Executive Summary
There has been a growing fear in recent years that we may soon, “finally” face a rising interest rate environment again for the first time in over 30 years. While the catalyst to trigger such a rate increase is uncertain – first it was anticipated with rising inflation due to the Fed’s QE policies, and now it’s expected as a result of the tapering that slowly ends them – it’s hard to argue against the view that from a long-term perspective, rates are likely to be higher at some point in the future.
While the ramifications are quite straightforward – and not very good! – for bond prices, and at least raise concerns for other asset classes like stocks and real estate, it’s notable that there are also many ‘secondary’ impacts of rising rates that are equally notable for financial planning purposes. In fact, for many clients, the most profound impacts of rising rates may be the planning issues most clients are not even thinking about right now!
For instance, while higher rates are negative for retail bond investors, it can be very good news for insurance companies, who invest the overwhelming majority of their assets into bonds that match their liabilities. With higher rates, insurance companies need less in premiums to secure the requisite cash flows for their future claims, potentially providing much needed relief to the premium pricing pressure on everything from long-term care insurance to secondary guarantee universal life policies. On the other hand, higher interest rates are also higher discount rates for other strategies, which can reduce the value of everything from a pension lump sum, to the benefit of delaying Social Security, to the borrowing limits on a reverse mortgage. On the other hand, the sustainability of safe withdrawal rates may be improved!
Perhaps the most significant shift with higher rates, though, will simply be the fact that once again, “cash” will actually pay something. For companies that offer money market funds – including the major RIA custodians – this represents a potentially significant financial boon, as rates rise to the point where companies don’t have to subsidize and can actually profit from their money market offerings. Yet given how much easier it is to now manage “cash” electronically, from a mobile device, and move money across accounts or even financial institutions to seek out a better yield, the coming rise in interest rates may open up a whole new world of “digital cash management” as well!
Insurance Premiums And Bond Yields
Insurance companies are in the business of providing guarantees, and because of their obligations, they require extremely stable cash flows to ensure that they can pay their obligations when due. As a result, insurance companies generally match the overwhelming majority of their future liabilities – i.e., anticipated claims that can be projected fairly reliably based on the law of large numbers – with assets that will provide the requisite cash flows at the appropriate time. In other words, insurance companies are heavy investors in bonds – typically as much as 65%-80% of total assets.
Because insurance companies tend to match their bonds to their future cash flow needs and then hold to maturity, they aren’t necessarily as threatened by the bond price losses that may occur with rising interest rates. However, the general level of interest rates is incredibly important, as it impacts the yield of the bonds that can be purchased in the first place, which in turn has a significant impact on the pricing of the insurance. After all, if you can invest the premiums collected at higher yields, you just don’t need as much in premiums in the first place. For policies that have already been issued, higher rates simply mean new premiums get invested more favorably going forward, to the benefit of the insurance company’s bottom line.
Accordingly, higher interest rates may have a significant effect for several struggling parts of the insurance world. For instance, rising rates may stabilize the premiums for long-term care insurance, reducing the need for future rate increases and potentially even leading to lower premiums (or at least a slowing in the rate of premium growth on new policies). It may also reduce the pricing pressure on secondary guarantee Universal Life policies since AG 38 was implemented last year. Higher interest 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 necessarily be as generous in raising payouts to existing indexed annuity products, and those who purchased “hybrid” asset-based long-term care insurance may regret having given up control of their money to reinvest for higher yields.
Discount And Growth Rates
Another significant indirect implication of rising interest rates is that it begins to change the discount/growth rates used in a wide range of other financial projections.
For instance, higher discount rates will reduce the lump sum that is available for those who wish to roll over a pension rather than taking a lifetime income, and make it more appealing to keep the lifetime stream of income. Similarly, higher interest rates may make annuitization in general somewhat more appealing.
Conversely, a higher discount rate makes other strategies less appealing. For instance, to the extent interest rates and overall portfolio returns are higher, there may be less value to delaying Social Security benefits in the future than there has been in recent years (i.e., the implicit internal rate of return for delaying Social Security is far more appealing compared to long-term bonds paying 3% than it would be if they were paying 6%!).
Of course, anything with an interest rate/discount rate assumption attached to it can be impacted by higher rates. For instance, just as affordability for traditional mortgages will be more difficult when rates are higher, so too will the borrowing limits for reverse mortgages become much lower (creating an incentive to establish a reverse mortgage sooner rather than later as a financial planning tool, even if just as a standby line of credit!). There has even been some discussion as to whether 4% safe withdrawal rates are threatened by today’s low yields; while the conclusions are still debated, there is clear agreement that sustainable retirement income would be bolstered by interest rates returning to a level closer to historical averages.
A New World Of Cash Management
Notably, the ramifications of higher interest rates are not only on longer-term bonds and financial projections. There is a significant short-term issue as well: cash management, and the prospective yields on interest-bearing cash/savings/money market accounts of various types.
Of course, investors with large cash balances have always cared about where they place their cash to earn a competitive yield, but from a practical perspective the yields on savings and money market accounts and CDs have been so low for many years since the financial crisis, that there’s just not much incentive to shop around.
Yet what’s different in today’s environment is our unprecedented capability thanks to online banking and the internet to both move money around more freely across accounts than ever before, and to shop around for the best rates across institutions. For instance, when funds can be moved between checking and savings accounts with a few taps on a smartphone, there will be a whole new opportunity for smart daily/weekly cash management to minimize the amount of funds sitting in low-/no-interest-bearing accounts.
Notably, higher yields also give “room” for institutions to earn their own spread again on money market funds; in fact, some institutions have actually had to subsidize their money market funds just to keep the yields from being negative after expenses! With higher yields comes the potential for large financial institutions to finally earn a spread again on their “in-house” money market funds, a potential boon to the custodians of most RIAs. (If you think the annual conferences for RIA custodians have been impressive recently, wait until yields are higher!)
On the other hand, “room” to profit on money market and cash yields also leaves room for financial institutions to use those offers as “incentives” and teaser rates. Expect to see a lot more interest from clients to move cash around to shop for (temporarily) higher yields, especially as it’s easier to find those high-yield accounts and electronically transfer amongst them in today’s environment. Conversely, be cautious about ensuring that cash balances really are transferred expeditiously if they’re moving around; remember, at a 5%+ money market yield (as we had 15 years ago!), moving $100,000 by paper check that takes a few days to mail and deposit costs the client $13.70 per day in foregone interest! So if you think “mobile check deposit” is important now, just wait until rates rebound!
The bottom line, though, is simply this: while there’s a lot of focus on the impact that rising rates may have on bonds and perhaps the rest of the portfolio, it’s important to remember that there are a lot of significant non-portfolio issues that will also be impacted by rising rates, some bad and some good!
So what do you think? What else might be impacted by rising interest rates that we're not thinking about right now? Are you adjusting any of your planning recommendations to account for the potential of higher rates in the future?
This is going to be bad for recent graduates like myself!
As always, great insight.
It’s ironic to talk about “finally” seeing rates rise in an article from May 2014. Who knows, maybe 2015 will finally be the year.
In addition to your list, I’ll be curious to see the impact of rising rates on housing prices.