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For Your Life January 17, 2020

How low interest rates can affect retirement

Have recent interest rate cuts impacted retirement? The short answer is yes. Things can get complicated, but low interest rates do have long-term effects on the economy and could alter your retirement planning.

Retirement Income

One of the most obvious short-term effects to lower interest rates is a decrease in income generated from CDs and savings accounts. You must go back to 2006 to experience a time period when interest rates were significant enough to really matter as a source of income in retirement.

2006 saw average CD rates around 5.5%, and savings and money market accounts over 5%. That was significant if you had a large amount invested. For every million dollars invested you were receiving over $50,000 in annual interest payments. The bonus was that these investment vehicles came with near zero risk of default and near zero risk.

Fast forward to present.  As of the writing of this article, late 2019, the average CD rate is currently around 2%.  Saving and money market accounts are around 1.75%. That same one-million-dollar investment is now paying $20,000 or less annually. Taking this conservative approach will cause inflation to slowly eat away at your portfolio.

One way to overcome this reality is to save more for retirement.  Easier said than done but having more money available will yield more income. The other way is to diversify your portfolio and be wiling to take on more risk or invest in some alternative investments. Dividend paying stocks, bonds, or real estate are the most common.

Low Rates and What They Do to Stocks and Bonds

A low rate environment will often give stocks a boost. The reason is rather straightforward. When rates are low conservative investments such as CD's and savings accounts become less attractive. Money begins to flow into stocks and bonds which increases share prices. This is a short-term effect, and if you have investments, then the past couple years have most likely been very good to you. But, retirement planning in a decades long process.

So, why then can low interest rates be a bad thing?  Low rates do in fact boost equity prices, but they also inflate a stocks price to earnings ratio, the P/E ratio. A high P/E ratio means that you are paying more today for every dollar that a company earns in the future. High P/E ratios historically can lead to lower earnings over the long-term. The long-term is the focus for retirement, so you can see the impact that this can have.

You could be up against lower investment growth and lower yields on your investments. To overcome you may need to set a higher savings rate and work longer than originally planned.

Assume for a moment that you reach retirement with a nest egg of $1,000,000.

  • If you have this money invested in stocks and bonds in such a manner that you are receiving a 7% return, then you be generating $70,000 in annual income.
  • If earnings are depressed, and your return is lowered to 5%, then you will be generating $50,000 in annual income.

In order to make up this $20,000 shortfall you will have to boost your nest egg to nearly $1,418,000.

$418,000 in additional savings is a significant amount to make up a 2% drop in returns. You can see how low interest rates can have a real impact on your retirement planning.

Planning for Retirement

Inflation will eat away at cash investments. Rates for FDIC insured accounts and CD's are anemic. Stock and bond investments may become depressed. It sounds like a bleak prospect for retirement planning. There is no easy answer, but the best thing to do is to start preparing early.

Run the numbers with a financial calculator or with your financial planner to see how much you will need to retire given various assumptions of rates of return.

The best way to overcome lower returns is to start saving more as early as you can. It will be much harder to play catch up if you are near retirement than it is if you still have several decades to work.

As mentioned earlier, you can also seek out some alternative investments outside of the more traditional stock and bond markets. Working longer or more is also an option if health allows.

With some proper planning and a proactive approach one can overcome a low rate environment. It does take discipline, a proactive approach, and starting as early as you can. Actions that you take today will impact your retirement decades into the future.

 

This article was written by Brian Lesko from All Things Finance and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

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