Friday, 8 December 2023

Your 401(k): Handling Interest Rate Ups and Downs

Your 401(k): Handling Interest Rate Ups and Downs
13 Feb
Businesswoman examining documents at desk
Interest rates rise and fall based on changes in the economy. When the economy is weak, the Federal Reserve (the Fed) — which controls the federal funds rate — may lower rates to support the economy. As the economy begins to gain strength, the Fed may choose to gradually raise interest rates. That’s what happened in 2018 and on into 2019. The Fed sees signs that the economy is growing, so it has started to raise interest rates from the historically low levels that have prevailed for most of the 2010s. Typically, the Fed raises interest rates to combat inflation.

What should you do when interest rates rise? Don’t panic. Rising rates are part of the economic cycle. They usually indicate that the U.S. economy is getting stronger, which is a good sign for stocks, as it typically means consumers are buying more products and services, leading to increased profits. Rising interest rates also mean borrowing is more expensive. Hopefully, a strong economy will give consumers the means they need to afford those higher interest rates.

Rising rates are a good time to review your investment portfolio, particularly your 401(k) plan, to make sure you are taking maximum advantage of current interest rates and that your investments are structured to meet your needs at retirement.

What to ask yourself when reviewing your 401(k)

A 401(k) is a savings vehicle that many companies make available to help their employees save for retirement. In 2019, you can contribute up to $19,000 of your earnings on a pretax basis, meaning anything you contribute is not taxed until you withdraw it, usually at retirement. Some companies match employee contributions up to a certain limit that varies by employer. These contributions are not taxable to you until you withdraw them. Companies offer employees a variety of 401(k) investment options. Some larger companies allow employees to choose from a dozen or more mutual funds, including various stock, bond and real estate funds.

While any time is a good time to review your 401(k) investments, a rise (or fall) in interest rates is a particularly good time to make certain your 401(k) investments meet your needs based on your age, years until retirement and risk tolerance, among other factors.

Virtually all 401(k) plans offer one or more fixed-income investment options. These typically include both government and corporate bonds of varying maturities. For example, a fund might offer a mutual fund that invests in short-term Treasury bills, one that invests in long-term Treasury bonds and one that invests in corporate bonds. Some companies might even offer a fund that invests in so-called junk bonds that pay a higher rate of interest in return for the risk of investing in low-quality bonds.

What to expect when rates rise

An increase in interest rates will eventually have an impact on all of these types of fixed-income funds. A fund that invests in short-term Treasury bills will be the quickest to react to this change. When the bonds that the funds hold mature over the subsequent year, the fund manager will reinvest the proceeds in bonds that pay a higher rate of interest.

A corporate bond fund, on the other hand, includes bonds with varying maturities. It may take time for the fund to invest its assets in bonds that pay higher interest, as most fund managers spread their investments over maturities between one and 30 years so that at least some bonds are always maturing to potentially be reinvested at a higher rate.

A rise in interest rates also will affect the price of existing bonds in a portfolio. Say the corporate bond fund you own has an XYZ Company corporate bond that pays 4% interest. As market interest rates rise, the value of that bond will decline to a point where the current yield on that bond is closer to the market rate. Since most fund managers anticipate that interest rates will rise, they have structured their portfolios to minimize the impact that an increase will have on the fund’s value.

Let’s return to reviewing your 401(k) investments. When you started your job, you probably picked a mix of investments and haven’t made any changes. That’s fine if you started your job two years ago. But if you have been working for the same company for 10 years, a review is a good idea.

Let’s say that when you started working for the company at age 30, you were single and invested 90% of your 401(k) in stocks and just 10% in bonds. Now, fast-forward 10 years. You got married. And while retirement is still at least 25 years away, it is something you can begin to see on the horizon. It might be a good time to increase your fixed-income allocation to add greater stability to your 401(k) returns — especially if interest rates are rising.

What to expect when rates fall

It’s important to keep in mind that interest rates also can fall. The bad news is this typically happens when the economy isn’t doing so well. The good news is your higher-rate fixed-income investments will be worth more. You can choose to sell them and take the profit or hold them and enjoy earning a rate that’s higher than the one currently available.

Investing when interest rates are falling requires a different strategy. Young investors with many years until retirement who have the bulk of their 401(k) investments in stock should be able to ride out a period of low interest rates without significant impact. Older investors who see retirement on the horizon or are already retired will find falling interest rates more problematic. Their investments may be concentrated in fixed-income vehicles, or they may be seeking solid long-term fixed-income investments to pay them the retirement income they need. Since nobody can predict how long rates will continue to fall, buying fixed-income investments with staggered maturities, sometimes called a bond ladder, is the best way to make sure you always have money available to take advantage of rising interest rates when they happen.

What’s ahead for 2019

As Federal Reserve Chairman Jerome Powell has raised interest rates based on a stronger economy, some argue he might be moving too fast. Critics say at least some of the significant stock market decline at the end of 2018 was due to the Fed raising rates too quickly. Add to that the slowing world economy and the ongoing trade war with China. This has the Fed rethinking its plans for 2019 rate increases. Some insiders say the Fed will raise rates only twice more during the remainder of the year, perhaps less. Bloomberg predicts that by the end of 2019, the fed funds rate will rise to 3% from the current 2.5%. All other interest rates on mortgages, car loans, bonds and certificates of deposit are pegged to this rate.

Bottom line

It’s important to remember that over the time horizon of your 401(k), interest rates will both rise and fall. Right now, they are rising. And at some point in the future, they will fall. Rates have been low for nearly a decade. The fact that they are now rising may make fixed-income investments more attractive. That will make more investors comfortable investing in them. And ultimately it will make it easier to put together a diverse portfolio to help get you over the retirement finish line.

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