Do Interest Rates Matter for Your Retirement Income?
You might have seen news about rising interest rates, but what does it mean for you and your retirement? That’s not always so clear, and it’s partly because interest rates affect so many different aspects of our financial lives.
That said, the core issues for many retirees are bonds and debt – many of us have both. Here’s a quick look at what rising interest rates can mean for your retirement income plan, and what you can do to mitigate the risks.
- As rates rise, bond yields rise
Rising rates can bring good news for bond investors: higher interest rates tend to mean higher payouts on fixed income securities. For those who rely on their bond portfolios for income, this can be a welcome change.
However, rising rates don’t imply you’ll see significantly more income right away – or even that it’s safe to start drawing more income from your portfolio.
A Morningstar study investigated what would happen if yields were to rise from the below-average levels we’ve seen recently. What the researchers found might surprise you: in a situation of rising interest rates, an investor with 60% of their portfolio in bonds would have the highest chance of financing their whole retirement if they used a 2.8% withdrawal rate.
That means this person would have a 90% chance of financing a 30-year retirement if they took just 2.8% of their account balance at their retirement date, adjusting the dollar amount upward every year for inflation.
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In other words, rising rates can mean more income, but it doesn’t mean you’ll be able to draw as much as you might want!
- As rates rise, bond prices fall
Generally speaking, the way bonds work is like this: when interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
This happens because the yield generated by a bond already on the market needs to “match” the yield offered by new bonds, assuming everything else is equal.
Here’s how it works: “Yield” is just a fancy way of describing what you get relative to what you paid – so if you buy a bond from a company for $100 and it pays a 3% coupon for some period of time before giving back your $100, you’re getting a 3% yield.
But say market interest rates rise and new bonds start paying $4 instead of $3. If you want to sell your bond, the buyer will also want to be making $4 for every $100 invested, and so the price of your bond will fall. This is obviously simplified, but the idea is that investors want to get the market rate of return, and prices will adjust so the math works out that way.
Why does this matter? Because the value of your bond holdings may fall as a result of rising interest rates. This can be difficult to watch as an investor concerned about their nest egg!
- Debt can get more expensive
Moving away from investment portfolios, rising interest rates have one very critical implication for retirees with debt: your debt can get more expensive.
Variable-interest rate debt is obviously the most likely to be affected by this – and it can become a significant risk factor for retirement. One study found that 40% of households between ages 62 and 68 had credit card debt in 2015, and researchers have voiced concern that high debt levels could erode the resilience of retiree finances.
Because higher interest rates can mean higher payments, you could see an immediate impact on your budget. But you could also experience a harder time paying off your debt. The power of compound interest works against you when you borrow, and higher interest rates help grow your debt balances faster.
What you can do to prepare
Rising interest rates can help or hinder retirement, and we believe the best way to take advantage of them and mitigate your individual risks is to work with a qualified financial planner.
To get started, we suggest thinking through the following key issues:
- Your existing investment strategy and how it might be impacted by rising rates
- Your income needs, expected lifespan, and current and potential income sources
- Your debt levels, what kind of debt you have, and what steps you could take to mitigate the effect of rising interest rates
- Work towards building financial resilience both now and in the future
A prudent retirement income plan will help you balance priorities and build reliable sources of income that can help you through the entirety of your retirement. If you’re struggling to put a plan together or feel you could benefit from professional advice, we recommend working with a financial planner today.
Are you ready for retirement?
There are many moving parts in a retirement savings and transition plan. Take some time out to learn about the core issues and start creating your very own plan with the following free guides:
Your Retirement Savings Workbook will walk you through some of the core issues involved in saving for retirement.
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Your Retirement Transition Plan will help you start building a personal road map to make the transition into retirement as smooth as possible.
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