Allow me to introduce the Oldster Tax. It is a tax for which there is no legislation. It is a tax that is not administered by the Internal Revenue Service. Instead, it has been imposed by the Federal Reserve, an institution that has the power to set interest rates.
The folks at the Fed don’t call it a tax, however. They call it a policy—ZIRP, for zero-interest-rate-policy.
Low interest rates are a two-edged sword. It’s great if you are a young borrower. A low interest rate mortgage means you can buy a bigger house. A low interest rate car loan means you can buy a more expensive car. The hope at the Federal Reserve is that young borrowers will splurge and stimulate the economy with their borrowing.
Sadly, the sword cuts the other way if you are a retired saver. After decades of saving, millions of oldsters are discovering that their savings earn next to nothing. Savings earn less than nothing if you consider inflation and taxes. Basically, the Federal Reserve has been trying to boost the confidence and living standard of the young— and paying for it by attacking the living standard of the old.
Can you avoid the Oldster Tax? Yes. Be poor. Have no savings.
You can understand the impact of the invisible tax on the elderly by watching the decline of interest income from $50,000 invested in a 5-year Treasury obligation. As recently as 2000, this would have yielded about 6.15 percent and an interest income of $3,075 a year. Now the same obligation is yielding 0.7 percent and an interest income of $350 a year. This is the lowest yield on this maturity of Treasury debt since the Federal Reserve started keeping an index of the yields in 1953.
But it’s more than a low interest rate. It’s an income decline of nearly 89 percent in just 12 years.
So here’s a tough question: How much would the standard of living of retirees decline if current conditions persisted into the distant future?
To measure this I created an imaginary retiree couple, Mr. and Ms. Pennywise, and used ESPlanner consumption-smoothing software to see how much their standard of living would decline under a variety of investment return assumptions.
Here’s what we know about the couple. They are both 65, just retired from their $45,000 a year jobs. They have regular savings of $90,000 and retirement account savings of $270,000. They own their $240,000 house free and clear. Supporting the house costs them $4,800 a year for taxes, $800 for insurance and $7,000 for utilities, services, repairs and replacements. Each receives Social Security benefits of $1,500 a month.
What does their retirement look like? Well, if their regular savings earn 5 percent and their retirement accounts earn 8 percent in a balanced portfolio and inflation averages 3 percent— figures that (believe it or not) represent historical norms— they would enjoy a constant, inflation-adjusted discretionary income of $35,578. This is the money they would have available to spend every year for the next 30 years after paying for taxes, Medicare premiums that rise faster than inflation, and all of their shelter expenses. At the end of the 30 years their savings would be exhausted, but they would still own the house.
If something like the present continues— a 1 percent yield on savings, 5 percent on a balanced portfolio and 3 percent inflation— their discretionary spending would drop to $26,414, a decline of 26 percent.
If things get worse and we have yields of 1 percent on regular savings, 3 percent on a balanced retirement fund and 4 percent inflation, their discretionary spending would fall to $20,988, a decline of 41 percent.
Is this how it would affect every retiree? No. Retirees with smaller nest eggs would be less affected because more of their income comes from Social Security and less from investments. Retirees with more in savings, however, would be more affected because a larger proportion of their income comes from savings.
How will lower returns affect you?
It all depends on your income, marital status, whether you own or rent, whether you have a mortgage, etc. But you can find out for yourself by going to basic.esplanner.com and using the free version of the consumption-smoothing software I have used as the basis for many columns.