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Unintended consequences of low interest rates

John Trujillo //July 25, 2014//

Unintended consequences of low interest rates

John Trujillo //July 25, 2014//

“Low Interest Rates are Here to Stay.” “Help Solve the Interest Rate Puzzle.” “Five Reasons Rates Will Stay Low for the Next Decade.” If these recent headlines sound familiar, we subscribe to similar news sources. Having survived the Great Recession of 2008, many are now wondering when the Federal Reserve will reverse its low interest rate policy and start to raise interest rates.

The Fed Takes Action

The financial crisis that began in 2007 was the closest comparable economic trauma the U.S. has experienced since the Great Depression of the 1930’s. In an effort to avoid a similar catastrophic financial event, the Federal Reserve implemented monetary policy changes. Reducing short-term interest rates to nearly zero, purchasing large sums of Treasury and government-sponsored agency bonds enabled the Fed to reduce and keep rates low to allow the economy time to stabilize and eventually start to expand.

These policy changes were very effective.  Individuals, households and businesses were able to reduce/refinance debt, rebuild balance sheets and generally stabilize their financial lives. But the unintended consequences of low interest rates may become a serious concern if the Fed does not start the difficult process of unwinding these accommodative policies.

Because of all this uncertainty, wealth advisers have started to see patterns emerge surrounding questions about delayed retirement, investing in riskier asset classes and heightened budget awareness.

Delayed Retirement

When Social Security was created in 1935, it was to be one piece of a three-part solution for Americans in retirement. It was never intended to be the sole retirement income for anyone.  The first component was company pension plans which have, for the most part, been eliminated.  The second component was personal savings.  The final one-third of retirement income was to come from social security. Fast forward to present day and most people do not have pensions, so Americans have had to increase their savings strategy. This heavier reliance on personal savings has created an increased reliance on investment performance for retirement income.

In a market with near record-low interest rates, individuals are finding they cannot live on the income available with conservative investments like bonds. Thus, many are forced to work longer and delay retirement. This unintended consequence has kept experienced workers in the work force longer which doesn’t allow for the rotation of these jobs to younger generations. As a result, we have seen the highest level of unemployment in the nation’s young adults.

Alternatively, some Americans are unable to delay retirement, due to health reasons for example, and have instead opted for a reduced payment from social security to start retirement early. So not only are they receiving less from their social security, but their investments cannot earn enough to meet cash flow needs.

Investing in Riskier Asset Classes

Investment-grade bonds have traditionally been labeled a ‘safe haven’ asset class for investors looking to earn income. Bonds are widely believed to carry less risk than stocks and have become a popular option for generating income in retirement. In today’s market, wealth advisers are seeing a noticeable trend moving more and more investors toward owning a higher percentage of stocks paying dividends to make up for income deficits.  In many cases, stock dividends pay a higher income than conservative bonds.  However, adding to stock increases the overall risk taken in the portfolio because the stock market can be more volatile resulting in price fluctuations and possible loss of value.

While assuming more risk in the stock market may be an option for some, increasing portfolio risk to offset low rates of return on bonds may not be a solution. Careful thought should be given to your own tolerance of risk to ensure the best choice is made for your particular retirement goals.  This is where a strong relationship with a wealth advisor will pay off and help minimize unnecessary risk in your retirement portfolio.

Budget Awareness

According to a recent survey, three quarters of working Americans don’t have enough savings to get them through six months of unemployment. While low interest rates may encourage people to borrow more, they may borrow more than they will be able to manage when rates rise. This lack of savings and fiscal unawareness may lead us to another financial crisis in the future. Savings really should be a budgeted line item, just as any other important payment in a monthly budget.

Managing Through the Unintended Consequences

Today, more than ever, the risks in the financial markets are complicated by government policy.  History will tell whether recent Fed actions were necessary or helpful in the long run. The best way to work through these markets is to understand your personal risk tolerance.  Work with a wealth advisor who will help put your unique long-term financial goals in perspective and build an efficient portfolio that matches your risk with your needs. The reality is that no one can control or predict when interest rates will rise (or fall), but having a sound financial plan, with a long-term focus, will properly position an account for the volatility. Being prepared is the best defense in an unpredictable interest rate environment.