Low Interest Rates Could Destroy Your Bright Retirement Future
If you’re closing in on your retirement age, it probably seems like you’re seeing the light at the end of the tunnel.
Sure it might be a couple of years yet, but after decades of putting money aside, you’re soon about to reap the rewards you’ve been promised.
Unfortunately, the economy over the past ten years or so hasn’t been the best, as you’re no doubt aware. This means low interest rates.
Interest Rates Hit Record Low
To be blunt, they’re not just dropping; they’re plummeting. In fact, back at the beginning of July, they hit record lows. After 20 years of trending down, many people expected that rates would soon be heading back up. Most analysts thought that, worst case scenario, they simply wouldn’t be going any lower.
In some countries, though, the entire yield curve points down. Then, the Brexit vote happened in the United Kingdom, which brought even more economic uncertainty to the world. These two factors alone basically guarantee that low interest rates will be here for the foreseeable future.
Baby Boomers Hit Hardest
Low interest rates will have an effect on all of us, but Baby Boomers will most likely be hit the hardest. This is a generation that has had a number of advantages over the years: economic prosperity and affordable college tuition with a job market that hardly even demanded degrees in the first place. The real GDP growth during their working years has averaged 3%.
Sadly, it looks like the Baby Boomers’ luck has finally run out. Just as this generation is finally gearing up to retire, low interest rates get lower to knock down the return on their savings.
That’s not all. Lower interest rates are going to mean a more expensive retirement too. Once you pass from earning and saving into the spending phase of your retirement, it’s usually wise to begin mitigating risk with your portfolio – often by switching over to bonds.
After retiring, the vast majority of people have far fewer sources of income than they used to. This makes them more vulnerable to swings in the market because they don’t have a steady income to fall back on.
Low Interest Rates Undermine Great Returns You Received on Stocks
To limit the risks they’re about to become exposed to, Baby Boomers would be wise to put their money in fixed-income products like bonds and annuities. The main problem with this option is that, when yields are low, fixed-income products become more expensive, making them a less than attractive offer.
To give you an idea of the type of impact these falling interest rates have already had, imagine you purchased a 20-year fixed nominal annuity back in 1996. At that time, $1 million in savings would’ve earned you roughly $83,000 back every year – not a bad little income. Back at the beginning of July, though, that same annuity would’ve run you $1.47 million.
Another way to look at it is that this 20 year decline we’ve seen in interest rates is the same as losing a third of your net worth. While these low rates may be great for younger investors, they completely undermine all those years you enjoyed great returns on stocks for your retirement.
One of the worst things about this situation is that these high prices for bonds and annuities will most likely force a lot of Baby Boomers who have meager retirement savings into staying invested in stocks. It will seem like the only way to earn the high returns they need to get their nest egg back on track.
More than likely, though, they’ll just be unnecessarily exposing themselves to needless amounts of risk. All it would take is one bad day for a lot of Baby Boomers to incur a devastating hit.
Many pundits, such Bill Gross , say that we will not be able to see a great return from stocks next several decades. Gross comes to the conclusion of, “my take from these observations is that this 40-year period of time has been quite remarkable – a grey if not black swan even that cannot be repeated. With interest rates near zero and now negative in many developed economies, near double-digit annual returns for stocks and 7%+ for bonds approach a 5 or 6 Sigma event.”
A Race to the Bottom
The other problem we need to look at when it comes to these distressing interest rates is that many Baby Boomers are going to get into low-quality bonds. As we touched on earlier, the further the price of a bond goes up, the less it will yield.
At the moment, countless people are buying lower-grade corporate bonds because their prices are so low, meaning their yield is comparatively higher. The consequence is that all these people buying these low-grade bonds is raising their price and making the entire issue worse.
As one class of bond’s price goes up, investors are going further and further down the ladder to find cheaper versions with higher yields and the entire cycle continues.
Investment Grade Corporate Bonds Still Remain a Safe Bet
Despite all of this doom and gloom, there are still some reasons to be optimistic. One is that the world is becoming increasingly comfortable with the Brexit vote. Although we’re still a long way from finding out what it will truly mean, the initial panic has subsided and the markets have calmed.
Therefore, corporate bonds are still a good investment. For one thing, diversification remains as important as ever. However, investment grade corporate bonds still remain the best hedge against market volatility, of which there could still be plenty in the years to come.
Furthermore, if you’re nearing retirement, it is incredibly important to not go looking for quick wins on the stock market. You only have a handful of years left; what you need right now is protection from an unexpected drop in the stock market. Corporate Bonds give you this. Hoping you find a winner by doubling down on stocks you already own or buying new ones does not.
Even if there is only minor volatility in the market, if you’ve been investing for decades, your portfolio is probably large enough that you’ll experience a distressing amount of fluctuation if anything goes even slightly wrong. This close to retirement is not the time for uncertainty.
Although younger investors may be enjoying the benefits of falling interest rates, if you’re nearing retirement, it’s definitely going to be a bit disconcerting in the near future. However, if you stay calm and keep money in investment grade corporate bonds, you should still be able to keep your retirement date intact.