Jason and Emilia discuss rising interest rates and what this means for your retirement.
Below is the full transcript:
Announcer: Welcome back America to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement. And now here’s your host, Jason Parker.
Jason: America. Welcome back to another round of Sound Retirement Radio. So glad to have you tuning in this morning. It’s my good fortune to have Emilia Bernal back on the program with me. Emilia, welcome back.
Emilia: Thank you. Hi Jason. How are you doing today?
Jason: Oh, I just had a MOCHA so I mocha, [inaudible 00:00:28] espresso it up. I said we better get this thing in before I crash and come down. And-
Emilia: So caffeine and sugar.
Jason: Caffeine, sugar. Yes. And Bacon, I had a bonus Bacon Gouda sandwiches from Starbucks. They are such a pretty taste.
Emilia: Oh, how was it? Yeah.
Jason: Pretty tasty.
Emilia: Yeah, sounds good.
Jason: All right, so this episode, 181. Interest Rates Are On The Rise. And so we just want to think about that. We want to think about what it means to see interest rates being on the on the rise. But before we do, we like to start the morning two ways. The first is by renewing our mind. In this verse comes to us from Matthew 19:26. Jesus looked at them and said, “With man, this is impossible, but with God all things are possible. And then you have a joke for us. And this joke came from Libby, my daughter who’s 10 years old. She said she couldn’t stop laughing. She just said you made her laugh so hard. So go ahead.
Emilia: Oh, I’m excited and I hope she likes the way I tell it.
Emilia: All right, so here we go. So there’s two guys, best friends and they love playing baseball and so they made a deal with each other one day and said, “If either one of us dies, I want you to let me know if there’s baseball in heaven.” So deals made, having a great time playing baseball one day, one of the friends is sliding into home and he dies. Right there on the baseball field. A couple of days later, the other friend that’s still alive has a vision. His friend comes to him and says, “So great news.” He’s like, “There is baseball in heaven, and you’re pitching next week.”
Jason: And you’re pitching next week. That’s so funny.
Emilia: Yeah. So I don’t know if that’s good or scary, but yeah, hey, good news. Baseball in heaven.
Jason: All right, so let’s get into this episode 181. Interest Rates Are On The Rise.
Emilia: Yes. So Jason, in the headlines they’re telling us that the Federal Reserve has increased interest rates Again. So why is this so important for our listeners?
Jason: Interest rates are on the rise, and I wrote about this in my book back when it first originally came out. We talked about the impact that interest rates have on certain financial vehicles, especially bonds. That’s where most people think about this, but it’s really kind of good news in many ways, because what it means is that the economy is strong, unemployment is low.
This is the first time in 10 years that interest rates are going to be higher or are higher than what the Federal Reserve’s inflation target is. So that’s pretty neat. Some of the concerns that this brings up is there are people out there that say that whenever there has been an inverted yield curve, that we’ve seen interest rates short term, interest rates longer than long-term interest rates. That’s what an inverted yield curve means.
That you can get a better interest rate on a short term, two year note than you could on a long term, 10 or 20 year bond. And we’re not there yet, but it’s … boy, you’re not getting compensated for some of this risk.
Emilia: Good to know. So how do interest rates increases impact bond holders for?
Jason: Yeah, that’s the first one. And that’s the most obvious. I think that’s what everybody’s been expecting. And I think what it did really, because interest rates were so low for so long, people said, “Hey, I really don’t want to earn, a couple of percentages on my money. I can get a better yield by investing in stocks and having them pay me a dividend.”
So what we’ve seen happen is a lot of money has flowed out of bonds and into stocks, which I think is exactly what the result was. You know, there’s an old saying that says, “Don’t fight the Fed.” And so as the Federal Reserve was slashing interest rates, people were piling into risk investments. And then we saw interest rates falling for 30 years. And most people know this, but if you buy a bond today and interest rates go down, then the value of your bond is worth more if you had to sell it before maturity.
