Wharton’s Olivia S. Mitchell speaks with Wharton Business Daily on SiriusXM about how low interest rates could impact retirees.

Retirees took another wallop from COVID-19 with the Federal Reserve’s announcement two weeks ago that it expects to hold interest rates near zero at least until 2023 because of the pandemic. That spells lower returns for retirement accounts, and it adds to the underfunding of pensions that has worried retirees for many years now.

The implications of lower returns on investments are that retirees may save less, dip into their retirement savings, and start collecting Social Security benefits earlier than planned, according to Olivia S. Mitchell, Wharton professor of business economics and public policy and executive director of the School’s Pension Research Council.

“Low returns from the market are essentially a tax on retirees,” Mitchell said in a recent episode of the Wharton Business Daily show on SiriusXM. (Listen to the podcast above.)

“In the good old days, people used to ladder their bonds, put a little bit of money in the market, and try to live off those returns,” Mitchell noted. (A bond ladder refers to investments in bonds with varying maturities so that a portfolio does not get locked into one type of bond.) “This is not feasible any longer. In fact, it’s even worse, because those lower nominal returns are in many cases negative in real, or inflation-corrected, returns.”

Retirees may respond to the prospect of low returns by saving less, Mitchell said: “If you’re not rewarded for deferring your consumption as much, then why do it?” Their savings would fall especially in tax-qualified retirement plans, she predicted. The tax-qualified feature is helpful for those who aim to build an asset base over time with interest and other returns on their investments, while they are in relatively lower tax brackets. But now, “those build-ups are simply not happening the way that people had planned,” she said. “If people do save, they’ll probably save less overall, and they will tend to save in other non-tax favored accounts like bank saving and checking accounts, where you’re lucky if you’re earning half a percentage point.”

Desperate Times

Mitchell recalled that the 2008–2009 global financial crisis was “a bath of cold water for retirees, savers, pension funds, insurance companies, and so on.” However, back then, an economic recovery followed, and “the labor market didn’t suffer as badly as it has during the COVID-19 pandemic, and for as long as it has,” she noted. Nowadays, people’s perspectives on retirement have changed and they are looking to work a little longer. “But the question is, can you even find a job, especially if you are an older worker?” she asked.

In times of desperation, some people may claim their Social Security benefits sooner than they may have planned — despite the fact that every year of delay could boost their eventual benefit by 7% to 8%, Mitchell said. “People who don’t have any retirement savings may have to go ahead and claim their [Social Security] benefits early, thereby experiencing a lower payout the rest of their lives.”

Others that have lost jobs have drawn down some of their 401(k) savings. Since April, they have been living off the government’s “economic impact payment” of $1,200 per individual (an additional $500 for each child), and the expanded unemployment insurance benefits contained in the $2.2 trillion CARES Act. “Those have now tapered off, and Congress has not yet been able to come in with a new COVID financing bill,” Mitchell stated. Some people might consider options like starting their own small business, but “this is a pretty tough environment in which to start a new business,” she added.

The 2020 CARES Act permitted individuals to make early withdrawals up to $100,000 from 401(k) and 403(b) accounts without penalties. That hasn’t caught on so far because the economic stimulus payments provided money to cope with the pandemic in the short term. However, it may not be possible to stave off early withdrawals from retirement accounts for too long, said Mitchell.

“Going into the fall and winter, I do worry that [early withdrawals from retirement accounts] will become more of an option if the labor market doesn’t recover,” Mitchell said. “And so, people might end up biting off their nose to spite their face. Yes, they’ll get some cash, but what does it say about their retirement? Not much [that is] good.”

“The first and most important thing that needs to be done by policymakers is to bring Social Security back into solvency.”

A Perfect Storm

Also looming is the possibility that the Social Security Trust Fund could run out of money by 2029, rather than 2032 or 2034 as had been predicted by the Penn Wharton Budget Model after the pandemic struck. This could happen “since people aren’t paying the payroll taxes needed to keep the system afloat and potentially because people are claiming [their benefits] earlier,” said Mitchell. “The first and most important thing that needs to be done by policymakers is bring Social Security back into solvency.”

For sure, pension funds and insurance companies have also been suffering from low returns, Mitchell continued. “Many of the state and municipal pension plans are probably not going to make it through this COVID crisis with any healthy amount of funding.”

As it happens, pension plans are facing “a perfect storm” now, said Mitchell. They faced the 2008–2009 financial crisis without being fully funded, but in later years “continued to invest in risky assets, hoping to make it up in the great capital market lottery.” During the pandemic, many pension funds lost 30% to 40% of their value, and the forecasted low returns will make it “very difficult for them to survive,” she added.

In that seemingly hopeless situation, Mitchell saw annuities as a “potentially appealing” option for retirement planning. Annuities are insurance products that pay an income in retirement. Even if the insurance investments held by annuity providers don’t make much money, investors who outlive others in their pool will be eligible for survival credits (also known as mortality credits), she noted. She suggested that it is a good idea for employers and retirement plan sponsors to include annuities in 401(k) and 403(b) accounts, now permitted by the Secure Act since late 2019.

Mitchell’s recent research volume on How Persistent Low Returns Will Shape Saving and Retirement may be downloaded for free.