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2015-12-15 12:11:47
Dec 10th 2015, 10:42 by Buttonwood
A LOW interest rate policy is designed, in part, to make people save less and spend more. The problem is that this approach eventually hits a wall. That is because the biggest reason people need to save is to cover their retirement, when they need to convert their savings into an income. And then low rates have a perverse effect.
Say you want a $20,000 private income (indexed to inflation) in retirement to top up your state pension/social security. The size of the pot you need depends very much on the income you can generate. So look at this simple table
Income rate Size of pot ($)
5% 400,000
4% 500,000
3% 666,666
2% 1,000,000
How many people have a million-dollar pension pot? If 2% seems a low income rate, remember that US TIPS - the only way of guaranteeing an inflation-linked income - yield just 0.7% (real yields on long-dated index-linked gilts in the UK are actually negative). Even getting 2% depends on taking some risk.
So even a shift from an assumed payout rate from 5% to 4% requires one to save 25% more. No problem, you might say, that pension pot will be invested not in cash, but in equities, which have rebounded strongly since 2009. True, but if you take a longer-term view, the S&P 500 is only about 40% ahead of its 2000 level (or about 2.5% annualised capital gain. Add in dividends of 2% and take out costs of 1% and you are talking about a 3.5% return). In the UK, the FTSE 100 is below its end-1999 peak (briefly surpassed this year).
Going forward, as we argued recently, investor returns are likely to be lower than they were in the past, because starting valuations are higher. Indeed, this year has illustrated the point. The S&P 500 is practically where it was 12 months ago, the MSCI world is slightly down, emerging markets have been terrible, and commodities have slumped.
Keynes's paradox of thrift was that, if everyone tried to save more, demand would fall, GDP would decline and, on average, everyone would be worse off. But this paradox is that, rationally, low rates should cause people to save more in the long run, not less. The personal savings rate in the US is 5.6%, double the level of 10 years ago. But it is a long way below the 10-12.5% range from 1960 to 1980. Perhaps people simply haven't figured out the problem or perhaps given the failure of real income to rise, they simply haven't been able to afford a higher savings rate.