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Will Negative Rates Finally Kill Pensions?

piggy bank with 'retire' written on it, suggesting the savings for a defined benefit retirement plan.
photo courtesy the American Advisors Group (aag.com)

Economists once thought that negative interest rates were impossible. Not only are they possible, but they may hasten the end of a dying business practice.

I have written in this space before about the repercussions of other countries issuing bonds with negative yields. The past decade has conclusively proved that negative interest rates are not only possible but likely to remain part of the international financial landscape. Negative interest rates are now entrenched in many parts of Europe, as well as Japan. By mid-2019, bonds with negative yields had surpassed $17 trillion worldwide. Some economists have expressed concern that countries that let interest rates go negative will have a hard time returning to positive rates in the future even as conditions improve.

As for the United States, there is no particular mechanism that prevents our interest rates from going negative, as former Federal Reserve Chairman Alan Greenspan observed in August. Investors are earning less than they used to from U.S. government debt – approximately 1.8% on 10-year Treasuries, compared to an average of 3.5% over the past 20 years – but they are still getting back more than they invested. Yet the economic circumstances look precarious from certain angles. The Fed has lowered rates three times in 2019. The central bank seems unlikely to raise them again anytime soon, though recent remarks from Chairman Jerome Powell suggest more cuts are not imminent either. This year’s cuts do not mean negative rates are inevitable; far from it. But they do mean the central bank will have a limited number of further cuts available in a future situation where it needs to stimulate the economy. As I’ve said in the past, keeping rates low now is no guarantee that interest rates will go negative. But it increases the odds that they could.

If negative interest rates do arrive in the U.S., they will affect our lives in a variety of ways. One of the less obvious results, but one that would have a major impact on many Americans’ retirement plans, is that negative rates could be the fatal blow to the defined benefit retirement plan.

Defined benefit plans are already on the ropes in this country. In contrast to defined contribution plans like 401(k)s, defined benefit plans provide a guaranteed income when workers retire. This places the burden of funding the plan and investing its assets on the employer, rather than the worker. Defined benefit plans were once common, but they have become less so over the past 30 years. According to the Labor Department’s Employee Benefits Security Administration, the overall number of defined benefit plans fell by about 73% between 1986 and 2016. Workers in some parts of the public sector still have access to defined benefit plans, but you rarely see these plans in the private sector. Only 17% of private sector workers had access to a defined benefit plan in 2018, according to the Bureau of Labor Statistics, and only 13% of workers took part.

Part of the reason for this shift is that defined benefit plans have become increasingly difficult and costly to administer. Plans are struggling to meet their obligations in the face of low investment returns. In addition, workers are living longer on average. Together, these changes have increased the amounts employers must contribute to prevent their plans from becoming dangerously underfunded.

My colleagues and I have written for years about the struggles of employers to meet pension obligations, in both the public and private sectors, as well as the painful consequences for workers on the other end of those broken promises. While benefits are guaranteed by the Pension Benefit Guaranty Corporation, that agency is chronically underfunded. Companies have tried to staunch the fiscal bleeding using a variety of strategies. Some have frozen their plans, meaning new hires cannot enroll and workers already in the plan cannot accrue further benefits. Some plans have considered merging in search of economies of scale. Still others are offering lump-sum payouts to retirees to stop the plan’s liabilities from growing further. Many have had to resort to cutting benefits for retirees.

In a low-interest-rate environment, defined benefit plans can be painfully expensive. If interest rates go negative, the exercise of funding them moves from hard to potentially impossible. Many pension managers have large portfolio allocations to low-risk bonds, to ensure they can make payouts when liabilities are due. In a negative interest rate environment, investing in government bonds means a guaranteed loss over time. In essence, employers would need to set aside more today than they will owe years from now. This is the complete opposite of how these funds were designed. Employers were meant to take advantage of high investment returns, compounded over time, to comfortably meet their obligations to workers without having to shoulder a significant burden along the way.

Most private sector companies already find defined benefit plans unsustainable in a low but positive interest rate environment. It seems likely that a negative interest rate environment would lead the private sector pension to its final demise. Government jobs may continue to offer defined benefit plans, in part because they are subject to different accounting standards. Yet as workers become more and more accustomed to defined contribution plans – and as municipalities and states continue to suffer funding shortfalls – I would not be surprised to see public sector pensions vanish as well.

No one can predict the future, including the future of U.S. interest rates. We may not ever see negative interest rate policy in this country. But it isn’t impossible, and if we do, it will serve to hasten defined benefit plans’ long, slow decline.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He wrote Chapter 12, "Retirement Plans"; Chapter 15, "Investment Approaches And Philosophy"; and Chapter 19, "A Second Act: Starting A New Venture." He also contributed to the firm’s book The High Achiever’s Guide To Wealth.

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