analyzes. This would increase the systems’ total shortfalls to about $6.5 trillion.
What’s the problem? It has to do with how pension funds are supposed to calculate how many dollars they need to have on hand today to cover the payments they’re obliged to make to workers past and present. The lower the rates, the more dollars a fund needs to have today to handle tomorrow’s obligations.
For example, if a plan expects to have to make a $10,000 payment in 20 years and uses a 3 percent discount rate, today’s obligation for that future payment is $5,537. But if it uses a 2 percent rate, today’s obligation jumps to $6,730.
Then there’s a second pension-plan problem. Low bond yields make it more difficult for pension funds to meet their assumed investment returns on their assets, which Piscataqua says averages 7.23 percent for the funds that it covers.
That puts pressure on funds to offset the low income on their bond holdings. So it’s natural for the funds to be tempted to put more money into risky, high-cost investments such as private-equity and venture capital funds.
Loading up on such assets can make things look better awhile, because you can make all sorts of optimistic assumptions about the return these assets will make. However, history shows that just shoveling lots of money into high-cost, high-risk assets tends not to end well.
Indeed. As I’ve said before (and will probably say again), very low rates like the ones we have now are bad for retirees who want to generate safe, reasonable income on the savings they spent a lifetime accumulating. That’s especially true for retirees of modest means.
About a decade ago, with the U.S. stock market reeling and the world financial system threatening to implode, the Federal Reserve drove down interest rates to stimulate the economy and nudge investors to put more money into stocks.
That worked out great for people who had financial staying power to handle the risks of buying stocks when markets were in disarray and the Great Recession was upon us.
These days, with the economy strong but interest rates falling, people are being nudged into stock markets again – although this time, I don’t think the Fed is doing it on purpose.
But unlike a decade ago, stock prices are quite high. That makes stocks a riskier investment than they were back then, because they’ve got less upside and more downside.
And finally, lower yields on Treasury securities mean less income for the Social Security Trust Fund, whose $2.9 trillion of assets consist entirely of Treasury securities. The lower the trust fund’s income, the earlier the fund risks running out of money.
So enjoy low interest rates if you’re a borrower or would-be borrower. But don’t forget about the clouds lurking behind the silver linings.