There is a retirement crisis, but not the one you hear about. This crisis comes down to risk. People in many developed countries, like the US, UK, and Australia, must finance their own retirement. We often hear they are not saving enough, but that is not their biggest problem. It is that they must bear a tremendous amount of risk to finance their retirement and their only options to reduce that risk has never cost more.
It is true we don’t save enough. But that is always true. But by most measures, retirees are not actually worse off than previous generations. Those wonderful gold-plate pensions of years past have mostly disappeared in the private sector, but not that many people had them. In fact, between Social Security and higher rates of savings because of 401(k)s, poverty in retirement is at its lowest levels.
But one thing that has changed for the worse is that we’re now on our own. Everyone is responsible for managing the complex financial problem of saving during their working years, and spending when they retire. This involves dealing with different sources of risk: the risk the stock market will crash, the risk you’ll out live your money, the risk you’ll need to finance a serious health event. You can deal reduce this risk by hedging your investments or insurance and both have become much more expensive in the last 25 years. It all comes down to interest rates.
Hedging involves balancing your exposure in stocks by investing in low risk assets, like bonds. This is also how pension funds de-risk. As bond yields fell over the years, hedging has never been more expensive because low risk assets offer such a low return. This means we either have to save more to make up for lower returns or accept more risk in our portfolio.
Insurance is another option. For example, you can buy an annuity, a type of insurance product which makes regular payments during your retirement. But low rates make annuities very expensive. Insurance companies base their prices for annuities on interest rates, the market rate for a regular stream of income. Twenty-five years ago when a 10-year bond yielded 6%, $500,000 would buy you an income of $40,000 a year for 20 years, now with rates at 3%, it only buys you $31,000.
Low interest rates are often assumed to boost the economy, by allowing employers to expand by borrowing cheaply. But for some sectors of the economy there are costs when low-risk assets become so expensive. It makes servicing pensions more expensive for states, municipalities, and the few companies left with defined benefit plans. And it also makes a low-risk retirement out of reach for many households. We still don’t now how that will impact the retirement of Baby Boomers. With less money available, it could mean retirees are nervous to spend their savings, or that they’ll run out of money sooner than they planned if markets crash.
Interest rates are starting to creep up, and that poses costs for employers and home buyers. But it also offers benefits, mainly that low-risk will be more affordable.