Low interest rate environment

Why low excepted returns should lead to reconsider our retirement systems

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Raimond Maurer has conducted a study on the consequences of a persistent low interest rate environment on households’ behavior in the United States. He delivers its mains conclusions and recommendations.

You have tried to evaluate how persistent low interest rates influence households’ behavior. Does it imply that this is your scenario for the years to come?

Persistent low interest rates over one or two decades is an assumption for our study, which is based on US data. In regards of the past five years, my belief is that low interest rates are not temporary. Moreover, we notice no change in central banks’ behavior at the moment. Does it mean that we are heading towards a Japanese scenario? At this point, this is conjecture, but people start to consider the matter, when 10 years ago nobody would raise the topic.

In your opinion, what is the most significant impact of low rates on individuals’ behavior?

There is no simple answer on private households, because work and saving patterns as well as social security benefit claiming ages are all interconnected. We need to evaluate how big and fast the changes will happen, and try to accommodate.

That being said, it appears that this environment will not lead to much reduction of consumption. But, with low interest rates and then lower returns, Tax Qualified Retirement Plans, the US tax-deferred retirement accounts, quite similar to the French PERCO, are becoming less attractive, compared to other saving accounts. On the other hand, the public retirement system becomes more attractive, because even though interest rates are decreasing, the State is maintaining a constant price for the life annuities they deliver to individuals through the Social Security benefits. Our study also demonstrates that people should be ready to delay their retirement date in exchange for increased retirement benefits. This is very relevant for women, living longer than men.

Are the behavioral changes due to low interest rates the result of a conscious decision-making process?

In our model, this is a very rational behavior. Individuals are constantly optimizing those different items: budget/leisure/time spent at work/consumption. In a low return environment, if people have the opportunity of favoring saving versus leisure, they do not change their behavior. They do not change their consumption either. But we observe a strong willingness to work more, in order to save more. And the money saved is allocated to risky assets, allowing to capture the equity risk premium.

Working longer in turn raises two questions:

  • When do you claim your security benefits?
  • When do you retire?
In the US, we now observe the emergence of a gap between the two.

Are those observations homogenous across the population?

In the US, education – which school and college you attend – is a powerful marker of the level of job you obtain. Our study of six different calibrated groups showed that education is a crucial factor in the behavior. People evaluate their labor income risk, meaning what can happen with their earnings. Poor people still have low earnings, so behaviors do not change. Individuals with higher degrees need more money to finance their consumption when they retire, more mobility to adjust their standard of living. Most of people, in the US, still retire at the earliest possible date, which is 62 years old. And 40 % of the US households claim their social security benefits when they retire. In a persistent low interest rate environment, those figures are more than likely to change.

Do you think similar conclusions could be observed in Europe?

Labor markets are quite similar on both sides of the Atlantic: they depend on education and gender. However, the social security retirement benefits are less generous in Germany than in the US. For example, in the US retirement benefits depend on the average best 35 salary years, in Germany we have a point system including all years, also those with low salaries. In addition, incentives for working longer in Germany - which is our next object of study – are far below the ones in the United States.

A major difference also comes from the fact that, in Germany, the equivalent of the US Tax Qualified Retirement system has guarantees, which is not the case in the US. In a low return environment, those guarantees are expensive for banks and insurers. As a result, in Germany and in this particular environment, the retirement system becomes substantially less attractive because guarantees are expensive.

A pan-european pension product is now under discussion. It is based on a great idea: following the European citizen along countries, when working abroad. One of its objectives is also to protect the so-called uneducated consumers. So it might provide guarantees, an instrument used for protection. I warn again about how expensive those are. Their cost can make this new pension product ineffective.

There are other possibilities for bringing consumer protection. Life cycle investing and asset diversification might provide a solution, with higher yields and a protection through diversification. Well diversified, low-cost equity funds could be a good solution for the savings of private households. I would advocate for life cycle strategies even in the decumulation phase.

Do you have other recommendations?

After researching the topic over the last couple of ten years, I would not recommend a mandatory annuitization right at retirement. It is indeed too risky, especially in a low interest rate environment. If one must buy annuities at this time, he/she will get a low-payout for the rest of his/her life.

I would advocate for a protection over life, taking into account longevity, with deferred annuities. It means buying annuities at the age of retirement – for instance 65 years old, with benefits starting at an older age. Of course, it opens a discussion on what old age is. Pricing might be difficult, but we need to take into account that people, especially women, now live for more than 80 years. I also think that a flexible retirement age is an important component. In Germany, for instance, labor unions are very helpful and provide flexible labor solutions, such as part-time labor for close to retirement people.

Very few countries also managed to put in place a private reverse mortgage system. It is the case in South Korea, where it works well, through mutualized solutions. It is, moreover, supported by the government.

As an academic, I think that more research should be done on the situation of the private pension system in Europe and more importance given to longevity risk.

À retrouver dans la revue
Revue Banque Nºhof2019