Numbers are a frequent topic of conversation among people working on Wall Street. We can debate which number is the most important, but a number that looms large in the minds of many traders, sales representatives and bankers is the number that tells them they are done — they have saved enough so that they can leave the toil of the Street either to retire or pursue a lower-paying occupation that provides them with more satisfaction, more time with their family or whatever else in life that gives them more fulfillment.
The topic came up on a recent trip to New York City in a couple of encounters with longtime friends. My friend Joe was reflecting on a 20-year career selling bonds and was contemplating a downshift in his career to spend more time with family. He has been reasonably successful, lived well within his means and invested prudently but fairly conservatively. We discussed another friend, who told him, “You should have it made by now.” Joe's response was: “That's [expletive]. You can't assume you are going to get 7% anymore. I don't know what the right number is, but I know it's gonna be a heck of a lot lower than that. People who plan their lives based on the old assumptions are in for a world of hurt.”
Welcome to the New Normal personal-financial-planning sector. Now it's not just Wall Streeters and others in the infamous “1%” — or even the top 10% — who need to think about lowering return assumptions and what that means. Going forward, it's the ever-increasing number of Americans whose retirements are largely dependent on the returns they get in their 401(k)s and individual retirement accounts.
THREE CHOICES
We speak daily with institutional clients who are ratcheting down their expectations for returns. By and large, they still have a long way to go to get to what we believe are prudent forecasts. Trailing behind them in this journey to the land of diminished expectations — aka reality — are most households and individual financial planners.
The math of what happens when assumed rates of return go down is pretty straightforward. To make up for this, those approaching retirement have three choices: 1) save more, 2) work longer or 3) tighten their belts in retirement. Each of these is a clear choice that each family must make, but what happens when the whole of society is faced with the same dilemma? What works for one household can be grossly suboptimal for society.
For now, let us assume that Americans would reject the idea of committing now to significant belt-tightening in the future. They may find that when they get to retirement, they have little choice, but few people would choose this before the time comes. All of us who have been at Pacific Investment Management Co. LLC for more than a few years have had the concept of the paradox of thrift drilled into our skulls by our former colleague Paul McCulley: If everyone saves more, we consume less and gross domestic product growth slows down. Anemic growth leads to the Fed Reserve's putting monetary policy on hold. If expectations for how long the Fed will be on hold are extended, low interest rates — particularly real ones — are the result.
PARADOX OF THRIFT
Given that the personal savings rate is a low 4.2%, significantly below the 6.9% average over the past 50 years, it is hard to argue that we are experiencing the paradox of thrift — at least not yet. We believe that there is a distinct wedge between households' desired savings and what actually can be put away, given budget constraints. Less explored is the linkage between “working longer” and interest rates.
The presumption is that if low interest rates make it more difficult for Americans to save money, they will end up staying in the workforce longer, even after normal retirement age. By construction, if labor force participation goes up, unless jobs go up proportionately, unemployment will rise. Given the Fed's dual mandate (fight inflation and stimulate growth/ lower unemployment) the central bank's natural response will be to keep rates low, thus completing the circle.
The crux of the argument hinges on two things: first, if elderly labor force participation goes up and there is not an offsetting drop among other age groups, and second, whether there is empirical proof that low rates can be linked to higher labor force participation among older Americans. With respect to the first item, if there were a compensating drop in labor supply among other age cohorts, causing the unemployment rate to be unchanged, that would be unambiguously bad, as these individuals are of prime working age. This would indicate serious structural issues and would likely be paired with slow economic growth.
TIED TO A HOT AIR BALLOON
Research shows that the lower rates go, the greater the inertia of the elderly to stay in the workforce. It makes sense that elderly participation fell in the 1960s, given the passage of Medicare under the Johnson administration and fell still further when more-generous benefits were granted in
Social Security during the Nixon years. Increases in the
Social Security normal retirement age phased in after reform legislation in 1983 induced gradual lengthening of working careers.
Intuitively, low rates leading to longer work lives just makes sense — especially in an era where fewer retirees will draw defined-benefit pensions. For those relying more and more on IRAs and 401(k) plans for retirement, the income produced is simply a product of portfolio yield and account balances. They alone bear the risk of market volatility and their own mortality. If anything, we would expect this to tie labor force participation more strongly to yield levels.
This is why some of us are wondering if the Fed is spinning its wheels by sticking to the old model of trying to stimulate growth. Maybe instead of pushing harder on the credit demand side of the ledger by doggedly keeping rates low, central-bank policymakers might benefit by looking at other parts of the equation — specifically, those parts of the puzzle that become more important as America ages.
Work a little longer. Save a little more. Get by with a little less. It's like each of our numbers is tied to a hot-air balloon that seems to rise higher as we get a little closer. Given our outlook for growth and the Fed's renewed commitment to keeping rates at “exceptionally low levels,” at least through mid-2015, it could be quite a while before those numbers are within reach.
James Moore is a managing director at Pimco. He leads the global liability-driven-investments product management team and is co-head of the investment solutions group.
