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As was pointed out in another article from this month's newsletter, we know that retirees have been hit by inflation impacting their cost of living and potentially how long their assets will last. But at least there was one positive upside to that period and that was many of the bank deposits, a common option for retirees savings, was seeing increased returns from higher interest rates.
However now with the threat of inflation potentially receding they now are understandably starting to get concerned about the impacts of falling interest rates as they seek to preserve the higher rates of return they’ve become accustomed to recently.
So we thought this article written by Liz Koh for Lifetime Retirement Income might be of interest. But please remember the information in this article is general and does not constitute specific advice to any person.
You can read the original article here: Retirees Shouldn’t Worry About Interest Rates Or you can read the article published in full below and tell us what you think in the comments section.
Retirees Shouldn’t Worry About Interest Rates
I was recently asked an interesting question. Why is it that when interest rates change, the media only seems to focus on the impact for people with mortgages? What about retirees? Of course, savers and borrowers are affected in opposite ways when interest rates go up or down. While homeowners with mortgages have been feeling the squeeze over the last few months, retirees without debt have been rejoicing in the extra income.
Impact of higher interest rates on retirees
Interest rates are the principal tool the Reserve Bank has to control inflation. In theory, the higher interest rates go, the less money is borrowed. Spending is reduced as a result of lower borrowing and tighter budgets arising from higher mortgage payments. So, for retirees, higher interest rates provide a double benefit of higher income followed by lower inflation. Falling interest rates usually indicate a period of slow economic growth requiring the stimulation of higher levels of spending. Of course, lower interest rates mean less income for retirees.
Interest is not an effective source of retirement income
Importantly, interest is not an effective source of retirement income. Bank deposits, while being low risk, provide a lower rate of return than other forms of investment and the interest income is taxable. The net return from bank deposits barely matches the rate of inflation, if at all.
A retirement portfolio needs to cater to both spending and investing, ensuring that sufficient money is available to spend when required with the rest invested to provide a good rate of return until it is needed to top up spending money. Money needed in the short term should be kept in a safe place - a savings account or term deposit, for example. Remaining funds can then be invested in assets that typically offer a higher rate of return than bank deposits, such as shares and/or property.
If money in the bank is thought of as spending money, then investors need not worry too much about what the interest rate is. The attraction of bank deposits is that they are a safe place to hold money in the short term until it is spent. This is a very important point to understand. The purpose of bank deposits is to hold money safely rather than to produce a return, although a return is an added bonus. Money in the bank should be split into a number of deposits with different maturities so that the funds can be accessed when needed. When the deposit matures is more important than the interest rate earned as availability of funds is more important than return.
Preparing for falling interest rates and risk management
Over the next year we will see interest rates gradually fall as inflation eases and the effects of economic restructuring kick in. When this happens it’s tempting to look for fixed interest investments, like bonds, that offer a higher return. When ‘shopping’ for interest rates, investors often overlook the importance of a security’s credit rating. A credit rating can range from AAA to D and indicates the likelihood of repayment in accordance with its terms of issuance.
What some investors don’t realise is that the risk changes exponentially with a change in credit rating. For example, a credit rating of AA implies a default risk of 1 in 300 over a 5-year period. This compares to a default risk of 1 in 30 for a BBB rating – 10 times the risk, in other words. Yet a BBB-rated investment may offer less than 1% more interest than a AA-rated investment. The huge investor losses in 2008/2009 when finance companies crashed provide tangible evidence of the lack of understanding of credit ratings. Hopefully, lessons were learned from that experience.
Strategies for managing savings and investments during interest rate cycles
So as interest rates fall, don’t worry about the rate you’re getting but think carefully about how much of your savings you need to keep handy in bank deposits or other fixed-interest investments. Remember that the goal for such funds is to keep short-term spending money in a safe place. Make sure the rest of your money is invested appropriately for your investment time frame with the goal of getting a good return for an acceptable level of risk.
Have you thought about Lifetime Retirement Income to look after your money in retirement?
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