What Interest Rate Cuts Mean for Your Retirement Portfolio

Key Takeaways

• We’ve seen cash yields begin to come down for the past year in anticipation of the Fed beginning to cut.
• Now that we’re seeing fixed-income yields come down a bit, that means that fixed-income investors will probably have their returns constrained a bit, and it will lower the safe spending rate for retirees.
• Generally speaking, interest rate cuts are a positive for the economy and for equities, but not in every single declining-rate environment.
• In almost any market environment, people should consider delaying Social Security if they can afford to do that, but especially when the safe alternatives look less attractive.

Margaret Giles: Hi, I’m Margaret Giles from Morningstar. The Federal Reserve has begun cutting interest rates in an effort to boost economic growth. Joining me to discuss the implications for your retirement portfolio is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning. Christine, thanks for being here.

Christine Benz: Margaret, it’s great to see you.

How Potential Interest Rate Cuts Affect Cash Yields

Giles: So I want to go asset by asset class here, starting with cash. Those holdings would seem to be the biggest losers in a declining yield environment, right?

Benz: I think that’s right. And the reason is that cash yields tend to be quite responsive to whatever is going on in the interest rate environment. We’ve even seen cash yields begin to come down really for the past year in anticipation of the Fed beginning to cut. So what we see is that sentiment about interest rate changes tend to get pretty quickly reflected in cash instruments. So unless you were smart enough to lock in some longer-term CDs, you will probably have to settle for lower yields going forward. And I think investors also need to be kind of cautious about how much they allocate to cash in a lower-yield environment. Because when you think about inflation, you know, maybe getting close to the yield that you are earning, there’s a real opportunity cost there. So you want to be careful not to overallocate to cash investments. You need some, but you don’t need too much.

How Interest Rate Cuts Affect Fixed Income in Your Retirement Portfolio

Giles: Right. How about fixed-income investments? So how do lower interest rates affect their returns both in the short and long term?

Benz: Yeah, generally speaking, the return you earn from fixed income will depend on whatever the yield environment was when you purchased that bond instrument. So when yields were a bit higher over the past couple of years, that portended better return potential for fixed-income investors. Now that we’re seeing them come down a bit, that means that fixed-income investors will probably have their returns constrained a little bit. If you are a bond-fund holder, when yields go down, you typically will see a little bit of boost in the price of the bonds in your portfolio. So a little bit of a capital appreciation boost in those environments. And the reason is that the older bonds that were in that portfolio have higher yields attached to them than the new bonds coming online that are related to the lower interest rates. So bond-fund holders are typically beneficiaries in that declining rate environment.

Do Equities Perform Better in Lower Interest Rate Environments?

Giles: All right. So let’s pivot over to stocks. Stock market investors usually seem to like rate cuts. Are lower yields a universal positive for stocks, though?

Benz: Well, oftentimes they are because they just grease the skids for the whole economy, that businesses tend to be a little freer with their capital if their borrowing costs are coming down. The employment picture might be a little better. And so people are out there spending more. Consumers might be spending more. So we definitely see the stock market go up on days when it seems that the Fed is going to be lowering interest rates. But I think that investors should be a little bit careful in terms of assuming that lower yields will always translate into better equity returns. If things are really worrisome from the standpoint of the economy, and that’s why the Fed is lowering rates, well, sometimes we can see that reflected in equity prices. Equities won’t necessarily perform especially well during that really gloomy, worried environment. So yes, generally speaking, it’s a positive for the economy and for equities, but not in every single declining-rate environment.

Giles: Right. Rates aren’t everything.

Benz: Exactly.

How Interest Rate Cuts Will Affect Retirement Spending

Giles: So you note that declining interest rates also have implications for retirement spending. What’s the connection there?

Benz: Yeah. So this gets back to the returns that we might expect to earn from those safer investments. If yields have come down, that means that the return potential for fixed-income assets would be lower. And we do this annual retirement spending research where we incorporate where yields are. Currently, we use some forecasts from another team at Morningstar to help determine what are safe withdrawal rates. One thing that helped us bump up the safe starting spending rate over the past few years related to the fact that fixed income yields were looking more attractive. With them coming down a little bit, that will affect the safe spending rate, I would anticipate, a little bit as well.

Why the Advantages of Delaying Social Security Are Even Greater When Yields Fall

Giles: All right. So lastly, there’s also a Social Security connection. What is that?

Benz: Yeah. So people get a really nice increase in their eventual benefits for every year that they’re able to delay up until full retirement age. And it’s an inflation-adjusted benefit. So it’s something to ponder for people who think that they have average or longer than average longevity. And the benefit of delaying looks even better when the return potential of safer investments looks worse. So we’ve been talking about how when yields go down, that depresses the return potential of safer investments. It makes the decision to delay look relatively better. So I would say that in almost any market environment, people should consider delaying if they can afford to do that, but especially when the alternatives, the safe alternatives, look less attractive. There’s even more reason to consider delaying. When yields were a little bit higher, it was maybe a little closer to a wash, still advantage delaying, I think. But when yields on safer investments come down, the advantages of delaying become greater, in my opinion.

Giles: All right. So that’s really helpful context on what rate cuts actually mean. Christine, thanks for taking the time.

Benz: Thank you so much, Margaret.

Giles: I’m Margaret Giles with Morningstar, thanks for watching.

Watch FAQs on RMDs: What Retirees Need to Know for more from Christine Benz and Margaret Giles.