Why Low Interest Rates Increase the Cost of Your Personal Pension Plan

Retirees and those saving for retirement should think of themselves as the managers of their own personal pension plan.  

Many people used to have access to a traditional, defined benefit pension plan through their employers.  With a defined benefit pension plan, someone else (an employer or professional managers hired by an employer) assumes responsibility for managing plan contributions, investments and income distributions. 

For most of us, the defined benefit pension plan has been replaced by the 401(k) and individual retirement accounts (IRA).  As a result, many millions of people are now responsible for managing their own contributions, investments and income distributions.  

In other words, the world is now full of millions of people who have to manage their own personal pension plan. 

If you are in the position of managing your own personal pension plan, then you need to think about your savings, investments and retirement income the way that a professional pension plan manager would—especially when it comes to today’s super low interest rates.  

A professional pension plan manager thinks in terms of assets and liabilities.  The assets consist of employer and employee contributions.  The investments that those savings are channeled into are also considered assets. 

The liabilities are the future payments or income distributions that need to be made to retirees. 

The pension plan manager is responsible for making sure that contributions and investment returns are adequate to support those future pension distributions. 

Interest rates play a critical role in this relationship between assets and liabilities.  

The reason is that a pension liability represents a future cash payment, and interest rates are the key ingredient in placing a present value on this future payment. 

When interest rates are low, the cost in today’s dollars of a future payment is higher. 

For example: 

• When interest rates are 5 percent, the present value or cost of a $10,000 payment made 5 years from today is $7,835. 
• When interest rates are 2 percent (as the 10 year Treasury is today), the present value or cost of a $10,000 payment made 5 years from today is $9,057 

A pension plan manager uses the future liability valuation to make decisions about investments and possibly about the amount of contributions that are required to support those future income promises. 

For example, maybe the asset allocation mix becomes more aggressive in an attempt to increase investment returns.  Another approach may involve increasing the amount of money coming into the plan in the form of pension contributions. 

You should think about retirement income planning the same way.  You also need to use your savings (your asset) to support a floor of future income (your liability) that will fund your spending during retirement. 

Low interest rates increase the cost of your future retirement income needs.  Every time interest rates decrease, the level of that retirement income floor increases—it is sort of like a seesaw.  

The options available to you in light of low interest rates include: 

1. Increase your personal pension plan contributions (save more). 
2. Adjust your personal pension plan investment policy (invest more aggressively). 
3. Reduce your personal pension plan distributions (ratchet down your retirement income). 

Each of the options above is pretty tough medicine, but the “save more” option is likely the most realistic and palatable for those who still have time to make the adjustment.