Implications of Negative Interest Rates on Retirement Plans

A few short years ago, the idea of a country having negative interest rates would have been considered unthinkable. Yet, persistently low inflation and the sluggish global economic recovery have caused central banks around the world to push interest rates below zero.  While negative interest rate policies (NIRP) were initially considered a temporary measure to further stimulate demand and tackle deflationary pressures, they are increasingly becoming the norm.

The European Central Bank was the first major central bank to experiment with NIRP in 2014.  However, policy makers in Sweden, Denmark, Switzerland, and, most recently, Japan, have followed their lead.  These policies are having a significant impact on the market in 2016 and creating meaningful challenges for investors’ retirement portfolios. 

Here’s what you need to know:

What are Negative Interest Rates?

During normal times, investors can expect to receive interest income from their fixed income investments. This is true whether you hold a money market instrument, a 10-year government bond, a higher yielding corporate security, or a bond mutual fund.  While yields have fallen significantly over the last three decades, bond investments still generate some income (at least here in the U.S.), albeit very limited, based on historical standards.  

But what does it mean when a bond instrument has a negative interest rate?  It means that the interest rate and principal payments collected from investments are now worth less than what investors paid for it; or in other terms, investors are paying for the privilege of lending their money to a government or institution.  While this may sound counterintuitive, it is happening in many countries across the globe. 

Why Would a Central Bank Set a Negative Interest Rate?

Since the onset of the financial crisis, central banks have actively experimented with unorthodox policies to boost lending, spur inflation, and reinvigorate the economy. With global growth still languishing and deflationary pressures showing no signs of easing, some central banks have lowered interest rates into negative territory in an attempt to further kick-start their economies. 

Theoretically, lower/negative interest rates should encourage banks to lend and households to borrow and spend. The subsequent increase in demand should place upward pressure on wages and prices, and help push inflation back towards the central bank’s target.  It can also cause a country’s currency to weaken, which should improve trade competitiveness for its exporters.

Are the Negative Interest Rate Policies Working?
It is still too early to judge whether the negative interest rate policies can deliver a sustained rebound in economic growth and lift inflation.  However, there are growing concerns that the unprecedented negative interest rate policies followed by many of the world’s leading central banks are doing more harm than good.  

For example, the negative interest rate policies have caused bank profitability to decline and margins to come under pressure, which has resulted in a rout in bank stocks. Consumer behavior has also started to adjust to this new reality, and there are tentative signs that many are choosing to save more, rather than spend and invest. This is a major reason why global growth continues to languish.  Foreign currencies, such as the Japanese yen and the Euro, have even appreciated in value, as opposed to the expected weakening.  

These unintended consequences have made it more difficult for central bankers to revive their economies, and appears to have punished savers without stimulating growth in a meaningful way. 

How Have Investments Been Impacted?

It was not that long ago when retirees were able to generate a reasonable return on their savings.  As early as 2007, many savings vehicles still generated yields in excess of 5%.  However, as zero interest rates were ushered in after the Great Recession, these same savings vehicles no longer generate any income.  Fortunately, the U.S. has not had to experiment with negative interest rates; however, if the economy were to slip into a recession at some point in the future, negative interest rates in the U.S. could become a real possibility. 

The government bond markets have not been immune to the global forces at play.  While the structural decline in interest rates over the last few decades remains intact, the negative interest rate policies followed by other central banks around the world have accelerated the pace at which developed market bond yields have fallen this year.  Exhibit 1 shows a quick look at the yield curves of the world’s three largest developed economies - the U.S., Japan, and Germany. With the exception of the longest dated maturities, almost all Japanese and German yields are trading with negative yields. U.S. bond yields have, thus far, bucked the trend.

Source: Bloomberg as of 10.11.2016

Exhibit 2 illustrates how rapidly negative yields have spread throughout the bond market in 2016.  As you can see, nearly one-third of the JPMorgan Global Government Bond Index, a widely-used benchmark for funds in Morningstar’s World Bond category, were trading at negative yields in mid-June.  As of July 15, 2016*, Fitch Ratings estimated that there is approximately $11.5 trillion of global sovereign debt trading at negative yields.  This is astounding.  Some managers have even started to suggest the bond markets are exhibiting signs of being in a bubble. 


