Monday, October 8, 2012

Pimco confirms the Retirement Plan Death Spiral

In an article on Pimco's Viewpoints, the author discusses how low interest rates reduce earnings on savings in both pension plans and individual retirement accounts and this in turn reduces demand as the loss in earnings is offset by lower current consumption and postponement of retirement.

This discussion confirms the Retirement Plan Death Spiral that is triggered by zero interest rate and quantitative easing policies.
The math of what happens when assumed rates of return go down is pretty straightforward. To make up for this, those approaching retirement have three choices: a) save more, b) work longer, or c) tighten their belts in retirement. 
Each of these are clear, individual family choices, but what happens when the whole of society is faced with the same dilemma? What works for one household can be grossly sub-optimal for society....
All of us who have been at PIMCO more than a few years have had the concept of the paradox of thrift drilled into our skulls by our former colleague Paul McCulley:  If everyone saves more, we consume less, and therefore GDP growth slows down. Anemic growth leads to a Fed on hold for a prolonged period....
Less explored is the linkage between “working longer” and interest rates. The right side of Figure 1 shows a possible feedback loop for that cycle – which has the same end result as the Paradox of Thrift, but gets there through a different mechanism.

Here we see low rates leading to longer periods in the work force which would lead to a higher fraction of older Americans continuing employment. By construction, if labor force participation goes up, unless jobs go up proportionately, unemployment will rise. Given the Fed’s dual mandate – 1) fight inflation, 2) stimulate growth/lower unemployment – the central bank’s natural response will be to keep rates low, thus completing the circle.

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