What is a 'real interest rate' and how does it affect retirees?

Ever wonder how interest rates affect you? Wonder no more.

  • By Alessandra Malito,
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Inflation may be climbing, but real interest rates are still relatively low. Because of this, retirees may want to adjust their saving habits accordingly.

If global capital markets are to continue generating low returns in the future, Americans might change how and when they retire, according to a newly released research paper by researchers at the Geothe University in Frankfurt, Germany, and the Wharton School at the University of Pennsylvania in Philadelphia. A low-interest world generates less income on investments, which would inevitably affect long-term funds, including 401(k) plans and Social Security. The researchers looked at “real interest rates,” which differ slightly from the nominal interest rates officially assigned to investments. The real interest rate takes into consideration the change in purchasing power after inflation.

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Men and women reacted similarly to these rate changes, whereas higher-educated individuals changed their behaviors more than those with less education, the study found. The researchers analyzed previous research about decision-making during surprise rate adjustments and market movements, as well as overall consumption, investments and saving strategies.

So, how will retirees be affected?

Retirement plans are thinner

Retirement accounts, such as 401(k) plans, see less of a return in a low-interest environment. When the safe yield, or a conservative measure of the return of an investment, is 0%, women between 45 and 54 years old earn about $145,000 in their 401(k) plans, compared with women in a 2% yield environment, who accumulate 20% more (or $168,400). Men would earn $176,000 in a zero-rate environment, compared with $206,700 in a 2% environment.

“The gain from saving in pretax plans is lower in a low return environment, depressing the tax advantage of saving in 401(k) plans,” the researchers said.

Also, many employer-sponsored retirement plans experience a drop because they use the Target Date strategy, which invests portfolios according to when the person is expected to retire. As people age, these plans begin to invest more in bonds than stocks (to reduce risk), but those asset allocations can be hurt substantially by interest rates — especially for older workers and retirees.

As a result, wealth inequality is most narrow during times of low expected returns, according to the study. Savings reductions are notably low for higher-educated individuals whereas in a high-interest environment, college-educated individuals save 30% to 40% more (likely because they’ll see greater returns on that money).

People claim Social Security later

When the long-term interest rate is 0% instead of 2%, average claiming ages rise by about a year and average work hours jump 5%, the study found. Fewer men and women claim at age 62 when interest rates are low — only 35.5% of women and 24.2% of men do so when the real return is 0%, compared with 46.1% of women and 37.2% of men at a 2% real return.

Lower interest rates almost always encourage people to claim later in life, in an attempt to get a maximum benefit. “The higher the portfolio return, the less value there is to delaying and the more beneficial it is to simply start Social Security early,” Michael Kitces, partner and director of wealth management for Pinnacle Advisory Group, wrote in his blog “Nerd’s Eye View.” In a low-interest environment, it serves retirees no purpose to cash in on those benefits as they won’t see much of a return in cash or Social Security benefits. Instead, Americans will get a bigger check just by delaying (the longer you wait to claim Social Security, the more money you’ll get). Of course, this isn’t possible for everyone. Some retirees need to claim as soon as they can if they don’t have enough saved for retirement.

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