The cruel punishment of savers and retirees

Back in March, we had an introduction to negative and zero (NIRP and ZIRP) interest rate policy. The idea is that short-term deposits or bonds actually charge you interest for the privilege of holding your liquid assets.

You might accumulate cash in a safe deposit box until you ran out of space, to avoid paying for the safekeeping.

Is that why there is talk of even eliminating the $500 or $100 bill? Central banks, especially in Japan and Europe, have been big buyers of bonds such that prices are forced upward limiting the supply available, thus creating negative returns.

Why do the banks do it? If cash is trash, so to speak, then it will be put to work in some kind of investments. The problem is that those with the cash, both individuals and corporations, don’t see many opportunities with appropriate risks and returns, so cash continues to build.

According to Merrill Lynch 28% of bonds in the developed countries have negative yields. Who buys this stuff?

One line of thinking is that negative yields could get even more negative, thus producing a gain in bond prices.

The other is the fear of deflation, which would cause the erosion of value in many asset types.

If it’s fear of deflation, paying off debt is job No. 1. You can see this in the high number of real estate foreclosures and short sales in our area. Surprisingly, despite low interest rates when deflation is a concern, savers and businesses don’t spend, they save even more. If there is a relative shortage of attractive investments, liquidity happens.

It’s just as if you were lost in the desert with a pocket full of money. You would spend it all for a gallon of water, but there is none; therefore, your money becomes worthless.

The central bank policy of low or negative interest rates assumes that it will cause people and businesses to borrow cheaply, financing an increase in the demand for goods and services.

Well, they can throw out that textbook. Not much has happened in the last eight years. What seems to have happened is more saving and reduced demand. Policies intended to solve the problem may in fact have made things even worse.

Even in “General Theory of Employment, Interest and Money,” economist John Maynard Keynes saw interest rates as the price of liquidity. The more liquid credit becomes, the lower the rate, and the less liquid (longer term) the higher the rate.

Keynes said that a lower interest rate will not necessarily stimulate employment. The lender needs rates sufficient to cover expenses, taxes, as well as risk. He correctly observed that cutting rates gets progressively less effective the closer to zero you get.

Investors know that negative or near zero interest rates are abnormal. What happens when conditions return to a more “normal” state?

• For one, the stock market will be without the support of money forced to leave liquid and safe places like savings accounts, which is now largely in stocks because there is nothing else. The central banks are undoubtedly aware and not likely to do anything too drastic very soon, in my opinion. They are stuck in a trap of their own making. They really don’t know the exit strategy needed to return to traditional interest rates without causing a recession and stock market decline, and by the way, neither do I.

Lower corporate tax rates and reduced regulatory burdens would be helpful, but politically difficult. I think politicians would prefer to blame the Fed rather than upset some constituents that think everything comes from the government for free.

The longer we persist with the punishment of savers with low or zero rates, the worse the next problem becomes.

I am talking now about the one area where retirees are generally very dependent. It is pensions from private insurers and state or local government.

All these guarantees are based on an interest rate (portfolio earnings) from a past era. Connecticut is still assuming 8% investment earnings. (Connecticut Teachers Retirement Board)

Talk about the head in the sand. Private insurance companies have similar problems.

How do you reinvest income in today’s low yield era?

The answer is you can’t, and that’s why there will be defaults unless conditions change.

This might apply to insurance annuities in some cases as well.

This, as you can well imagine, has thrown a monkey wrench into all those fancy financial plans that assumed you could withdraw 5% each year and pretty much have a very low likelihood of running out of money.

Just like an annuity or pension plan, there is not enough income available for reinvestment and compounding required to fully fund future benefits.

Some pension funds, such as the state employees’ and teachers’ funds in Connecticut, are so severely underfunded that there is no politically acceptable way to raise contributions enough to correct the past sins of underfunding and overpromising.

For instance, according to Retirement Cheat Sheet, the state employees fund is No. 49 and only 49% funded.

Hey, we beat Illinois at 47%!

It is here, right at home where we see the folly of the central banks and zero or negative interest rates. The retirees who saved their entire lives or contributed to a pension or IRA now find it impossible to get sufficient dependable income. Ever notice all the seniors working at Lowe’s and Home Depot?

It’s not for recreation. It’s because they have a shortfall in their retirement income. The truly sad part is that the policy of zero interest rates is not producing enough economic growth for interest rates to rise very much if at all. This is going to be a problem that lingers for a long time.

The good news is there are a few pockets of quality higher income around in today’s markets. Combined with a conservative hedging strategy it is still possible to find double- digit income. Sorry, I can’t get specific as I am not allowed to make specific recommendations to a mass audience.

Update: The stock market continues to slog along. September and October have poor historic returns so caution is warranted. If you stick with income and hedging for additional income, the near-term direction is not so important.

Questions may be answered by contacting Don Hutchinson at 203-301- 0133.