But in a rising interest rate environments if you own a bond today and interest rates are going up, and you have to sell that bond before maturity. Then the bond that you hold today would be worth less money. And so what people need to realize is that’s the interest rate environment we’re in. See a lot of times people are making investment decisions based on what has happened in the past.
And even though every prospective tells you past performance is no guarantee of future results, we still see people that look at the past performance of a mutual fund, for example, and they’ll say, “Well, Jesus Mutual Fund has done really good for the last 10 years, so we must,” or their expectation is, it’s going to do really good going forward.
And many times what they’re looking at are these mutual funds that were invested in bonds. And so in a falling interest rate environment, it made sense that those bond, mutual funds did well. But what we need to be thinking about is how they’re going to perform going forward. And I, just out of curiosity, I did a little bit of research Emilia, and I wanted to share some of this with you.
So interest rates are a moving target and obviously they’re going to change. But as I was looking him up this morning, what I saw is that a two year treasuries were paying 2.835%. 10 year treasuries were paying 3.065%, and 30 year treasuries were paying 3.19%. Now obviously again, that’s going to change by the minute potentially, but I’m just kind of gives us a baseline.
So think about that. You could get a little bit more than 3% to tie your money up for 10 years, or 3.19% to tie your money up for 30 years. Why that’s important is if people own bond mutual funds, at least when you own an individual bond, you have an instrument that you can hold till maturity. And so you don’t have to sell it as interest rates are going up, you don’t have to recognize a losses interest rates are going up.
But today a lot of people have their diversification not by owning individual bonds, but by owning bond mutual funds or bond ETFs. And so the way that you want to evaluate those different instruments is, by looking at the duration. How much risk are you taking? Because there’s a direct correlation between interest rate risk, and duration. Generally speaking, if interest rates go up 1%, then you would look at the duration of your fund and expect the fund to fall in value by whatever that duration is.
So for example, I looked up, a couple of the bond ETFs out there, some of the really big ones. And I found that a short term treasury ETF had a duration of 4.48, whereas a long-term treasury ETF had a duration of 17.42. And an intermediate term bond ETF had a duration of 7.47. Now again, those were moving numbers, but what we’re trying to understand is the risk associated with the bonds.
So once you understand the duration risk, you can look at your, let’s say you have one of these bond ETFs and you would say, okay, I have this intermediate term bond ETF that has a duration of 7.47, we would expect that if interest rates go up by 1%, that we would expect that portfolio to fall in value by 7.47%. So that’s quite a bit of risk, 7% decline as a result of 1% interest rate increase.
And then you have to say, “Okay, what am I being compensated? What’s the return expectation?” Because in a rising interest rate environment, there’s not going to be capital appreciation as a result. All you’re going to be compensated is the yield that you’re earning. So if you’re SEC yield is less than 3%, which is the case on many of these funds I was looking at this morning.
You have to ask yourself, “Jesus, am I willing to earn 2.85% and take on risk of a 7% decline? In an environment where the Federal Reserve has said interest rates are on the rise. So what this really does though is it forces people to ask the question why they’re diversified. What’s the purpose of the money? We want to make sure that the investments match up with their time horizon, because it could be completely acceptable to have this much risk in an investment portfolio, and have these bond positions in the portfolio, as long as the portfolio matches up with their time horizon.
And that’s one of the things I’m always trying to teach people is, we want to match your assets to your spending, because retirement is an exercise and cash flow. That’s the first one. It’s the big one everybody’s thinking about is what’s been happening with bonds and what’s going to continue to happen with bonds as interest rates continue to rise. And the Federal Reserve says they’re expecting one more rate increase before the end of 2018.
Emilia: Sounds great. This is a big part of what you teach in your webinars and of the overall plan for retirement, including the bonds. So we just want to remind our listeners that we have a webinar replay available to all of you at soundretirementplanning.com. So you can just kind of get an overall view, think about what it is with bonds that incorporates into your retirement plan and get some more information and let us know if you have any questions.
