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Retirement Savings in a Low Interest Rate Environment

As experts in public finance and public policy, Econsult Solutions, Inc.(ESI) has conducted detailed analyses on the preparedness of private sector workers for retirement, and evaluated policy and economic considerations associated with state and local programs. Recently, ESI performed a study for the Pennsylvania Treasury which quantified the net impact of savings shortfall on the economic and fiscal health of the Commonwealth of Pennsylvania. The study was released at a January 25th hearing on the Treasurer’s Private Sector Retirement Security Task Force, and can be found here. The issue of private retirement savings is increasingly being understood as a public policy challenge, given its significant (and growing) fiscal and economic implications. In this Present Value post, Christopher Swann expands on this important topic.

The Downward Drift

Western economies have experienced a secular decline in real interest rates across asset types in the last 30 years. The underlying economic causes may be due to secular stagnation, a global savings glut, or a scarcity of safe assets, the downward drift has been unmistakable. To be sure, the global monetary easing in the last decade after the Great Recession—designed to add liquidity to weak economies and stave off deflation—has been a contributing factor. Whatever the causes, the consequence has been a reduction in after-tax, real returns to saving, and that has had a profound effect on balances both before and after retirement.

In a presentation given to the Philadelphia Council for Business Economics (PCBE), held at the Greater Philadelphia Chamber of Commerce, and sponsored by ESI, James Poterba addressed the effect of low real returns on retirement savings and the extent to which tax policy might moderate the impact of a low interest environment on saving. Three important questions posed were, given the difference between pre-tax and after-tax returns: (1) how are retirement savings affected across cohorts of savers; (2) how has the choice of retirement vehicle (IRA- or Roth) been affected; and (3) what rate of accumulation is needed and what prescriptions can be offered?

As a backdrop, Poterba demonstrated from his research that real pre-tax returns on 10-year Treasuries dropped steadily over the last three decades, from over 4.0 percent in mid-1990 to about 0.1 percent by the end of last year. Post-tax returns consequently fell from just under 2.0 percent in mid-1990 to -0.6 percent last year, a negative after-tax return. Moreover there are low expectations that index-linked bond funds in the U.S. or globally will see much of a rise in yields in the coming decade.  The secular change in yield has therefore affected generations of savers. Those who were lucky enough to retire two decades ago, after accumulating in a much more robust investment climate, did substantially better than those who have been participating in savings vehicles since then. The incentives to save by younger cohorts are potentially diminished unless there are higher-return vehicles that reward aggressive efforts to accumulate. The tax effects on funds accumulated at a much lower return is an added impediment. With substantially lower returns, by 2017 the effective tax rate, as a share of the real return, increased over ten times its 53.2 percent rate in 1990. Since many households have both tax-deferred (IRA, 401(k) plans) and taxable (Roth, other) forms of saving, the tax effects will affect the allocations between them, and that choice can substantially effect the accumulation of household wealth. None of Poterba’s research would advise against participating in a tax-deferred vehicle, especially in the presence of matching funds.

What he does point out, however, is that the difference between the after-tax real return on tax-deferred accounts against the same for taxable accounts (the value of “inside build up”) has shrunk substantially since 1990; from 2.25 percent in 1990 to 0.68 percent in 2017. To some extent this results from investment choices by some savers in favor of less-risky, fixed yield assets or by investment in lower-yield mutual funds in some 401(k) plans, but marginal tax rates during contribution and accumulation versus upon withdrawal play a role. pexels-photo-164661What is clear is that slow accumulation of assets during working years results in low payout from that accumulation during retirement years. So with low real wage growth and low real interest rates, retirement wealth relative to final earnings ranges between 20 percent and 40 percent depending on the time of accumulation and the choice of assets, with higher accumulated wealth resulting from a higher proportion of equity relative to fixed income vehicles and with a longer saving horizon.

The question then is what is the savings rate that is necessary to increase retirement wealth to as much as one-half of final earnings? Poterba’s research suggests that over a short 20-year saving horizon, savers would need to boost the rate of savings by 28.0 percent with a 3.0 percent real interest rate prevailing and by nearly 50.0 percent with a 1.0 percent real interest rate. However while investors may be “reaching for yield,” evidence suggests that the rate of saving is not increasing, which is akin to saying that while the goalposts (wealth ratio) have moved, savers are not running faster. There are a number of factors that bear on this result; nevertheless the first objective of public policy is to raise the savings rates, including extending or restructuring existing taxable and tax-deferred vehicles. Incentives for staying in the workforce longer would yield the double benefit of lengthening accumulation time and reducing payout time. Finally some concern should address inter-generational impacts. Low after-tax returns in a low interest rate environment is just one part of a mosaic of issues involving future retirement payout and wealth inequality discussed in several papers presented at the American Economic Association meetings held in Philadelphia in early January.[1] Concerns and issues for public policy include:

  • With the decline in defined contribution retirement plans, lower income retirees have come to rely more on Social Security for retirement income.
  • The structure of 401(k) plans and the limitation of savings vehicles available to the public may deter lower-income individuals from accumulating wealth at all. Indeed, to the extent that end-of-life wealth reflects retirement wealth, roughly forty percent of individuals at the end of life have zero wealth.
  • The occurrence of a health event or a chronic health condition results in lower accumulated wealth and greater wealth disparity.


[1] Poterba, James, “Steven Venti, and David Wise, “Longitudinal Determinants of End-of-Life Wealth Inequality,” Revised August 2017.  Johnson, Richard W., “Delayed Retirement and the Growth in Income Inequality at Older Ages,” December 2017.  Ghilarducci, Theresa, Siavesh Radpour, and Anthony Webb, “Inequality in Retirement Wealth.”

Christopher Swann is an economist and Senior Advisor at Econsult Solutions. He is an adjunct professor of economics at Temple University and Drexel University.

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