Low rates are a long-term threat to retirement funds

Kirsten Temple JANA’s Manager of Research discusses what low interest rates mean for those who are relying on investment returns.

‘Superannuation funds and their members face a conundrum: continue to target the same returns knowing that it comes with higher risk – and a greater chance of failing to hit objectives – or accept that the cost of retirement will need to be funded more by current income.

For each of us this is ultimately a trade-off between our current and future needs. It will be hard to put our future first while the economy remains fragile – but our future still needs taking care of.’

One casualty of the coronavirus pandemic may be the cost of your retirement. Although superannuation balances are looking a lot healthier than they were in March, longer term returns will be increasingly hard to come by.

The Reserve Bank’s decision to cut interest rates supports the economy and is great for mortgagees, but not those relying on investment returns. You need only look at the rate paid on term deposits or the yield of a bond fund today to know that retirees will struggle to get much income from the more stable cash and bond component of their retirement pot.

It seems hard to imagine now that back when I opened my Dollarmite account along with all the other kids in second grade, cash rates were in high double digits.

Even then, it took some convincing for me to part with my pocket money for what seemed like a small return. Little did I know, it was as good as it was going to get.

Low interest rates drive the price of growth assets (like shares) higher as investors who can’t achieve the returns they need from cash and bonds shift up the risk curve. That creates competition. When the price of an investment increases, the amount you need to invest to gain an income stream or a share of future growth is much higher.

Just as the amount you need to invest today in that term deposit to get your income stream is higher, so too is the amount you would need to invest in your diversified superannuation portfolio.

The superannuation system relies on an assumption that the value of your contributions will grow over time. The idea is that you can sacrifice less now from current income than you need when you retire because your investments will do some of the heavy lifting for you.

But with rates as low as they are today, it seems unlikely that the investment returns achieved over the nearly 30 years since superannuation was first mandated can be repeated going forward.

The notion of “lower for longer” is not new. Global central bank rates have been falling ever since the Global Financial Crisis. In June 2019, Australia’s 1.5% cash rate was considered relatively high and many were concerned that markets were overvalued.

That was before there was a global pandemic or an economic crisis to recover from. Yet markets have rebounded rapidly, and we are faced with high asset prices and a challenging outlook for future economic growth.

Just to complicate the situation further, the role of “safer” bond investments in portfolios is under question.

Bonds have traditionally provided investors with stable returns and have played defence when markets are rocky. This dynamic has supported the high allocations most superannuation members have to growth assets, allowing them to target a higher investment return and thereby contribute less current income to their retirement savings.

With a lower starting yield, not only is the income paid on a bond portfolio unattractive, the ability for bond prices to rise during equity market turmoil is reduced. Yields and bond prices are inextricably linked – when the bond price goes up the yield must go down. But with 10-year Australian Bond yields now below 1%, and US 10-year Treasuries yields at 0.60%, there is less and less scope for bond yields to fall further.

While we can’t completely rule out Australia or the US adopting negative interest rates, there appears to be a limit to just how negative investors will allow the bond yield to fall – even in a crisis. We saw this play out in March, with lower yielding government bonds failing to play defence effectively, while relatively higher yielding US Treasuries and Australian Government Bonds performed well on the back of rate cuts.

Superannuation funds and their members face a conundrum: continue to target the same returns knowing that it comes with higher risk – and a greater chance of failing to hit objectives – or accept that the cost of retirement will need to be funded more by current income.

This is not just a problem for individuals. It is a problem for Australia.

Compulsory superannuation was intended to reduce the financial burden an aging population would have on the age pension. It has no doubt helped with that problem to date and has given much needed income to many retirees, but we must now determine whether to continue with mandated increases in the superannuation guarantee in coming years – and whether these will be enough.

In my house I know I’m going to have a harder task convincing my children that parting with their pocket money is worthwhile at a 0.25% return. If interest rates go negative, it may well be impossible.

For each of us this is ultimately a trade-off between our current and future needs. It will be hard to put our future first while the economy remains fragile – but our future still needs taking care of.