Jason: Yeah, and it’s a piece I think so many people miss out on. They have investments, they have an investment strategy, but they don’t understand the plan. And I believe so strongly that that plan comes first. And so we made the webinar replay available because we want people to understand from a planning perspective what I think constitutes having a good plan so they can watch our specific process for developing a plan.
And then they can say, “Do I have this already?” If not, then they at least have an idea of what a good plan should look like in my opinion. And then, once you build the plan, then you go out and you find the investments and you and you allocate the portfolio based on what the plan tells us. But unfortunately, what I find is most people have the investment strategy, but they don’t have the plan. They’re kind of putting the cart before the horse.
Emilia: Great. So remember to take a look at that webinar and I’ll replay it if we do get a chance. So just taking this back to our discussion for today, Jason, what are some of the other implications of rising interest rates?
Jason: Well, one of the areas I think that we’re going to see this impact in people, is on housing. You know, banks land based on your income, and debt to income ratios. They don’t land based on assets. I’ll never forget, a friend of mine was trying to buy a house shortly after the financial crisis and he had a lot of money in cash in the bank, like a lot of money.
And he went to buy this house. In his situation, it was not a very expensive house, but his business had had a down year that year as a result of the financial crisis. And the banks wouldn’t lend him, they wouldn’t give him a mortgage because his business had debt that year. So he was in a position where he just pulled cash out of the bank and paid cash for the house.
But, I’m just reminded that banks lend on income not on assets. And so, as interest rates rise, that begins to put pressure on how much house people can afford. And one of the effects of having these all-time low rates is you have to think, “Well, what was that intended to do?” Well, one of the things that was intended to do was help housing recover from the severe shock of the financial crisis.
And that has happened in some areas more so than others. But out here in Washington state, we have definitely seen housing prices skyrocket as a result of interest rates being so low. But as interest rates rise, especially I think where this is going to have the biggest impact is on really high valued homes. So people that are trying to sell their million dollar plus homes, they’re just going to find that there are fewer people that can afford those homes that can qualify for those loans in a rising interest rate environment.
Because again, banks are looking at your debt to income ratios and the higher the interest rate, the less house, people can generally afford. Either that, or they have to come up with a bigger down payment. And so, that’s definitely one area. The other thing that’s, I think a little bit of a headwind for housing, especially again on the higher value homes.
The tax law that recently was past said that the cup on home acquisition indebtedness, used to be $1,000,000. So you could write off interest on the purchase of up to a $1,000,000 house. Now they’ve lowered that down to $750,000. So the tax code is saying, “Hey, if you’ve got a one and a half million dollar house, it’s going to be less attractive for somebody to buy that house from a financing standpoint. And be able to capture the interest expense.”
But also you’ve got a interest rates on the rise. And so, I think those two things, those two elements, especially for people that are looking to buy a house right now, could really impact how much house they could afford.
Emilia: Great Information. All right Jason. So what are some of the steps that people should think about with rates … the impact people are for … Excuse me, jeez. Look at now I need some Mocha coffee here.
Jason: And some bacon.
Emilia: And some bacon. Sorry. How did the interest rates impact people who are saving money now?
Jason: Well that’s the good news. So for so many years, retirees have just been really slammed. They had money in the bank and they just haven’t been able to earn much interest. And now we’re seeing for the first time in a long time you can actually earn a little bit of interest on your savings accounts, on your money market accounts. We’re seeing some really competitive interest rates out there.
Two of the high yield savings accounts I’ve found that have been looking pretty attractive as one that’s offered by American Express. They have a high yield savings account, another one that was being offered by Capital One. And so it’s just encouraging for people that have money in the bank that they can actually start to earn interest again. Now what that means though is that inflation could be on the rise and so inflation means that our dollars might be purchasing less in the future.
So while we’re starting to earn money again, you know also the flip side of that coin is the inflation piece.
Emilia: Wow. Things are changing, things keep changing.