Negative interest rates have also spilled over into the corporate bond sector. Companies such as Nestle, Royal Dutch Shell, and Novartis have been trading at sub-zero rates for more than a year**.  Since sovereign debt is regularly used as a reference point for pricing corporate bond spreads, it is only a matter of time before more corporate bond yields are dragged into negative territory.

Why Would an Investor Own a Bond with a Negative Interest Rate?

This is a logical question.  A rational investor faces a trade-off:  they can either choose to hold cash as opposed to accepting a negative interest rate, or seek higher returns elsewhere by investing in a riskier asset.  Unfortunately, pension funds and insurance companies do not have the same choice, as they are required to own bonds, regardless of the level of interest rates, to meet their reserve requirements or match the duration of their pension liabilities. 

Investors may also be willing to purchase bonds with negative yields if they expect yields to decline further (and prices to appreciate) or are concerned about a “flight to quality” in the financial markets.  Since high quality government bonds are perceived as safe-haven assets, investors tend to flock to these securities during periods of heightened market stress or extreme risk-aversion.  An example of this occurred after the British voted to leave the European Union in their June referendum. The surprise outcome led to a sharp decline in global bond yields, with the 10-year U.S. Treasury yield tumbling to an all-time low of 1.38%.   

However, the average investor or retiree purchases bonds or bond mutual funds as part of their overall asset allocation strategy to provide safety and stability to their portfolios during market downturns.  While bonds and bond mutual funds remain an important diversifier, many investors have increasingly looked towards equity alternatives that provide similar characteristics and higher yields than traditional bonds.  

From an investing standpoint, it is clear we are living in unusual times when investors are willing to buy bonds for capital appreciation and equity funds for income. 

What Should Retirement Plan Investors Do?

While interest rates continue to hover near record lows, and in some cases negative territory, it is still appropriate to own bonds as part of a long-term diversified portfolio allocation.  As stated above, this is because bonds or bond mutual funds act as a shock absorber when equity markets tumble. This remains true whether yields are currently positive or negative.  However, retirement plan investors should review their asset allocations and be aware of the unintended risks in their portfolios. The three most important areas where misconceptions can lead to unintended consequences for retirees center on duration, global diversification, and credit or yield risk.  

Duration risk is one of the key determinants of volatility and total return of fixed income investments.  Generally speaking, the longer the duration, the greater the sensitivity to a move in interest rates.  With bond yields declining precipitously this year, long duration bonds have generated extraordinary returns in 2016. For example, the 30-year U.S. Treasury bond has delivered a nearly 17% return through the end of Septmber.  With interest rates so low, retirees should be mindful that the risk-reward profile of longer duration bonds is skewed to the downside. Should interest rates rise to where they started at the beginning of the year, these safe-haven investments would produce sharply negative returns. 

Global diversification has also long been a strategy to reduce risk and provide greater opportunities to enhance returns for fixed income allocations. While this remains true, investors should pay close attention to the composition of the underlying indices many foreign bond investment managers follow.  For example, nearly 90% of the Citigroup World Government Bond index is comprised of the investments in the U.S., Japan, and the European Union.  As the Japan and European central banks have reduced interest rates into negative territory to counter deflationary pressures, bond yields across the majority of the maturity spectrum are now trading below zero.  Retirees who use foreign bonds in their asset allocation may want to consider managers who are not as constrained to a developed market only mandate.
Retirees should also be cognizant of the credit risks associated with their investments, particularly as many have allocated an increasing portion of their savings into riskier corporate debt, and sometimes equities, to generate a reasonable return.  While high yield and equity income alternative investments are important diversifiers in your asset allocation, retirees must be aware of current valuations and the potential risks.  Should the economy fall into another recession, face an unanticipated shock to the financial system, like the massive decline in oil prices last year or another bank failure, or a sudden rise in interest rates, credit/yield sensitive risk assets could quickly come under pressure and erode past investment gains.  As always, investors should ensure their allocation is appropriately sized relative to their risk constraints.  

Investors should ensure their retirement plan assets remain properly diversified to help their portfolio withstand any future market volatility.  Diversifying risks will lead to better, more stable performance over time.  Most importantly, retirees should re-assess their savings contributions to their retirement plan. In this new normal of low/negative interest rates and low expected returns, any opportunity to increase savings will go a long way in helping to achieve retirement goals. 


Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

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