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Researchers: Persistent Low Interest Rates Weigh on 401(k) Savings

You may have read about the impact of prolonged interest rates on defined benefit plans – but researchers say they have an impact on 401(k)s and individual retirement savings as well.

A new paper by The Wharton School’s Olivia Mitchell and Goethe University Frankfurt’s Vanya Horneff and Raimond Maurer explains that, “Persistent low returns can compel workers to save more and invest differently when allocating across stocks and bonds. Moreover, the low interest rate environment can also change retirement decisions, especially regarding how long to work and when to claim Social Security benefits.”

The researchers’ lifecycle model simulates 100,000 independent life cycles based on optimal feedback controls for each of six population subgroups and integrates what they describe as “realistic tax, Social Security, and minimum distribution rules, as well as uncertain income, stock returns, and mortality.” As a baseline, they found a large peak at the earliest Social Security claiming age at 62, which, as they note, is in line with the evidence. Baseline results also produce a smaller second peak at the (system-defined) full retirement age of 66. This they cite as confirmation that their “model produces realistic results that agree with observed work, saving, and claiming age behavior of American households.”

Based on that modelling, the researchers draw the following conclusions regarding saving behaviors during periods of low returns.

People are predicted to save less during periods of low returns (or perhaps as it is stated elsewhere in the paper, “in the low return environment, workers build up less wealth in their retirement plans.” The researchers also explain that, “when the interest rate is low, people work fewer hours per week early in life, compared to workers in the higher interest environment,” also contributing to lower savings rates).

People finance consumption relatively early in retirement by drawing down their 401(k) assets sooner. “When the real interest rate is low, a worker can delay claiming Social Security in exchange for higher lifelong benefits, and the cost of taking more from his retirement count to support consumption is lower,” according to the paper. That’s certainly a rational approach, and one increasingly touted by financial planners – but is it what is happening now?

During low-return periods, workers are predicted to save less in tax-qualified accounts and more outside tax-qualified plans. Or at least until retirement (here the researcher rely on a rational argument that the tax advantages of saving in 401(k) plans are relatively less attractive, inasmuch as the gain from saving in pretax plans is lower, and because the return on assets in the retirement account are lower in a low return environment – though this would seem to ignore some of the obvious advantages and incentives for saving in those retirement accounts).

Low interest rates drive workers to claim Social Security benefits later, ostensibly so they can take advantage of the relatively high payoff to deferring retirement under current rules.

Now, if these projections don’t seem to match what we see in the real world (aside from the Social Security drawdown patterns, anyway), the researchers note at the outset that their research focuses on “how people might optimally respond to a persistently low return environment by adjusting their consumption, saving, investment, and retirement patterns compared to what used to be perceived as the 'normal' environment.”

All of which would might mean more if people could be counted upon to respond “optimally” in the real world.