Jason: The other thing I would say they’re Emilia, you’ve got a bank CDs that are starting to pay a better interest rate. You’ve got tools like fixed deferred annuity contracts that are starting to pay better interest rates. You’ve got immediate annuities, they’re tied to interest rates, and so people that are looking to use that type of an instrument for income in retirement, they’re going to find a better income as a result of the rising interest rates.
So interest rates affect a lot of things. Another thing that I was thinking about is if people are going to go out and they’re going to buy something like a car and they’re going to finance that car. Well again, higher interest rate environment means that they could end up with higher payments if the car prices stay the same or continues to rise. The other thing is, some people are carrying around credit card debt.
And credit cards have been charging really ridiculously high interest rates anyways. But those interest rates could be going up. And so one of the things we want people to do is, yes, we want your money working for you. We want you to have a good emergency fund cash set aside. But if you’ve got this debt that’s really high, we want people to be thinking about paying off that debt.
Interest rates are still, even though they’re increasing, their still mortgage rates are still at really low level and so it’s still a good time to refinance if you have the opportunity to refinance and shave a percentage off the mortgage that might be a good chance to lock in some really low interest rates. Some people I meet out there stove, these variable interest rate mortgages. These, they’re called arms adjustable rate mortgages.
And so, now that interest rates are on the rise, people might want to start thinking about locking in some low rates before they continue to rise. You know, the Federal Reserve says that they have a target there. They’re thinking that by 2020 we’re going to be up to about three and a quarter to three and a half percent interest rates. Today we’re at two to two and a quarter percent.
So, if interest rates are going to continue to rise, you want to just be thinking about some of those responsibilities, some of those obligations you have and see if you can shore up some really low a low interest rates, lock those in while they’re still low.
Emilia: Yeah. So on the topic of making some changes and looking at your costs and your spending, if you’re going to save money on interest rates. We just want to remind our listeners that we have a great tool out there to help you with budgeting. It’ll look at these different changes in your payments or however you see, but retirement budget calculator is a great tool to use for that.
And so we want to let our listeners know that there is a coupon code that they can use to get 50%t off of the retirement budget calculator. And that code is podcast. All caps, one word, podcast. For any of our listeners that would like to take a look at that tool. So I’m just taking it back again, Jason, to our topic today. What are some of the steps people should be thinking about with rates increasing?
Jason: Well, one of the things that happen because people have been chasing yield, they’d been wanting more yield out of their portfolio, so been doing two things. They’d been taken on more credit risk and they been increasing the maturity and the duration of their investments, their bond investments. I just ran across this recently where somebody came in and they had these long-term bond investments.
We’re talking 20 plus year maturities with really high duration. So one of the things you want to look at again is just make sure that the portfolio is structured in such a way where you’re thinking about interest rates. A lot of people are keeping their duration risk really low if they want to have bonds in the portfolio because they recognize that in a rising interest rate environment, those really long term bonds are going to provide the highest potential risk for them as interest rates increase.
So I would say that would be the first thing. It doesn’t mean you have to eliminate bonds from your portfolio. That’s certainly not what we’re saying. And Emilia, because bonds can help cushion portfolio volatility if things go sideways. If things get really crazy, it will be nice to have some high quality, low duration bonds in a portfolio. Hopefully. I mean that’s how they performed historically is to help produce income for portfolio, help dampen volatility.
Again, it just comes back to your time horizon and understanding when you’re going to need those assets and making sure that your investments are matched up with your time.
Emilia: Great. So, why are fees so important in a high interest rate environment?
Jason: Well, yeah, they’re especially important now. Again, so if you’ve got a bond mutual fund that’s paying, has a 3% yield and that’s really what the return is that you’re expecting because again, interest rates are on the rise. And then you’re paying one and a half percent fees. So that one and a half percent in fees, you got to figure on that portion of your portfolio, it’s taken 50% of your return.
If you’re earning three and you’re paying one half percent fee, so low fees are always important. Now, at the same time, you don’t want to be … I’ve had people say to me, they said, “Jason, I don’t care what the fees are, if I’m earning enough money, I’ll pay whatever fee people want to charge.” I think there’s some truth to that too. I mean, but at the same time, what we can control, what we have influence over our fees.
