CAN A NATION $17 TRILLION IN DEBT AFFORD HIGHER INTEREST
RATES
& Will This Change Our Retirements?
By Daniel R. Amerman, CFA .
http://danielamerman.com/va/Conflict.html
Very brief Introduction, by Hugo Adan
Not only young people
have no future under the current neoliberal system. Many older people do not
have it either.
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“The bottom line is that for people
to get the returns that they've been told they can expect with long-term
savings – and to enjoy the retirement lifestyles that go with it – they need
higher rates of interest than are currently available.
“If the federal government can't
afford substantially higher interest rates – it could be a very, very long time
before medium and high interest rates return. And if that is the case – tens of
millions of people may never achieve the compounding of wealth they were
anticipating for retirement, nor the level of cash flow they were counting on
after retirement.
“Before any problem can be solved,
the necessary first step is to recognize the existence of the problem. Which is,
in this case, to understand that a $17.5 trillion federal debt is neither
irrelevant to our personal lives, nor is it just a problem for the distant
future – but rather it is influencing and changing each of our lives every day
right now, and is likely to continue to do so for many years to come,
particularly as the debt grows steadily larger”. By D. Amerman
The United States federal government currently has about $17.5
trillion in debt outstanding. What this
means is that if the interest rate on that debt were to rise by even 1%, the
annual federal deficit rises by $175 billion. A 2% increase in interest rate
levels would increase the federal deficit by $350 billion, and if rates were 5%
higher, the annual federal deficit rises by $875 billion.
Clearly, the federal government cannot afford substantially
higher interest rates.
At the very same time, because of the current extremely low
interest rate environment, tens of millions of retirees and long term investors
have seen their returns slashed, with
potential reductions in their standard of living as well.
Could it be there is a fundamental clash between the
financial interests of the federal government and the financial well-being of
long term retirement investors?
A Mysterious Reduction in Interest Payments
The graph below shows the amount of federal debt outstanding
over the last 40 years. As can easily be seen, the federal debt exploded
upwards with the financial crisis of 2008, and began its meteoric rise to $17.5
trillion dollars outstanding.
See graph: Total Federal Debt http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
Now ordinarily if we think about having our debts balloon out
of control, we would expect to be making much higher interest payments. All
else being equal, if our debt doubles or triples then our interest payments should
double or triple. However, as can be seen in the graph below, this hasn't
happened for the US government.
See graph: Federal debt Interest Payment. http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
Indeed, interest payments by the federal government have
either been falling or level ever since the financial crisis began. How can this be?
The answer, as plainly seen in the graph, is that interest
rates have in recent years plunged to
their lowest levels in the last 40 years.
See graph: 10 Years Treasury Yield (from October 1973 to
October 1013) http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
The Real Reason for Quantitative Easing
Now if the federal government were an individual, one might
think that this was extraordinarily good luck. To have interest rates plunging
even as the amount of debt outstanding was soaring upwards.
And generally speaking, this is where a lot of confusion can
occur when trying to understand the debt and the deficit, because indebted
national governments which can borrow in their own currencies are nothing
whatsoever like individuals or corporations being in debt.
In the case of the United states, interest rates have been
controlled for some years now through the Federal Reserve and its program of
quantitative easing.
As illustrated in the graph below, at the very same time
that the federal deficit has been soaring, the Federal Reserve has been
creating quite literally trillions of dollars out of the nothingness and using
this newly created money to purchase United States debt – not directly from the
US government, but through the markets.
See graph: US Treasuries Held by the Federal Reserve. http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
In doing so, the Fed has taken control of interest rates in
the short term, medium term and long term in the United States.
There is nothing fortuitous or lucky about the low interest
rates, but rather the government is dealing with a huge problem that it has
with a very high debt level through quite deliberately taking control of
interest rates and keeping them very low.
The true purpose behind quantitative easing the entire time
has been to reduce interest rates for the United States government and for
mortgage borrowers.
The
Impact on Savers & Investors
So it is the deliberate and massive market interventions by
the Federal Reserve which slash the interest costs for a government that is
$17.5 trillion in debt – even while it simultaneously has reduced interest
rates to some of the lowest levels that savers and investors in the United
States have ever seen.
What is the impact for someone who is pursuing a long term
investment program, perhaps to fund a desired retirement lifestyle?
As can be seen in the graph below, a saver who invests at a
7% rate for 30 years can expect to turn a $10,000 initial investment into a
$76,123 investment, meaning their total earnings were $66,123. This is the math
that drives conventional long-term investment models – each dollar invested
creates another six dollars and more, thus savers who practice long-term
discipline are highly rewarded over time.
