Over the past year, we’ve all been acutely attuned to the Fed’s actions. We’ve watched interest rates swing from near zero to the highest level since the financial crisis – all within the span of a few months.
The Fed’s rapid tightening has squeezed our budgets, but it doesn’t impact everyone equally. One contrast is startlingly apparent in the field of wealth management – retirees often reap the benefits of higher rates, while young workers miss out.
Tighter Policy Impacts Investments for Retirees and Young Workers
Higher rates impact investments – and therefore investors – differently. Retirees with robust bond portfolios could see their monthly income grow. On the other hand, young workers with stock-heavy portfolios could see their savings shrink.
Higher Rates Equal Higher Bond Yields, A Boon for Retirees
For many retirees, bonds are an important part of their portfolio because they provide much needed income. After all, one of the most important steps to a successful retirement plan is ensuring that monthly expenses are comfortably covered by investment income. As yields rise, many retirees see an increase in their monthly income as well.
The Fed funds rate is one factor that can dramatically change bond yields. This fact can clearly be seen during the latest bout of Fed tightening. From December 1, 2021, to December 1, 2022, the 10-year Treasury yield rose nearly 1.5x. Shorter-term bonds reacted even more substantially, with the 3-month Treasury yield rising more than 70x.
Higher Rates Can Negatively Impact Stocks, A Curse for Young Workers
While retirees’ portfolios tend to lean toward bonds, young workers typically invest heavily in stocks for their long-term growth potential. As such, young workers often see their portfolio values tumble when the Fed tightens policy.
Higher interest rates can also dampen consumer demand and raise costs for businesses – translating to lower business profitability and, therefore, lower stock prices. Additionally, growth stocks are often valued using formulas that rely on the “risk-free rate” – typically the 3-month Treasury rate. When that rate rises, growth stock valuations tend to fall.
The Impact of Higher Rates Varies Depending on Investment Goals
To illustrate the impact of rising rates on different investors, consider two sample clients – Bob, age 70 and Kevin, age 30. Bob’s primary investing goal is generating income to cover his retirement expenses, while Kevin is concerned with growing his nest egg.
On November 30, 2021, both investors began with a $1,000,000 portfolio. Since Bob is seeking to generate income, his allocation is 80% bonds, 20% stocks. On the other hand, Kevin’s portfolio is 20% bonds, 80% stocks according to his goal of long-term growth. For simplicity, stock and bond investments are represented by the Vanguard Total Bond Market and Vanguard Total Stock Market Index Funds, which are mutual funds designed to provide broad exposure to their respective markets.
By November 30, 2022, Bob’s monthly income had risen from just over $1,200 to $2,660. During that time, his portfolio value declined, but that is not important to Bob since his goal is generating income. During the same time period, Kevin’s portfolio value decreased from $1,000,000 to just under $870,000. His investment income increased during this time, but that is not important to Kevin who is not investing to generate income.
As you can see, the goals of the investors determined how they viewed their investment performance.
The Flip Side: Lower Bond Prices and More Investing Opportunities
Higher bond yields can be advantageous for retirees, but that is not the whole picture. Bond prices move counter to bond yields, so even conservative investors could see their portfolio value fall as rates rise. This can be troubling for retirees who need to sell their investments.
Similar to the way rising bond yields do not benefit all retirees, falling stock prices do not harm all young workers. In fact, some young workers celebrate an opportunity to buy when stocks are more affordable. This goes to show that how an investor views the impact of higher rates depends on their unique goals and objectives.
Rising Rates Mean Higher Borrowing Costs
It is no secret that monetary policy impacts the rates that consumers pay for their debt and last year proved this point. As the Fed tightened policy, mortgage rates briefly topped 7%, auto loan rates reached 5.5%, and credit card rates hit the highest level since the 1990s.
Young workers are disproportionately impacted by higher loan rates because they typically have more new debt than their retired counterparts. Evidence of this is present in the mortgage market where 90% of all new mortgages are issued to people under age 65.
Higher borrowing costs could impact young workers’ ability to purchase homes, cars, and other large items. Those that do qualify at the higher rates could see a greater percentage of their monthly budget go to servicing their debt. This leaves less money each month to save for retirement and other financial goals.
Tighter Policy Means Fewer Jobs for Young Workers
The crux of the Fed’s dual mandate is that they often must sacrifice employment to achieve stable prices. While the labor market has remained strong thus far, the U.S. has already seen significant layoffs in the tech industry and more are expected in the coming months.
While unemployment may not have as direct an impact on retirees, it can be a significant barrier for young workers. They could face layoffs and difficulty finding replacement employment if the job market weakens. Those who do keep their jobs could lose the benefits of a tight labor market – like rising wages and better benefits – because employers don’t have to try as hard to keep employees.
The Bottom Line: When Rates Rise, Retirees Often Win, Young Workers May Lose
When the Fed tightens monetary policy, young workers often feel the pressure acutely. They can see their retirement accounts tumble, job security vanish, and dreams of homeownership evaporate. Meanwhile, retirees may feel some discomfort as their portfolio dwindles, but additional bond income can outweigh the negative aspects of higher rates.
Keep Your Destination in Sight, But Adjust Your Plan as Needed
Whether you’re 20 or 90, higher interest rates – and the economic slowdowns that often accompany them – can be nerve-wracking. When rates rise, you could see impacts in many aspects of your life from your monthly debt payments to your investment returns.
You might be tempted to make drastic changes to your financial plan in response to higher interest rates. Instead, remember that your investing decisions should be intentional and made with long-term goals in mind. That’s why our advice is the same in all economic conditions – find an advisor you trust and create a nimble plan.
Prepare for Higher Interest Rates with Financial Fingerprint™ by Meld Financial
When faced with economic uncertainty and higher expenses, you need a financial plan that can adapt to changing market conditions and a team of experienced professionals to support you. For these needs, turn to Financial Fingerprint™ by Meld Financial. This comprehensive wealth management plan, is quick to assemble, easy to understand, and simple to modify as your circumstances change. It accounts for changes in interest rates, investment markets, and your own life. Best of all, your financial plan is supported by Meld’s experienced team of tax, legal, and investment professionals.
Whether you are retired or just beginning your career, the team at Meld Financial can help you navigate the markets and secure your financial future. To learn more about Financial Fingerprint™ and get started, contact us today.