3 Risks Higher Interest Rates Pose to Your Retirement Plan

Key Takeaways

• Higher yields are a positive when it comes to retirement planning. They lift the return prospects for bonds, which means that you don’t need to take as much risk in order to earn a decent safe return. We also see positives for insurance-type products like annuities.
• We’re talking about potentially interest rates declining in the second half of 2024. If you are a cash investor and you’ve hunkered down in cash, you love those 5% yields that you’re getting, that could prove fleeting.
• You want to be careful about overallocating to cash, certainly because of inflation, but anything with a fixed rate attached to it that’s paying you a fixed rate of interest.
• Now that we’re in a higher rate environment, that means bigger tax bills. It bears paying attention to asset location, what types of assets you’re holding where.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Higher interest rates are generally a positive for retirement planning, but there are also some potential risk factors to be aware of. Joining me to discuss some of them is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning, and she’s the host of The Long View podcast. Thanks for being here, Christine.

Christine Benz: Hi, Susan. Great to see you.

Positives of High Yields in Retirement Planning

Dziubinski: So, first summarize, let’s focus on the positive, some of the ways in which higher yields are a positive when it comes to retirement planning.

Benz: Right. They’re mostly a positive. They really make everything easier, almost everything easier, for retirement planning. So for one thing, they lift the return prospects for bonds, which means that you don’t need to take as much risk in order to earn a decent safe return. So that’s a huge plus. And that’s one of the reasons why when we did our retirement spending research at the end of 2023, we concluded that retirees could actually reasonably take a higher safe starting withdrawal rate than they could in 2022 or 2021. That owned largely to higher yields that have come online. And so that’s a huge positive. We also see positives for insurance-type products like annuities. So for people who want to potentially augment what they’re getting from Social Security with a very simple annuity product, those payouts have also lifted significantly because the insurance company takes these funds in, and they need to invest them in something. Well, they can offer a higher payout if they know that they can earn a safe return on annuitants’ money. So it’s definitely a benefit for people from the standpoint of retirement portfolios and safe retirement income.

Risk Number One: Higher Yields Could Prove Fleeting

Dziubinski: Let’s talk about some of the risks then that people should be attuned to in this sort of higher-rate environment. Now, one of them you say is that today’s higher yields could prove fleeting. What are the risks associated with that?

Benz: Right. We’re talking about potentially interest rates declining in the second half of 2024, so we might not even have to wait around that long. And so this is a benefit for you if you hold bonds, you at least benefit from rising bond prices in a period like that. Your yield might shrink, but your bond price gets elevated. That’s a good thing as a bond investor. But if you are a cash investor and say you’ve kind of hunkered down in cash, you love those 5% yields that you’re getting, well, that’s what could prove fleeting because banks and other institutions offering savings accounts and CDs and all that stuff, they’re going to change up interest rates really quick if prevailing yields drop. So that is one caution against hunkering down with too much of your portfolio in cash securities. With bonds, at least, you pick up a little benefit in terms of rising bond prices. As a cash investor, you’re just kind of stuck there, and so you probably don’t want to overallocate to cash.

Risk Number Two: Inflation and an Overallocation to Cash

Dziubinski: Now, another risk is inflation and probably being overallocated to cash, right?

Benz: Yeah. Cash would be most at risk of inflation, where inflation is just eating away at your purchasing power. I think the most recent inflation read was like 3.2%. Well, even if you have a really lush-looking 5% yield, you’re down to 1.8% once inflation is taken into account. And I know we’re going to talk about taxes, but taxes factor in there, too. So you want to be careful about overallocating to cash, certainly, because of inflation, but anything with a fixed rate attached to it that’s paying you a fixed rate of interest, well, that’s perfectly vulnerable to loss of purchasing power, which is one reason why we always say for people, especially who are spending from their portfolios, lock some of that down in some type of bond, whether it’s I bonds or Treasury Inflation-Protected Securities. You want something that’s going to help make you whole with respect to inflation, because the most recent inflation readings were a little bit hotter than anyone expected, and it’s anyone’s guess what we’ll see from here. So I think you want to protect yourself there.

Risk Number Three: Higher Interest Rates and Higher Tax Bills

Dziubinski: And then this last factor is one you just mentioned, and that’s related to higher interest rates and higher tax bills.

Benz: Exactly. It’s a high-class problem, right? But when we were in this mode where everything was paying 1% if you’re lucky, now that we’re in a higher-rate environment, well, that means bigger tax bills. And so I do think it bears paying attention to asset location, what types of assets you’re holding where; it didn’t matter too much if you held that 1% high-yield savings account in a taxable account a couple years ago, well now, at higher yields, taxes will take a bigger bite. So you want to be mindful: If you can hold those income-producing assets that produce income that’s taxed at your ordinary income tax rate, hold them inside a tax-sheltered account if you can. If you’re a high-income person, if you’re, say, in the 24% tax bracket or above, you’d want to look at whether municipal bonds, even municipal money market funds—if you’re holding assets in that taxable account, you may want to look at munis if they’re not the better deal for you on an aftertax basis.

Dziubinski: Christine, thank you for your time today. We appreciate it. Higher rates are a good thing, but again, have to keep your eyes open.

Benz: Exactly. Look alive.

Dziubinski: That’s right. Thanks again.

Benz: Thanks, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch 4 Must-Dos Before Tax Season Wraps Up for more from Christine Benz.