Lower Interest Rates Could Ruin Your Retirement
Stocks and bonds have their ups and downs, but low interest rates can erode investment returns for decades to come. With interest rates falling, now is a good time to make sure your retirement assumptions reflect the new reality.
Lower interest rates can give a temporary shot in the arm to stocks and bonds; but in the long run, low interest rates may do your retirement plan more harm than good.
The reason is that stocks and bonds have their ups and downs, but low interest rates can erode investment returns for decades to come.
The best cure is to face up to the reality as soon as possible. Use a retirement calculator or visit your financial planner to validate your assumptions. The longer you wait, the harder it is to make up for the damage low interest rates can do to your retirement plan.
To understand why, it helps to look at how interest rates affect stocks and bonds, and what this means for your future earning power.
What Lower Interest Rates Do to Stocks and Bonds
There’s a simple premise behind investing in stocks and bonds – you pay money now in the hopes of getting a reward later.
For bonds, that reward comes in the form of future interest and principal payments. For stocks, it comes indirectly in the form of future corporate earnings, which eventually support the company’s future stock price.
When interest rates are high, those future rewards might look less attractive because of the interest you could safely earn just by keeping your money in an FDIC-insured, short-term interest account. That’s why high interest rates tend to make stock and bond prices fall.
On the other hand, lower interest rates reduce the reward of keeping your money in a short-term interest account. Lower interest rates increase the incentive to invest in the future rewards of stocks and bonds. So, stock and bond prices tend to rise as interest rates fall.
The Best Investment Advisors Are at Your Fingertips
Finding the best investment advisor accounts to meet your needs is as simple as using our search tool. Try it now and find today’s best online brokerages and advisors.
Lower Interest Rates Make It Harder to Retire
Good returns for stocks and bonds so far in 2019 would be a happy outcome if that were the end of the story. Unfortunately, retirement planning is a decades-long process, so the story is far from over.
You see, while stocks and bonds may have given your net worth a nice bump this year, your future earning power may have been weakened. That’s a problem for your retirement plan.
Retirement assumptions should reflect future earning power
Meeting a retirement-savings target depends on two things: how much you put aside for retirement each year and how much your investments on that money will earn.
If you’ve ever used a retirement calculator, you’ve probably had to enter a return assumption. That return assumption is used to calculate how fast your retirement investments will grow.
Of course, the higher the return assumption, the more your retirement investments will be expected to grow by the time you retire. The problem is, that future growth rate is now threatened.
The return assumption in any retirement plan should be based on the long-term rates of return you expect to earn on your retirement investments. For stocks and bonds, lower interest rates may well reduce those long-term rates of return.
How lower interest rates hurt the earning power of stocks and bonds
Take bonds, for example. Yields on U.S. Treasury securities now range from 1.59% for 1-year securities to 2.28% for 30-year bonds. These yields can be considered decent estimates of what your return on these instruments would be if you held them to maturity.
As for stocks, while falling interest rates have given their prices a short-term boost, the problem is that stock prices have been rising much faster than earnings. This raises the price-to-earnings (P/E) ratio of stocks.
A high P/E means you are paying more for every dollar the company earns in the future. Paying more up front means less return in the future. Many studies have shown that, historically, high P/E ratios have led to lower future returns on stocks – not necessarily in the short term, but over the long term. It’s this long-term perspective that matters for retirement planning.
So, while your portfolio may be looking good today due to lower interest rates, low bond yields and high stock P/E ratios may limit its future earning power.
Earning Power Beats Net Worth
The diminished earning power of stocks and bonds could hurt your retirement plan in two ways:
- Slower investment growth means you’ll have to put aside more of your paycheck to reach your retirement savings target.
- Lower yields mean you’ll have to set a higher savings target to generate the retirement income you need.
The money you have saved by the time you retire depends on how much money you put aside year after year and how much that money earns once it’s invested.
Reduced rates of return mean that you’d have to set aside more of your paycheck to meet the same retirement target. Here’s an example:
- If you set aside $750 a month in a tax-deferred retirement account and earn 7% a year, in 25 years, that account would be worth $587,281.
- Lower that annual return to 5%, and it would take monthly contributions of just over $1,000 to raise the same amount in 25 years.
Retirement income generation
Now let’s say you’ve reached retirement age and have managed to accumulate the $587,281 nest egg used in the example above. Consider what lower bond yields and stock returns would do to the ability of that nest egg to generate earnings you could use toward retirement expenses:
- If that $587,281 were earning 7% a year, it would generate nearly $41,110 toward your annual retirement expenses.
- At a rate of return of 5%, that same nest egg would generate just $29,364 toward your annual retirement expenses.
- At a 5% rate of return, you’d need a nest egg of $822,194 to generate the same amount annually as you would with a nest egg of $587,281 at 7%.
Again, a lower rate of return inhibits both the growth of your investments as you save for retirement and the annual earning power of your nest egg in retirement. That’s the reality you have to face due to lower interest rates.
Scared of Stocks and Bonds? Why Cash is No Bargain Either
There’s one other problem with lower interest rates. Not only do they make it harder to earn decent returns, but they also make it harder to manage risk.
The backdrop for this year’s interest-rate drop is increasing concern about the health of the economy. A growing number of investors fear that a recession may be looming in the next year, which would have a dampening effect on stock earnings.
Meanwhile, low interest rates leave bonds – especially long-term bonds – very vulnerable to financial shocks like an uptick in inflation.
Normally, the safe haven for people who are concerned about stock-and-bond volatility would be cash equivalents like savings accounts and CDs. However, with the average savings account rate well under 1% and dropping, this option has limited appeal. It would probably be very difficult to meet your retirement targets with a substantial portion of your assets earning next to nothing.
Factoring Low Rates into Retirement Assumptions
So today’s environment includes the prospect of lower returns on stocks, bonds and cash going forward. There’s no magic bullet here, no investment tip that is going to save your retirement plan. The best way to face up to the reality of lower interest rates is to start preparing.
Whether you have run the numbers yourself on a retirement calculator or had a financial planner do them for you, those calculations would have been based on an annual-return assumption.
Now is the time to go back and see if that annual return assumption still makes sense in an investment environment of low interest rates and high stock P/Es.
Given the reality that both stocks and bonds may earn far less than their historical average returns going forward, lowering your return assumption may be the safest way to prepare for retirement.
Use the MoneyRates Retirement Savings Calculator
How to Strengthen Your Retirement Plan
Here’s the bad news: Lowering your return assumption means you will have to contribute more each year to meet the same retirement savings target.
As tough as that sounds, keep in mind that the sooner you start doing this, the less severe the increase in your annual savings will need to be. If you wait until years of sub-par returns have put your retirement savings plan way behind schedule, then playing catch-up will be even more painful.
Think of this as tough love for your retirement plan. Far from being a benefit to retirement savers, lower interest rates only make their job more difficult in the long run. Still, the real pain will be felt by those who don’t adapt to this environment by updating their retirement-plan-return assumptions.