And we have some influence over taxes. We have no control over performance. We don’t know what the market’s going to do, but we do have some control over our fees and our taxes. So let’s try to influence the things that we can and keep those fees reasonable and as low as possible.
Emilia: So one follow-up question two as well. Why is inflation important then for the changes?
Jason: Yeah. Well, we know that a dollar that we have today is going to purchase more than a dollar we’ll buy in the future because the Federal Reserve says they want inflation. They have an inflation target. What we don’t want is deflation. Deflation means that things are falling in price, that the price of everything is falling. That it was be like what we had during the great depression or even in some cases during the great recession with some assets like housing.
We saw so many people default on their mortgages and homes going into foreclosure and banks repossessing those assets that, it took about 10 years in some instances for housing to recover from that big sell off. So, a lot of times you’ll hear people say, “Oh, they are not printing any more real estate.” So it’s a for sure thing. But boy, I met a lot of people that got hurt pretty bad in the financial crisis that we’re overly weighted in real estate.
But with inflation that the reason that, on the retirement budget calculator that you mentioned earlier, one of the reasons that we built that was we wanted to give people the ability to project out into the future how they’re spending is going to change. And one of the things that really makes the retirement budget calculator unique is that you can add a different inflation factor for each of your expenses.
So for example, something like a mortgage has no inflation, it’s a fixed expense and it goes away at a future point. So you wouldn’t add any inflation to something like a mortgage because it’s a fixed expense. But health insurance, healthcare expenses, they’ve been gone up considerably. So, maybe the long-term consumer price index says that inflation spend 3% for most of your expenses.
But maybe for health insurance you’d want to assume like a four or 5% inflation factor. And the neat thing about the retirement budget calculator is that we’d give you the ability to do that because you know that you’re spending is not static, that it’s going to change over time.
Emilia: Great. And again, I just want to remind our listeners, you’re receiving a lot of great information today and there’s also … looking at your overall retirement planning process, we have a webinar replay for everybody to go to at soundretirementplanning.com just to review everything that Jason’s discussed on retirement planning and how it can help you with high interest rates and inflation and kind of overall everything. So, Jason, was there anything else today that you-
Jason: Yeah. I just want to emphasize again the fact that the Federal Reserve is increasing interest rates is a good sign for the economy. It means that as they look out into the economic landscape, they’re really happy with what they see in terms of unemployment, in terms of worried that things are going to overinflate or that prices will spike. So they’re trying to avoid inflation.
It’s really a good time to be an investor. I think where it creates a little bit of concern is for those people that are just getting ready to retire because the traditional thought used to be, if you wanted more safety that you just put more money in bonds and if you’re doing that right at a time you’re getting ready to retire and interest rates are going up, you may actually be taking risks that you hadn’t really considered.
So rising interest rates are not a bad thing. It still means you can have exposure to fixed income in your portfolio. Again, you just want to make sure that the risk you’re taking matches up with your time horizon. Time is the cure to the volatility of the stock market. And so we just want to make sure time on your side. For people that have bonds, again, a great way to look at the risk of those bond mutual funds and bond ETFs is the duration risk.
And they can find that for free. Just go to any one of these websites out there that help you look up duration risk on your bonds and they can find that information. But Emilia, thank you so much for being here. Until next week.
Emilia: Thank you.
Jason: signing out.
Announcer: Information and opinions expressed here are believed to be accurate and complete for general information only and should not be construed as specific tax, legal, or financial advice for any individual and does not constitute a solicitation for any securities or insurance products. Please consult with your financial professional before taking action on anything discussed in this program.
Parker financial, its representatives or its affiliates have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance related discussions are subject to the claims paying ability of the company. Investing involves risk. Jason Parker is the president of Parker financial, an independent fee based wealth management firm located at 9057 Washington Avenue Northwest, Silverdale, Washington. For additional information, call 18005145046 or visit us online at soundretirementplanning.com.