See Graph: Total Earnings over 30 years. http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
As shown, if we drop that interest rate to 1% – then the
profits earned over thirty years plummet from $66,123 to $3,478, which is a
reduction of 95%.
If interest rates turn out to be 2% on average, a saver
would fare better with earnings of $8,114, but that is still a reduction of
88%.
On the other hand, if the saver were able to get a 10% rate
of return, then their earnings would soar to $164,494, with that 3% increase in
interest rates leading to a near tripling of investment returns.
The "Miracle" Of Compound Interest
Most of financial planning is arguably based on what many
people consider to be the "miracle" of compound interest. The basic
principle is that if we engage in a disciplined process of saving and investing
money over a period of decades, then our wealth will compound as our money
works for us, building a surprisingly large amount of savings over the years.
This principle applies whether we're talking about actual
interest payments or assumed stock returns, and it is exactly why the advice is
so widespread to begin saving for retirement in our 20s and 30s. For the longer
the time period, the greater the compounding of returns and thus the more our
money works for us, rather than us working for our money.
However there's another factor that can be even more
important than the length of time invested, and that is the rate at which money
is invested.
The interest rate or rate of return is what drives the
compounding and creation of wealth, and when that drops too low – the fuel gets
cut off, so to speak.
So the paltry 1% rates that many savings and retirement
accounts are earning right now translate to losing 94% of anticipated earnings
relative to 7%, which could translate directly to a radically reduced
retirement standard of living.
The bottom line is that for people to get the returns that
they've been told they can expect with long-term savings – and to enjoy the
retirement lifestyles that go with it – they need higher rates of interest than
are currently available.
The Federal Government's Compound Interest Problem
While little remarked upon or understood, the United States
government has a compound interest problem of its own when it comes to the debt
and the deficit.
That is, tax revenues are not sufficient for the federal
government to make either principal or interest payments on the federal debt.
So each time a principal payment is due – the federal
government issues a new debt to get the money to pay off the old debt. And each time an interest payment is due, the
federal government issues new debt to make that interest payment. Indeed,
borrowing the money to make interest payments is the source of over half of the
annual federal deficit.
What this means is that the federal government has a
compound interest problem, as shown in the graph below. It's not just that the
level of interest rates goes up, but the amount of borrowing that must be
entered into to pay those interest payments rises sharply as well.
The exact same rising interest rates that would provide what
savers need – which is the rapid compounding of investment interest – would
simultaneously set off the extraordinary danger of a rapid compounding of debt
interest for the federal government.
See graph: US Federal debt Outstanding. http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
As shown in the graph, a 5% increase in interest payments
for the federal government would cause the level of federal debt to rise to $85
trillion over the next 20 years because of the compounding of interest, and a
10% increase in interest rates would cause the federal debt to climb to over
$200 trillion.
Shared Interest Rates, Opposite Objectives
Now if interest rates were entirely different for savers and
investors than they were for the federal government, this problem with the
government needing low interest rates on its extraordinary amount of debt would
not be an issue for savers and investors. Unfortunately, the opposite is true.
Whether explicitly stated or not, almost all interest rates
are effectively tied to what is known as the risk free rate, which is the
government bond rate. In other words, this federal borrowing rate is the base,
most other interest rates are effectively tied to that base, and therefore most
interest rates tend to rise and fall with the base federal rate.
So when interest rates on the federal debt climb, interest
rates on deposits, money market funds, bonds and mortgage securities all rise
as well.And when interest rates paid by the government on its debt
falls, all of these other interest rates usually fall as well.
So there is a sharing of interest rates so to speak, where
the interest returns received by investors very directly correlate to the
interest rates paid by the government. Which
means that we
have a huge conflict of interest between the objectives of savers and the needs of the government.
Impact On Retirement Standard Of Living
There is another crucially important factor which is not
just the returns when someone is building wealth by investing over a period of
decades, but also the lifestyle that can be afforded once one has actually
retired and is drawing down their portfolio to fund their lifestyle.
The graph below assumes $250,000 in retirement savings being
evenly drawn down over a period of 20 years, with nothing left at the end of
the 20 years.
Now the higher the interest rate, naturally the more the
interest income each year, which allows the principal to be drawn down more
slowly. So with higher interest rates, retirees get both higher interest
payments and larger average principal balances over time, which can combine to
make a surprising amount of the difference.
See graph: Retirement Cash Flow. http://futurefastforward.com/images/stories/financial/ANationOfUS$17TrillionDebt.pdf
So if we assume a 7% interest rate, as bonds have often
returned over the last 40 years, the $250,000 portfolio would produce $23,598
per year in cash available for spending.
