Record Low Interest Rates…What’s Really Going On? – Part 2

Have you read part 1 yet? If not, simply click here to read the 1st part of this blog series.

In last week’s blog, I stated that government-provided retirement programs will ultimately need to be cut. The basis for my conclusion is that the present value of the unfunded obligations of these programs is greater than the entire net worth of American households.

Some readers will argue that as government retirement programs are not funded like a pension plan (they are funded on a pay-as-you-go basis), the difference in present value of liabilities vs. household net worth doesn’t matter.

Let’s look at this problem from both perspectives.

Based on information at the Social Security’s own website (PDF), the Social Security trust fund is projected to be exhausted in 2033, with automatic cuts to benefits estimated at 23% as required by law.

Between now and 2033, one or more of the following will need to happen to keep Social Security benefits at the current level:

1. Taxes are increased.
2. Benefits are cut.
3. Other government spending is reduced,  allowing for additional amounts to be spent on Social Security.
4. Neither taxes, benefits, nor other programs are cut and benefits are financed entirely through additional government borrowing.

The third and fourth options above would also necessitate legislation, which would significantly change how the current Social Security system is financed.

That is a lot of uncertainty!

Changes to fix Social Security are relatively modest compared to the necessary actions to bring Medicare into balance. None of the above addresses similar retirement-plan issues existing at the state and local levels, but the broad solutions for Medicare and the states are similar to those listed above. Options 1, 2 and 3 all require that someone takes a haircut either workers, retirees, or other government workers/contractors.

So, why would the above lead to disinflation, or worse, deflation?

Let’s consider inflation. Grade school taught us that inflation is an increase in prices because there are “too many dollars chasing too few goods and services.”  So, disinflation/deflation would be caused by “too few dollars chasing too many goods and services.”

Why are “too few dollars” expected to be in circulation ultimately leading to disinflation/deflationary expectations reflected in record-low bond yields?

Every year that passes without a fix to the structural imbalances of government-provided retirement programs means the fixes will be increasingly Draconian. Not knowing if, when, and how one will be affected means that all who are potentially affected will be more cautious in their spending patterns, not just those who will actually be affected.

The reason for this rationale is simple. If one thinks his/her income in the future will be reduced, the rational thing to do is adjust one’s spending today to better align with future income levels.

In some sense, any solution to the imbalances in government-provided retirement programs would be better than waiting for a fix because everyone would be able to plan accordingly and stop hoarding cash (for those who actually have cash).

How did these imbalances happen? It’s not just one thing but many:

1. Greater chance of drawing benefits. -The probability of actually making it to retirement age to begin drawing benefits has improved dramatically. In 1960, the expectation was that only 60% of men and 71% of women would live to age 65. Now, the expectation is 80% of men and 88% of women will do so.
2. Drawing benefits for longer. In 1960, the life expectancy of a person age 65 was 13.2 years for men and 17.4 years for women. Today those values are 19.3 and 21.6, respectively, which is six years longer for men and four years longer for women!
3. Less people supporting more retirees. The proportion of workers (i.e., those paying into the system) to those retired (and drawing benefits) has decreased significantly due to lower birthrates and longer life expectancies. In 1960, there were 5.1 workers for every retiree. This amount decreased to 2.9 in 2012 and is projected to be 2.1 in 2031.
4. Stagnant wages. The inflation-adjusted median household income was $51,681 in 1989 and just $51,017 in 2012. There were lots of ups and downs in between, but essentially the middle has not moved in 25 years. This income stagnation reduced  the amount that would otherwise have been taxable and contributed into the system.

In summary, compared to original financial projections (and even as modified when the system was changed in the 1980s), there are more people drawing benefits for longer periods of time, with less people paying into the system and earning less to be taxed.

You don’t have to be an actuary like me to do the math and see it doesn’t work.

So what are the implications for employers?

The obvious ones are:

1. Employees are going to want to work longer.
2. Transitioning to part-time employment prior to a full retirement will become more and more the norm.
3. Top-tier employers will provide the tools and support for employees to transition to part-time work, then to retirement.
4. Keeping a healthy workforce will be more difficult and  critical to company performance.
5. Access to health care will become even more competitive.
6. Access to quality of health-care providers will become the standard rather than the exception.

High-performing employees have always been the differentiating feature between good and great companies. Being aware of, and planning for, the financial and demographic challenges of our future workforce will be critical for companies to survive and thrive over the next ten to twenty years.