High Anxiety Over Low Interest Rates?
Posted July 22, 2011
High Anxiety Over Low Interest Rates?
The current low interest rate environment has made it complicated and challenging for investors to navigate the fixed income marketplace. This is especially true for retirees and near-retirees who traditionally shift assets from a diversified portfolio to longer-term, higher-yield investments as they begin relying on their nest egg for income.
One major challenge right now is that the yields on traditional fixed income investments, such as money market funds, CDs and fixed annuities, are near historic lows. Slightly riskier fixed income investments, such as taxable and municipal bonds, also carry low yields and varying degrees of credit risk.
What may need to happen to deal with this reality is a shift in thinking from a strictly income-oriented focus to a customized, multi-level asset management approach.
Think of it Like This
One way of thinking about the challenge is like a college endowment manager, with an eye on current needs, intermediate needs and the long-term future.
The college has commitments to scholarships, grants and other assistance to students, and to certain annual operating expenses. Cash must be readily available to fulfill these obligations, so a portion of the total portfolio is held in low-risk assets with modest yields, but relatively stable principal value.
First-level funds would quickly be depleted if not for a second level of investments intended to replenish the immediate cash needs year after year. This level of assets is invested with a time horizon of approximately one to three years, depending on the investor's tolerance for risk.
Now that short-term and intermediate-term cash needs have been planned for, it is prudent to structure the remainder of the investment portfolio to take advantage of a longer-term time horizon. Investments targeting higher yields and capital gains are often part of the portfolio at this level, and inherently exhibit more short-term volatility. The endowment manager, or you as an individual investor, don't plan to rely on these funds for immediate needs, although they are accessible in the event of an emergency.
Ultimately, the college endowment manager wants the endowment to last forever, so it can continue supporting the college and its students. Even the most optimistic and confident retiree knows that he/she won't live forever, however, retirement may last for many years beyond what your financial resources are able to cover, if they are only held in cash and traditional fixed income investments.
This can be a significant challenge, especially when you need to make reasonable assumptions for unknown factors such as long-term inflation and ever-changing federal and state tax laws.
A Disciplined Approach
Like the endowment manager, you may want to take a disciplined approach to three levels of financial needs:
Your immediate cash needs — Enough "cash" or liquid assets to cover spending needs that are over and above your fixed income from wages, pensions and other forms of stable income, for six months to a year. The objectives for this tier are safety, liquidity and convenience.
Your intermediate liquidity needs — These are funds that you might need in one to three years. Here you can afford to earn higher yields from relatively short-term investments.
Your long-term financial security — Like the endowment manager, you don't want to run out of money, even if you are faced with major medical expenses, long-term care or other high costs.
A portfolio that is constructed in this way can provide protection against many of today's concerns:
- The threat of rising interest rates and the impact on the principle of various types of fixed income instruments
- The negative impact long-term inflation can have on the purchasing power of your hard-earned nest egg
- The uncertain future tax environment and steps that can be taken to be adequately prepared
- Longevity risk, and providing for an adequate degree of confidence that your income needs will be met through your life expectancy
Your situation is unique, and so should your approach to planning for these risks. A successful spending and investment plan, created and maintained by you and your financial advisor, should allow you to reduce your anxiety about interest rates and other factors beyond your control.