In its recent meeting, the Federal Reserve decided to maintain the federal funds rate in the 5.25% to 5.50% range. The Fed's statement also indicated that we can potentially expect three cuts of 75 basis points each in 2024, although this is not set in stone.
Rate cuts, along with the associated easing of inflation that the Fed cited as one reason behind the announcement, could have several potential effects on clients who are retired or nearing retirement.
Lower interest rates and lower inflation are generally positive factors for the markets and the overall economy. However, each client has an individual situation that may be affected a bit differently by rate cuts and reduced inflation.
Here are some potential impacts of the Fed's announcement, including the prospect of easing inflation. Note that other factors beyond interest rate declines and easing inflation will often come into play, potentially causing different outcomes than we might anticipate.
Higher Returns on Bond Holdings
The value of bonds moves inversely with the direction of interest rates. If interest rates fall, clients could see gains in the value of bond holdings in their portfolio. This includes individual bonds, bond mutual funds and bond exchange-traded funds. Longer duration bonds would see the greatest impact.
While certainly not advocating market timing, should these rate cuts materialize and lead to declines in bond yields, it may make sense to review clients' bond holdings.
Individual bonds held to maturity through a bond ladder or similar strategies should be fine, but bond funds and ETFs could experience more volatility than normal depending upon what the Fed does with rates after any initial cuts. This may result in more risk than anticipated for retirees and those approaching retirement following the initial gains in value from the rate cuts. This should be a consideration as you review client portfolios and as you rebalance them.
Savings Vehicles and CDs
One of the positive aspects of higher rates has been higher interest rates on safe investments such as money market funds, certificates of deposit, money market accounts and similar savings vehicles. These rates have led to the popularity of Series I savings bonds as well. Retirees and near-retirees have realized solid returns on these very low-risk investments.
If the Fed follows through on the suggested rate cuts for 2024, this would directly affect the yields available on these safe investments. This could lead to lower income for these clients or force them to seek higher yields in riskier investments. While money markets and similar savings vehicles are not expected to revert to the yields below 1% that we saw just a couple of years ago, interest rate cuts will reduce the rates on these types of accounts.
In the case of CDs, this may indicate a good time to consider a laddering approach if appropriate. This locks in current higher rates over time and allows you and your clients to determine the best use of this money when each rung of the ladder matures.
Fixed Annuities
Another benefit of the current interest rate levels for retirees and those nearing retirement is higher guaranteed payouts on most fixed annuities. When bond interest rates are higher, insurance companies can guarantee a higher fixed interest rate over the guarantee period.
