Why interest rates wi ll remain low, and what that means for your retirement security
If you are saving for retirement in an RRSP or a company defined contribution pension plan, your retirement security might well depend on the future direction of interest rates.
Gone are the days when long-term government bonds yielded four per cent more than inflation. Back then, any investment looked good, especially compared to today’s environment when interest rates in most developed countries still languish near record lows. Yields on 10-year government of Canada bonds are less than two per cent. The situation in the United States and Europe is similar. Low rates make it hard to achieve good returns on one’s retirement savings and unless rates rise, it will be equally hard to generate decent retirement income when the time comes.
One would think that interest rates fell so far because of the unusual short-term economic conditions following the Great Recession of 20082009. In the aftermath, companies and individuals opted to conserve cash rather than borrow, while the central banks (the U.S. Federal Reserve in particular) flooded the monetary system with liquidity to force interest rates even lower. If this were the only reason interest rates are so low, it would only be a matter of time before they rise again.
It is increasingly likely that the real reasons for low interest rates are more complicated, which means a return to so-called normal levels will not happen for a long time to come. A powerful force is at work and its effect will not dissipate any time soon. In a word, the problem is demographics. As highlighted in a paper by Michael Walker (published by the Fraser Institute in January), the aging population has been slowly changing the delicate balance of savers and borrowers, reaching what appears to have been a tipping point around 2010, at least in North America.
The basic idea is that older people tend to be savers, especially people between ages 50 and 75, while younger people (under 50) tend to be borrowers. When the ratio of “old” to “young” (in terms of population) is very low, the supply of funds that can be made available for borrowing becomes scarce. Borrowers have to compete for those scarce funds and are forced to pay higher interest as a result. In 1990 for instance, that ratio was 27 per cent in both Canada and the U.S. which, in hindsight, proved to be very low; this explains why interest rates were so high at the time.
The “old” to “young” ratio has been climbing ever since, thanks to three factors:
1. People are living longer, which makes the saver group larger than it would otherwise be.
2. Fertility rates are dropping, which means the borrower group is growing more slowly. The fertility rate (average number of births per woman) in the U.S. and Canada was 4 in 1960, but is now well below 2.
3. Baby boomers grew older and transformed themselves from borrowers to savers over the past 15 years.
As a result, the ratio of “old” to “young” climbed to 42 per cent in Canada by 2010. Given what is happening globally, it seems that a ratio of 40 per cent is a tipping point. Below that, it is still more or less a saver’s market and above that, it is a borrower’s market. The ratio in 2010 was a little more than 40 per cent in Europe and slightly less in the United States.
While this phenomenon has taken most of the developed world by surprise, it is something we should have seen coming. All we had to do was look at Japan, which had a 20-year head start on us, demographically speaking. Japan’s “old” to “young” ratio first surpassed 40 per cent around 1993 and is now about 60 per cent. For the entire time, Japan has been gripped by an economic malaise, has flirted with deflation and has seen its long-term interest rates remaining stubbornly close to zero. While we used to think these symptoms were strictly a Japanese phenomenon, we now find the same happening in other countries with “old” to “young” ratios of 40 per cent or more.
As the chart shows, we cannot expect relief anytime soon. The ratios will continue to climb in all developed countries beyond 2030 and, if the Japan experience is anything to go on, it means we may be mired in low interest rates and low inflation the entire time.
Besides the impact on interest rates, this aging trend is also responsible for sluggish economic growth. As a result, stocks are unlikely to perform as well as they have historically. This might seem a surprising conclusion given that stock prices have tripled since the end of the 2008-2009 recession, but that rise took place from a very low base and was spurred by declining interest rates. Neither of those factors will help to raise stock prices in the future.
If you think that China will bail us out because we benefit indirectly from their dynamic, young population, then think again. China’s ratio of “old” to “young” has indeed been low, being only 20 per cent up until 2000, but it has been climbing quickly. Their ratio is expected to exceed 40 per cent for the first time by 2020 and then breach the 50 per cent threshold by 2030.
The most likely outcome for savers is lower investment returns, higher savings rates and later retirement.