Will rising interest rates affect your retirement?
Low rates have left seniors without the safe streams of income they traditionally counted on. Will this be changing with the sudden rise in rates?
The retiree's lament over low interest rates has been one of the few downsides of the Federal Reserve's sustained effort to pump so much liquidity into the financial system that borrowing costs nearly fell to zero for many debtors.
This also meant the retiree's traditional dependence on safe streams of interest income was a bittersweet casualty of Fed policy. Investors chased yield as best they could, but fear of getting burned by another deep market decline has sharply limited the appeal of higher-return investments.
In recent weeks, interest rates have started to increase. Even a mild reference to possibly easing monetary policy at a future date from Fed Chairman Ben Bernanke was enough to start a stampede in the bond markets and a sharp fall in bond prices. (Bond yields and prices are inversely related. When interest rates increase, the prices of existing bonds -- those with fixed rates of interest -- decline until their effective yields are consistent with the new level of interest rates.)
To date, rising interest rates have occasioned more fear about rising mortgage rates than cheers of approval from fixed-income investors. Investors are more likely to lick their wounds over losses suffered on falling bond prices, but at some point, a sustained rise in bond yields will be noted as a plus for retirement portfolios and income streams.
Two major players in the retirement research space -- the Center for Retirement Research at Boston College and the Employee Benefit Research Institute -- recently issued their takes on the impact of rising interest rates on retirement prospects.
A weak link
There is no question that higher interest rates increase the level of income that investors receive from financial debt instruments. However, as the Center for Retirement Research concluded, the relationship between this fact and the ultimate retirement security of Americans is weaker than you might think. The center developed a statistical model called the National Retirement Risk Index that tracks the shifting odds that Americans will be able to maintain their pre-retirement living standards when they retire.
Not surprisingly, the NRRI has been posting some worrisome readings since the recession. "Changing interest rates has only a modest effect on the NRRI," the center stated in a report issued last month. The retirement adequacy of more than half of all workers is at risk in today's low-rate environment and would still be at risk if interest rates returned to historically normal levels. "Regardless of the interest rate, today's workers face a major retirement income challenge," the report said
A second key distinction about the center's approach to retirement prospects is that it concludes interest rates don't affect retirement outcomes. While this may not appear logical to people depending on interest income, the center says when it looks at age, wealth and income over time, there is a very stable relationship that exists despite shifting levels of interest rates. "Interest rates do not play a role during the asset accumulation period," the center concluded.
Different models, different conclusions
The Employee Benefit Research Institute, on the other hand, found that shifting interest rates have a substantial impact on retirement adequacy. Without getting into an extended assessment of its retirement model versus the one developed by the Center for Retirement Research, it is important to note that the models do differ.
The EBRI model, for example, does not assume people annuitize their assets at age 65 but that they spend their Social Security and any traditional pension income and then withdraw money as needed from their 401(k)s and individual retirement accounts. If they run out of money, EBRI assumes they convert their home's equity into a lump-sum distribution and spend these funds as needed.
The EBRI study looked at three sets of interest rates and investment gains on stocks and bonds:
- Historical averages of 8.6% real (post-inflation) gains on stocks and 2.6% real gains on bonds.
- A middle-ground scenario of 6% stock and 0% real bond returns
- Results comparable to those of recent years, with stocks returning 4.6% a year and real bond returns being negative 1.4%.
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"Moving from the historical-return assumption to a zero-real-interest-rate assumption results in an 11 percentage point decrease in simulated retirement readiness for Gen Xers with one to nine years of future eligibility, and a 15 percentage point decrease for those with 10 or more years of future eligibility," EBRI said in a study released last month.
To be affected by interest-rate shifts, a household needs to have financial resources and retirement savings. "There appears to be a very limited impact of a low-yield-rate environment on retirement income adequacy for those in the lowest- (pre-retirement) income quartile," EBRI reported. People in this group depend almost entirely on Social Security, in which payments in inflation-adjusted terms are not affected by interest rates.
More from U.S. News & World Report:
- 10 trendy 401k plan perks
- 8 retirement investing essentials
- 12 ways to increase your Social Security payments
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