J. Andrew Concannon

Senior Partner

Low Interest Rates Require More Savings

October 2016
Central bankers across the developed world continue to rely on low or even negative interest rates to spur economic growth. The resulting low returns on bank accounts and bonds, they believe, will cause individuals to spend more and save less.1 And this increase in spending will in turn boost economic growth. This all sounds logical coming from the mouths of central bankers. Their fellow citizens, however, are not on board with the program.
Figure 1 shows that household savings rates across the U.S., Europe, and Japan have actually risen in recent years. Why would people choose to save more money when the interest rates they earn on it are so low? The answer is simple: Because they need to.


The Effect of Low Interest Rates on Investment Returns

Long-term investment returns contain two parts. The first part is the risk-free return, which in the U.S. is typically measured by the yield on 1-month Treasury bills. The second part is the risk premium, or the extra return received for accepting the risks of price volatility and actual loss. The amount of risk premium varies by asset class. For example, the average annual risk premium for a 20-year U.S. Government bond over the past 90 years was 2.2 percentage points, as the average annual return was 5.6% versus 3.4% for Treasury bills.2 U.S. large company stocks over the same period provided a larger risk premium of 6.6%, reflecting their higher level of volatility and potential for loss.These figures are before taxes and investment expenses.


If we assume for simplicity’s sake that risk premiums will remain the same going forward, then investors’ expectations for annual returns should fluctuate with changes in the risk-free return. Applying this assumption to the current risk-free return of just 0.2%4 suggests a 3.2 percentage point reduction in the expected annual returns for various asset classes versus their 90-year averages. It is this large decrease in expected returns that requires people to save more to reach their goals or to spend less in order to make their savings last.


To illustrate the current size of this challenge, let’s look at a 45-year old with a $500,000 portfolio and a goal of growing it to $2 million by age 65. Assuming a balanced portfolio of stocks and bonds, the annual return over the past 90 years would have averaged approximately 5.4%, net of taxes and investment expenses. At that annual return rate our saver would need to contribute $1,312 per month to reach her retirement goal. However, if you reduce the net annual expected return to 2.9% to account for the current low level of interest rates, the required monthly contributions jump to $3,446.5



Our example is an extreme case because it assumes the unlikely scenario that interest rates stay at current levels throughout the entire 20-year period. Should interest rates rise, long-term returns will likely rise as well. However, it illustrates the need for people to save more and spend less—which are the opposite behaviors that current central bank policy is intended to encourage. It also illustrates why central bankers need to rethink their current low-interest-rate policies.


A Good Thing That has Lasted Too Long

Lowering interest rates can initially provide positive stimulus to an economy. The drop in interest rates allows individuals and businesses to borrow at lower rates or refinance current debts at lower rates, thereby improving their cash flow and financial flexibility. It also allows banks to earn more by dropping rates paid on deposits faster than the rates charged on their loan portfolios.


But there is a limit to how long low rates can positively stimulate economic growth. Nearly eight years into the Federal Reserve’s low-interest-rate program, it appears we are past that limit. Individuals and businesses have long ago refinanced debts at lower rates. And banks of late have faced declining profit margins because there is no room to lower deposit rates in order to offset falling interest rates on loans. Add to these issues the need for individuals to save more to reach their financial goals and it’s easy to see why central bank policies are not having their intended economic effect.


Federal Reserve officials, being an intelligent group, are well aware of these issues. But there are many other issues officials must consider in setting interest rate policy, such as the relative strength of the U.S. dollar and the cost of financing the federal government’s massive debt. Recent Federal Reserve talk about raising interest rates, however, may be an indication that officials realize that low rates are no longer providing positive stimulus to the economy.


We, of course, have no say in when central banks will move to raise interest rates. But even if they were to begin raising rates today, it will be some time before interest rates rise back to their long-term averages. Given that, a policy of saving more and spending less seems wise.


1 This is just one of several positive effects that central bankers hope low interest rates will have on their economies.

2 Ibbotson® SBBI® Long-Term Government Bonds and Treasury Bills 1926-2015

3 Ibbotson® SBBI® Large Company Stocks 1926-2015

4 The 2016 year-to-date average yield for a 1-month U.S. Treasury bill

5 Results are based upon month-end contributions and even return distributions. Net returns reflect the deduction of 1% annual investment expenses as a percentage of market value, and a 20% tax rate on all earnings. Actual results will vary.


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