Key Takeaways:
- The Federal Reserve signaled interest rate cuts, which would likely affect retirees’ income.
- Strategies such as bond laddering and dividend-stock investing could help increase and maintain income in a low-rate environment.
- Lower interest rates may prompt investors to shift from bonds to stocks for potentially higher returns.
As inflation cools, the Federal Reserve has indicated that it may slash banks’ overnight lending rate later this year. That would have a ripple effect on other interest rates affecting consumers.
If you’re considering buying a home in the next couple of years, you may be celebrating. But if you’re in retirement or close to it, you may be wondering how lower rates may affect your nest egg and your ability to finance the lifestyle you’ve dreamed about.
“The idea of lower rates certainly can make retirees nervous, but at least in the short term, there is little to worry about,” said Carla Adams, founder and certified financial planner at Ametrine Wealth in Lake Orion, Michigan, in an email.
When interest rates go down, she pointed out, that doesn’t change the interest rates on any bonds that investors currently own. “So whatever bonds you own will continue to pay their same rate, and even better, they will increase in value,” she said.
Here’s how that works: Selling an existing bond after rates decline may result in a capital gain because the bond’s higher fixed interest rate is now more attractive to buyers.
Dual-Edged Sword of Lower Rates
Lower interest rates pose a dual-edged sword for fixed-income investors, said Brian K. Seymour II, founder and CEO of Prosperitage Wealth in McDonough, Georgia.
On one hand, lower rates reduce yields, impacting the income generated from bonds and other fixed-income instruments, Seymour said in an email.
“On the other hand, the value of existing bonds may increase, providing a potential capital gain. In these environments, investors should try not to panic but to reassess their portfolio, considering diversified fixed-income assets with varying maturities and credit qualities,” he said.
To decrease the effects of interest rate risk, Seymour said retirees could buy bonds with varying maturities. That’s a strategy known as a bond ladder, which helps manage interest rate risk while providing a steady income stream and liquidity.
Higher Risk Equals Higher Potential Return
Bonds with longer maturities typically carry more risk than those with shorter maturities. A simple way to understand that: It’s easier to make an educated guess about interest rates a year or two from now, but who knows where rates will be in 20 years? That uncertainty amounts to more risk with a longer-term bond but also means investors get paid more to hold them.
Seymour also recommended that retirees diversify bond credit qualities.
For example, high-yield bonds, or those issued by companies with a higher risk of defaulting on their debt, pay more than investment-grade bonds, issued by companies in a better financial position. The extra risk of high-yield bonds means they pay more.
While it’s always important for investors to understand what they own and why, Seymour said retirees shouldn’t lose sight of the bigger picture.
Focus on Overall Portfolio Goals
Regardless of what’s going on in the market, Seymour said, “a prudent step is to focus on the overall portfolio’s goals, understanding that lower rates can signal broader economic trends that may influence investment decisions beyond fixed-income.”
For example, lower rates also benefit stocks as companies’ borrowing costs decrease. For capital-intensive industries, such as technology or pharmaceuticals, that can affect earnings.
In addition, as bond yields decrease, investors turn to stocks for a higher return.
Dividend-Paying Equities to Generate Income
So how can retirees diversify their portfolios to accommodate for lower interest rates?
“Utility stocks or mutual funds are an excellent way to generate income,” said Steven Conners, founder of Conners Wealth Management in Scottsdale, Arizona, in an email.
He added that utility companies are mostly monopolies, which means there isn’t competition from other utility companies. That helps them maintain a steady revenue stream.
“The risk for most utility companies is rising interest rates. Now that rates have most likely already peaked, now may be a good time to leverage the dividends that these companies pay,” he added.
Other asset classes can diversify a portfolio and help retirees grow wealth and preserve capital, even as interest rates decline.
Conners also said real estate investment trusts, or REITs, are a way to generate passive income.
“For example, if you have noticed a new apartment building being constructed, perhaps it is owned by a REIT,” he said.
The Internal Revenue Service mandates that REITs must pay shareholders at least 90% of their earnings. Increasing property values may also benefit REIT investors, Conners added.
Stocks with a steady history of increasing their dividends are also investments to consider in a declining-rate environment. Their consistent payouts offer income and stability, making them valuable portfolio additions for investors seeking income.
Techs Often Outperform as Rates Decline
As rates decline, equity opportunities aren’t limited to dividend-paying stocks. The tech sector frequently benefits from lower rates as companies can innovate with a lower cost of capital. This growth potential attracts investors seeking higher returns.
The reverse is also true: Rising rates in 2022 were a factor in the tech sector’s decline of 31.55% that year.
But in 2023, as investors began to believe the Federal Reserve’s series of rate increases would come to an end, tech stocks were off to the races. The Technology Select Sector SPDR ETF (ticker: XLK) returned more than 17% in the fourth quarter.
As rates drop, investors must shift their thinking to what happens if they stay lower for longer, although most analysts don’t see rates falling to pre-pandemic lows in the next couple of years.
In addition to being open to portfolio adjustments, retirees could also reevaluate their income sources as well as expenses. Possible steps include reassessing the budget, exploring part-time work and evaluating health care coverage.
Diversifying income sources and staying financially flexible are always good ideas for managing cash flow in retirement as economic conditions change, which they inevitably will.
