Thursday, September 22, 2011

With Twist, Fed Takes Knife to Pension Funds

It is people saving for their retirement who are ruining the economy.

That, in drastically simplified form, is the theory behind monetary policy. In a recession, the central bank takes steps to lower interest rates, so that you can no longer put your money in the bank and earn interest. The hope is that you will withdraw your savings and spend it on something useful, and that will get the economy moving again.

Individual savers in the United States have not been earning real interest in three years. And now pension funds may face the same predicament, as the result of the Fed’s new Twist strategy to lower long-term interest rates.

The result is that, as of today, every pension fund in the United States is underfunded. Pension funds count on earning interest, mostly on long-term bonds, to provide most of the money for the pensions they have to pay. If the interest isn’t there, the sponsors have to put in more money up front, or the pensions have to be reduced.

Economic theory suggests that lower interest rates make people more eager to take risks, but most people don’t like the idea of taking those kinds of risks with their retirement funds, and pensions in the United States are no longer permitted to take the kinds of risks they routinely took a generation ago.

Nor are pension funds permitted to remain underfunded for long. By next year, employers and governments will be obliged to put more money into their pension funds as a consequence of the Fed’s new initiative. At the same time, individual savers who are paying attention may realize that they need to put more money aside too, to compensate for the risk that their pension payments will be smaller than planned.

Of course, if employers must put more money into pensions, they will have no money for raises or hiring, making it that much harder for individual workers to save.

In other words, by forcing individuals and pension funds to save more, the Fed’s latest initiative will create a drag on the economy that will last at least for two or three years and will not be quick to reverse after the Fed changes its mind.

Retirement savings, including pension funds, were already so large that they were a risk to swamp the financial system. Now, with the financial system in retreat from problems of its own making, and the Fed’s new policy forcing retirement savings to grow still larger, retirement savings have become a threat not just to the financial system, but to the economy as a whole. It is just what the monetary theory says. But the theory, in this circumstance, is acting as something of a self-fulfilling prophecy.