Savers have a problem: interest rates are likely to be very low for many years. In the UK, bond markets expect five-year yields to be just 1.2% even in five years’ time. In Germany they expect yields to be just 0.3%. Both imply negative returns after inflation.
Things are a little better in the US, but not much: even in five years’ time, markets expect five year bonds to yield only 0.6 percent after inflation. Savers therefore face lousy returns not just today, but for years to come.
Central bankers hope you’ll react to this by spending rather than saving. And if you must save, they want you to buy shares and company bonds rather than keep the money in cash. Buying shares and company bonds saves companies money, thus encouraging them to invest more.
Through these mechanisms, among others, low interest rates are supposed to stimulate the economy. But there are good reasons why you should not do what central bankers want you to do.
Want to bet?
Markets expect bond yields to stay low for many years because they fear economic growth will be weak. This isn’t the right situation for holding lots of shares. Yes, those fears might prove mistaken – but it’s a brave man or woman who’ll bet a lot on that. More likely, low interest rates and low bond yields mean low returns on shares too.
Worse still, low returns on financial assets generally mean, of course, that your wealth will grow more slowly, so you’ll need to save more to reach a particular target level of wealth. For example, if you’re saving for a pension over 30 years you’ll have to save 18% more each year to get the same pension pot if annual returns fall from four to three percent.
This poses a difficult question which hasn’t got anything like the attention it should: how should we prepare for retirement in the face of potentially long-term poor returns?
How to prepare
Here are three tips. First, start saving as soon as possible. The power of compound interest means that over a long period, even low returns can add up nicely. If you save £1,000 a year for 30 years at three percent a year, you’ll end up richer than someone who saves £1,000 a year for only 25 years at four percent.
Secondly, prepare to work longer. This means finding a job you enjoy, or at least can tolerate. It also means developing general rather than job-specific skills, so you can stay employable in the face of unpredictable changes in the job market.
Thirdly, you may need to give up hope of leaving a bequest for any children. One way to maintain your living standards in retirement in the face of low returns is simply to run down your wealth, leaving nothing behind.
Maybe growth will pick up
Of course, we might get lucky and this advice will be unnecessary. Maybe financial markets are wrong to expect persistently low interest rates. Maybe the economy will pick up, raising interest rates and returns on financial assets. It would, however, be unwise to bet everything on this.
Here’s a better answer for an inherently unpredictable world where it’s impossible for individuals to save the right amount for retirement. The job would be better done by governments. Not only can governments pool the risks involved, but permanently low interest rates reduce their future liabilities, allowing them to pay better pensions. It’s for reasons such as these that most developed economies pay decent state pensions.