If we were to increase that rate to 10%, the annual standard
of living would be almost $30,000 per year.
If on the other hand we were to drop it to 5%, the annual
standard of living that could be supported from these investments would fall to
$20,061.
Now the heart of the
issue with very low interest rates is that if someone holds their money in
short-term, high-quality investments that pay a 1% interest rate – then
specifically because the federal
government has suppressed interest rates to keep them down to a mere 1% – the
saver's income is only $13,854 per year for those 20 years.
At a 2% rate it would be $15,289.
While this is little remarked upon, it's the incredibly
important heart of the issue.
This drastic reduction in interest rates to serve the needs of a
heavily indebted federal government may drop retiree incomes by 30-50% for
decades relative to what they would
be with longer-term average interest rates.
So tens of millions
of retirement investors who are planning on supporting themselves primarily
with their investment portfolios and the rewards of their many decades of
disciplined savings may see their lifestyles drastically reduced – specifically
because the federal debt outstanding is now approximately 17.5 trillion
dollars.
It needs to be understood that the extraordinary amount of
federal debt outstanding and future retiree lifestyles are tightly linked
together.
Who Is Really Paying For The Debt?
Many well-intentioned older
people feel very bad indeed about the massive federal debt which they believe
we are leaving for our children and grandchildren to repay. And they are
correct in that we are leaving tremendous financial challenges for our children
and grandchildren, of which this extraordinary level of federal debt is a key
component.
There are many more people who don't worry or think about
the size of the national debt at all – and who have a strong desire to keep
things that way. Yes, they are likely aware that the federal government owes
some fantastic, almost surreal amount of money, but it doesn't seem to be
affecting their personal daily lives in any way that they can see – so they
just choose to ignore it.
Unfortunately, both groups of people – which is the great
majority of the population – could not be more mistaken when it comes to the
national debt being primarily a problem for the somewhat distant future.
For if we're talking about the value of the federal debt and
its repayment in the decades ahead, the debt is actually far more likely to be
paid in inflation or through a combination of inflation and
artificially-suppressed interest rates than by our children and grandchildren
toiling for decades to slowly repay the debt with dollars that have the same
value as today's dollar.
Rather than being some far-off burden for our children and
grandchildren to bear – the price of the massive amount of federal debt is
being paid in the here and the now.
Anyone who has been frustrated by the paltry returns on
their savings deposits, money market funds or bond funds is paying the
financial price for $17.5 trillion in debt right this minute. Just as they've
been paying the price for years now. And they are all too likely to keep paying the price for
years and decades to come.
Anyone who has a retirement account is paying a price.
Anyone who has or is entitled to a pension is paying the price, because that
pension may very well be in financial distress now or in the future because it
just can't get the interest earnings needed to meet its obligations.
Conversely – anyone who uses a loan to buy a car now or in
the future is likely to benefit from low rates. As will anyone who takes out a
mortgage to buy a house.
In some ways, the current extraordinary level of federal debt could be
likened to sharing our solar system with a financial black hole. Just because
people aren't seeing it every day – doesn't mean it isn't there. Whether seen
or not – the massive gravitational pressure dominates everything around it.
And every time someone saves, invests, retires or makes a
major purchase – the massive weight of that $17.5 trillion debt pulling
interest rates down through the corresponding governmental interventions
impacts their life, right that minute.
This "black hole" can be found in other nations
around the world as well, for the United States is far from alone when it comes
to having huge national debts with a rapidly aging population.
While this massive weight affects every part of society,
there is one group that is more affected than any other. That group is the
people who are following traditional retirement planning or other long-term
investment strategies.
Traditional financial planning doesn't take massive federal
debts into account, nor does it take into account the Federal Reserve creating
money by the trillions to force interest rates downwards. Instead, investors
are supposed to receive market interest rates that will reward them with a
compounding of wealth before retirement, and a generous cash flow after
retirement.
But if the federal government can't afford substantially
higher interest rates – it could be a very, very long time before medium and
high interest rates return. And if that is the case – tens of millions of
people may never achieve the compounding of wealth they were anticipating for
retirement, nor the level of cash flow they were counting on after retirement.
Before any problem can be solved, the necessary first step
is to recognize the existence of the problem. Which is, in this case, to
understand that a $17.5 trillion federal debt is neither irrelevant to our
personal lives, nor is it just a problem for the distant future – but rather it
is influencing and changing each of our lives every day right now, and is likely
to continue to do so for many years to come, particularly as the debt grows
steadily larger.
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