If you're a retiree, congrats! Now that you're in retirement, protecting your nest egg is crucial. But how should retirees invest in a rising interest rate environment? Let's dive in.
The Federal Reserve slashed the Fed Funds rate to 0% – 0.25% in 2020 to combat the economic slowdown due to the coronanvirus pandemic. What unprecedented times we all experienced. But, things are recovering and there will be a time when the Federal Reserve will raise interest rates again. This post addresses that scenario.
The Federal Reserve aggressively hiked rates from the end of 2015 up until mid 2019. For retirees this was fantastic news as their retirement income was likely generally increasing as well. Aspiring retirees also don't have to build as large of a retirement portfolio to achieve the same amount of income.
But of course, there's no free lunch. As rates go higher, bond investors tend to lose in the form of declining bond prices as their bond yields are no longer as attractive.
That said, the US Treasury market, specifically the 7-10 year treasury bond market dictates rates. Despite the Fed raising rates so consistently from 2015 to mid 2019, treasury yields actually declined (flattening of the yield curve) and bond investors did great through 2019!
The chart below shows how treasury rates have declined since 2H2018, putting pressure on the Fed to cut rates.
I believe we will be in a low interest rate environment for the rest of our lifetimes thanks to technology, innovation, speed of information, and policy experience.
That said, I could be wrong. So just in case, here are some things investors, especially retirees, should do to invest in a rising interest rate environment.
How Retirees Should Invest In A Rising Interest Rate Environment
1) Shop Around for the Highest Cash Yields
In 2019, you could get an online savings rate for 2.4% or buy 3-month treasury bonds for 2.45%, or 12-month CDs for 2.5%. Rates in 2022 are significantly lower, however. Roughly 0.5% for a top rate savings account and 0.55% for a 12-month CD.
But if rates start to skyrocket again, you want to aggressively take advantage of the short end of the yield curve because the yield curve is flat. For example, why lock up your money for 5-10 years for 2.5% – 2.65% if you don't have to lock up your money at all for 2.4% with an online savings bank? I would jump for joy if I could get 2.4% in a savings account again.
As a retiree, be sure to factor in your need for liquidity and FDIC protections. Yields will tend to be highest on CDs, and CDs offer FDIC protection (up to the limits); the downside is that you won't have daily access to your funds, so CDs are a poor choice for ongoing expenses.
Money market mutual fund yields are now higher, in many cases, than those on online savings accounts. These funds offer daily liquidity but aren’t FDIC-insured. Online savings accounts are FDIC-insured up to the limits and offer daily liquidity. In many ways, they offer the best of both worlds.
2) Mobilize Your Cash In Your Brokerage Account
As you're attempting to wring a higher yield out of your cash holdings, don't ignore the cash you have sitting alongside your long-term portfolio holdings in your brokerage account.
Such cash accounts, often called “sweep” accounts, offer ready access to purchase long-term securities. But they typically offer yields that are well below competing types of cash accounts. This is one of the key ways brokerages make money. They pay you nothing on your cash and use the liquidity to reinvest elsewhere.
In most cases, brokerage sweep accounts are paying less–typically well less–than 0.30% today. You can usually find higher yielding money market mutual funds or savings accounts at your brokerage firm or mutual fund company.
The key drawbacks relative to the sweep account is that money market mutual funds aren't FDIC-insured. In addition, you won't have immediate access to your funds to purchase long-term securities. You'd have to place a sell order first.
If you're not an experienced investor, I recommend signing up with wealth advisor like Personal Capital. They offer a lot of free financial tools to every user. And signing up for a personal financial advisor is completely optional. Those who do get fantastic support and benefit from low fees.
Remember, the key to building wealth is long-term, low-cost, consistent investing.
3) Stress-Test the Impact of Rising Rates
Rising interest rates have a depressive effect on bond prices. In other words, when higher-yielding new bonds come available, that puts downward pressure on older bonds with lower yields attached to them.
You want to make some pro-forma calculations on how much a 1 percentage point increase could hurt your bond portfolio. Take Vanguard Total Bond Market, for example. With a duration of six years and a 3% SEC yield, investors could expect a roughly 3% loss if rates increased by 1 percentage point over the next year.
On the flip side, a 1 percentage point increase in interest rates might also signal it's time to reduce your red hot stock portfolio. There's always a Yin and a Yang with investing.
4) Diversify Your Bond Holdings
Rising rates are only a problem for investors in bond funds, right? Well, sort of. If you hold an individual bond to maturity and the issuer makes good on its interest payments, you won't lose money, even if interest rates shoot up over your holding period. But investing in individual bonds carries drawbacks of its own.
It can be difficult for smaller investors to adequately diversify across bond sectors and issuers with individual bonds. Those individual bonds may be tough to research; as a small investor, high trading costs could eat into your returns. Bond mutual funds, by contrast, offer professional management and diversification.
Moreover, an investor in individual bonds effectively locks in his or her yield, whereas the bond-fund managers can take advantage of higher-yielding bonds as they become available.
My recommendation is to focus on low-risk treasury bonds and AA-rated municipal bonds. Both have next to zero default ratings. The whole point of investing in bonds is so that you can receive a fixed income and sleep well at night.
5) Pay Down Debt
When in doubt, the easiest thing you can do in a rising interest rate environment is pay down existing debt and shun taking on more debt because it will cost more.
Tackle your highest interest debt first, such as your credit card debt. Then work your way down. Mortgage debt is usually the most common debt still remaining for retirees.
You will never feel bad paying down debt. I've created the FS-DAIR framework for those of you trying to figure out how much of your cash flow to use to pay down debt and invest. FS-DAIR is both logical and helpful.
If you have debt that has an interest rate of greater than the risk-free rate of return (10-year bond yield), it's always good to pay it down.
6) Invest In Real Estate Passively
Bonds usually get all the attention in periods of rising interest rates. But I would pay attention to the real estate sector, especially REITs and real estate crowdfunding investments.
As you can see from the below chart, REITs performed the best in the 20-year period between 1999-2018. REIT performance of 9.9% was more than double Bonds performance of 4.5%. During this 20-year time period, interest rates have moved up and down. However, REIT performance may lag if the Fed starts raising rates aggressively post pandemic.
If you think about it, real estate is like a bond, but better because there's actually an underlying physical asset that provides utility: shelter. Real estate also produces rental income.
My favorite invest over the next 20 years is investing in real estate in the heartland of America where valuations are cheaper and cap rates are much higher.
My favorite platforms are Fundrise and CrowdStreet. They enable retail investors to more strategically invest in real estate that was once available only for ultra high net worth individuals or institutional investors. It's free to sign up and explore.
Additional Reading
Here's some additional reading to enjoy.
- Fundrise eREIT Fees Compared To Blackstone And Starwood REITs
- Best Guaranteed Return: Online Savings Rate
- Debt Consolidation Strategies To Lower Your Interest Payments
- How Does The Stock Market Perform After A Fed Rate Cut?
Make Sure You Have A Good Grasp On Your Portfolio
As a retiree, your #1 goal should be to stay retired and live the life the way you want. If you're feeling stressed about how your retirement portfolio will hold up during a rising interest rate environment or a downturn, you are probably taking too much risk.
I would leverage a free award-winning financial tool by Personal Capital to x-ray your portfolio for excess fees and excess risk exposure. The tool is free to sign up and use. I run my portfolio through Personal Capital at least once a quarter to make sure I'm investing the way I want.
Remember, there's no rewind button in life. Stay on top of your money by leveraging technology. Rebalance when you feel your portfolio is too exposed or underexposed to certain assets. And most of all, enjoy life!
About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world. You can sign up for his free private newsletter here.