A holiday gift to investors from Chairwoman Yellen
On the seven-year anniversary of interest rates near zero percent, the U.S. Federal Reserve finally raised interest rates last week. A scan of financial headlines could easily lead investors to the conclusion that decisive portfolio action is necessary to remedy the quarter of a percent change in interest rates. However, for investors growing their wealth for retirement, a myopic focus on finding the perfect “rate-proof” bond portfolio or identifying the equity sector that will benefit most, misses the much broader and more important question: how does an interest rate change affect an investor’s overall ability to retire?
To answer this question, it might help to
- identify the main components that balance the retirement equation
- examine how the components of the equation are affected by a higher interest rate.
To balance the retirement equation, an investor “simply” needs to answer the question, “Is what I have now enough for what I need in the future?” Said in slightly more technical terms, “Are the retirement assets accumulated to date sufficient to cover the cost of future retirement liabilities?”
If the answer is yes, that individual is likely ready for retirement.
Interest rates and the retirement readiness equation
There are two aspects of the retirement readiness equation that are impacted directly by a change in interest rates:
- Assets: The value of what you have now
- Liabilities: The cost of future retirement spending (i.e. what you need)
The interesting question, once you pay attention to both sides of the retirement equation, is: which half of the investor’s balance sheet (assets or liabilities) decreases more in response to an interest rate rise? To answer that, we need to know how an investor’s assets and liabilities are affected when interest rates go up. Most of the discussion in the popular press revolves around the assets side of the equation. We believe you need to focus on both parts.
On the asset side, when interest rates rise:
- bond prices fall, so a portion of an investor’s asset portfolio is likely to experience a decline;
- historically equity prices have risen, so a portion of an investor’s asset portfolio is likely to increase in value;
On the liability side, when interest rates rise:
- the cost of funding retirement liabilities may come down on all (not just a portion of) retirement liabilities
If the positive effect of a rate rise on the investor’s total liabilities outweighs the negative effect on their bond assets, higher interest rates may end up being a windfall for the investor. The change in monetary policy may improve the investor’s financial ability to retire without the investor having done anything differently.
We’ve written before on this blog about how equity assets have historically performed positively following a rate increase and how higher rates will affect bond assets as well. Let’s go into more detail on how higher interest rates have the potential to reduce the future cost of retirement spending.
The cost of funding retirement liabilities can come down
Higher interest rates can lower the cost of future retirement liabilities – specifically they increase the discount rate (interest rate) used to calculate the liabilities. Restated, higher interest rates lead to a higher discount rate, which means the cost of liabilities goes down.
This effect can be observed by looking back at historical annuity prices. The chart below shows an example of how much lifetime monthly income a healthy 65 year-old male was able to buy with a lump sum premium of $100,000 in an immediate annuity at different points in history. The higher the interest rate, the higher the monthly payment has historically been. A higher monthly annuity payout is comparable to a lower cost for future retirement spending. Meaning, if interest rates are higher, then $100,000 today can buy more future income, all else equal.
Let’s try another example to illustrate this same concept of how higher discount rates can lower the cost of future spending. In this example we are going to compare how many holiday wreaths an individual with $100 today could buy next year, assuming a current discount rate of 1% and 5%.
If a discount rate of 1.0% is used, an individual could afford two holiday wreaths next year (mathematically, the individual could actually afford 2.9 holidays wreaths. But of course wreaths cannot be purchased in part, so the investor can only afford two full wreaths). If the discount rate was 5.0%, then the same individual could afford three holiday wreaths for the same $100. The only thing that has changed is the discount rate, which is determined by the level of interest rates.
Going back to where we started, this highlights how higher interest rates (and therefore a higher discount rate) empower the same level of assets today to pay for a larger portion of retirement liabilities tomorrow.
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