By now, you may feel as though you have been hearing it forever: We will soon face a sustained rise in interest rates for the first time in 30 years. The catalyst that will trigger this rate increase is uncertain. First, it was expected to be part of the rising inflation that would be unleashed with the Feds quantitative easing. Lately, it has been forecast as a result of a Fed taper.
Still, its hard to argue that rates wont be higher at some point in the future.
While the ramifications are quite straightforward and not very good for bond prices and raise concerns for asset classes like stocks and real estate, there are also many secondary effects of rising rates that are notable for planning purposes.
For instance, while rising rates are negative for bond investors, they can be very good news for insurance companies, which invest most of their assets in bonds. Once rates are higher, insurers will rely relatively less on premiums to secure the requisite cash flow for their future claims. This could potentially provide relief for those paying premiums on long-term care insurance and secondary guarantee universal life policies.
Yet higher interest rates are also higher discount rates, and can reduce the value of other strategies: a pension lump sum, the benefit of delaying Social Security and borrowing limits on a reverse mortgage. (The sustainability of safe withdrawal rates may improve, though.)
Perhaps the most significant shift with higher rates, though, will be the fact that once again, cash will actually pay something. For companies that offer money market funds including major RIA custodians this represents a potentially significant financial boon. Yet the coming rise in interest rates may open a whole new world of digital cash management, as well.
Insurance companies are in the business of providing guarantees, and they require stable cash flows to ensure that they can pay their obligations. Insurers generally match most of their future liabilities with assets that will provide the requisite cash flows at the appropriate time. In other words, these companies are heavy investors in bonds, using them for 65% to 80% of total assets.
Because insurance companies tend to hold bonds to maturity, they arent necessarily threatened by drops in bond prices. Still, general interest rate levels are incredibly important, as they have a significant impact on insurance pricing. After all, if you can invest the premiums collected at higher yields, you dont need as much in premiums in the first place. For policies that have already been issued, higher rates mean new premiums are invested more favorably going forward, to the benefit of the insurance companys bottom line.
Accordingly, higher interest rates may have big benefits for several struggling parts of the insurance world. Rising rates may stabilize the premiums for long-term care insurance, reducing the need for future rate increases (or at least slowing the rate of premium growth on new policies).
Higher rates may also reduce pricing pressure on secondary guarantee universal life policies since Actuarial Guideline 38 was implemented last year. Higher rates will also allow for more favorable participation rates and other terms on equity-indexed annuity products.
On the other hand, there may be some risk that, as rates rise, insurance companies will not be as generous in raising payouts on existing indexed annuity products. And those who purchased hybrid asset-based long-term care insurance may regret having given up control of their money and being unable to reinvest at higher yields.
PENSIONS & SOCIAL SECURITY
Another significant indirect implication of a rate increase: It begins to change the discount and growth rates used in a wide range of other financial projections.
For instance, higher discount rates will reduce the lump sum available for those who wish to roll over a pension rather than taking a lifetime income stream. More broadly, higher rates may make annuitization more appealing.
Conversely, higher discount rates make other strategies less attractive. To the extent that interest rates and overall portfolio returns are higher, there may be less value to delaying Social Security benefits in the future. The implicit internal rate of return for delaying Social Security is far more appealing with long-term bonds paying 3% than it would be if they were paying 6%.
Of course, anything with an interest rate or discount rate assumption attached can be affected by higher rates. For instance, just as traditional mortgages will be more difficult to afford when rates are higher, borrowing limits for reverse mortgages will tumble creating an incentive to establish a reverse mortgage sooner rather than later.
There has been debate whether the 4% safe withdrawal rate is threatened by low yields. Yet there is clear agreement that sustainable retirement income would be bolstered, potentially above 4%, if rates returned to a level closer to historical averages.
Higher interest rates also have short-term ramifications for cash management, affecting prospective yields on interest-bearing cash, savings and various money-market accounts.
Investors with large cash balances have always cared about where they can earn a competitive yield, of course, but in recent years, the yields on savings and money market accounts and CDs have been so low that there was not much incentive to shop around.
Now, however, online and mobile banking have given consumers unprecedented abilities to shop around for rates and move money more freely across accounts; funds can be moved between checking and savings accounts with a few taps on a smartphone. A rate increase could create new opportunities for smart daily or weekly cash management to minimize the funds sitting in low- or no-interest-bearing accounts.
Higher yields would also let institutions earn their own spread again on money market funds. Recently, some institutions have been subsidizing money market funds just to keep yields from being negative after expenses. Higher yields could be a boon to most RIA custodians.
There is also room for financial institutions to use those offers as incentives and teaser rates. Expect to see a lot more clients demanding to move cash around to gain (temporarily) higher yields.
But ensure that cash balances really are transferred expeditiously. Remember, at a money market yield of more than 5% (as we had 15 years ago), moving $100,000 by a paper check that would take a few days to mail and deposit would cost the client $13.70 per day in unreceived interest. If you think mobile check deposit is important now, just wait until rates rebound.
The bottom line, though, is simply this: While theres a lot of focus on the impact that rising rates may have on bonds and perhaps the rest of the portfolio, its important to remember that there are a lot of significant non-portfolio issues that will also be affected by rising rates.
Michael Kitces, CFP, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., and publisher of the planning industry blog Nerds Eye View. Follow him on Twitter at @MichaelKitces.
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