Retirees have been keeping a close eye on interest rates for a while, many of them trying to offset years of near-zero rates by pouring money into long-term bonds that generate larger yields.
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Soon -- no one is certain exactly when -- the Federal Reserve is going to start raising rates and retirees need to adjust their investment strategies accordingly.
With interest rates at rock bottom for over seven years now, a lot of retirees have shifted money from other areas of their portfolios and invested in long-term bonds in an effort to chase the larger yields generated by those securities.
Now, with an interest rate hike extremely likely at least at some point in the next 12 months, financial advisors say retirees should trade in those long-term bonds for short-term securities.
“A lot of retirees have been chasing yields and they were taking risks they’re not aware of by going far out on the maturity ladder,” said Bernard Kiely, a financial planner in Morristown, N.J. “They’ll get the interest on their bonds but they’ll see their principles starting to drop. They should be getting out of long-term bonds and getting into short-term bonds.”
Many retirees gravitate toward bonds and bond funds once they are no longer taking home a steady paycheck because bonds are far less risky than stocks and because they generate a small but steady income if held onto for the duration of their maturity.
The Flip Side
“I’ve asked a lot of retirees if they understand the relationship between rising interest rates and declining bond principle and a lot of folks clearly don’t understand,” Kiely said.
For example, a 30-year bond that pays a 3% interest rate and was purchased by a retiree investor for $10,000 will lose some of its value (or principle) if interest rates move to 4% because investors can now get a 4% annual return on that same $10,000 investment.
Kiely said many retirees who have invested in low-interest long-term annuities will also get burned when rates start to move higher. As interest rates move higher so will inflation as higher borrowing costs push up the prices of everything from homes to cars to household appliances. Consequently, the set amounts of money being paid out to retirees at regular intervals from their annuities will buy less and less as inflation pushes the prices of goods higher.
The flip side of that situation is the benefits higher interest rates will provide for retired savers, millions of whom have waited out the low-interest rate era collecting next-to-nothing on their savings accounts and money market mutual funds.
Even as all of the major U.S. stock markets have regained their losses incurred in the wake of 2008 economic crisis and each has recently topped all-time highs, savings accounts and money market mutual funds have languished due to the Fed’s easy-money policies, notably six and a half years of near-zero interest rates.
Low Rates Burn Savers
In the years since the Fed lowered rates to near-zero savers have watched their money stagnate in bank accounts and money market funds that have offered virtually no returns. Consider that in the first quarter of 2015 the average annual percentage yield for a U.S. savings account was 0.09%, which means that a saver who put $1,000 in the bank would earn just $9 in interest after 12 months.
Indeed, the cost to American savers since the Federal Reserve lowered interest rates to a 0%-0.25% range in December 2008 in an effort to spark lending and spur economic activity has been almost a half-trillion dollars in interest income, according to a recent study by insurance giant Swiss Re.
The result has been millions of American retirees who live off interest earnings from those accounts (as well as other interest-related investments) struggling to make ends meet.
So higher rates will be good news for them, allowing them to finally start reaping some rewards for their frugality.
Experts emphasize that the category of savers is a vast one and goes well beyond elderly retirees whose money is socked away in various interest-earnings funds and accounts. The category also includes young couples saving for their first home, as well as youngsters stashing away after-school job money to save for college.