Rounding it up
A retirement plan typically consists of setting aside money in savings and investment accounts that will generate income for your non-working years.
Whether your retirement funds are in savings or investment accounts, they are affected by interest rates.
As interest rates rise, savings accounts and long-term bonds become more attractive. As interest rates fall, stocks become more attractive.
You should pay close attention to interest rates, especially if you are nearing or in retirement.
While you may not make a habit of listening in on the central bank’s meetings (kudos to you if you do) or paying close attention to changes in monetary policy, you are still probably well aware that interest rates are a hot topic at the moment. Regardless of when they make headlines, though, interest rates are always important.
Interest rates affect the entire economy from the stock market to consumer spending, and—to prematurely answer the question of this article—retirement funds. If you plan on retiring in the near future or are currently retired, it’s a good idea to pay close attention to fluctuations or potential fluctuations in interest rates.
How do interest rates affect retirement accounts?
A retirement plan is how you plan to support yourself during retirement; typically, this consists of setting aside money in savings and investment accounts that will generate income for your non-working years. For most, this means somewhere around age 65, others may see themselves working until age 80, and some may aim to ditch their corporate career by 35, exploring alternative methods of saving such as the Financial Independence, Retire Early (FIRE) method.
Whenever you plan to retire, it’s crucial to understand how interest rates affect your retirement plan, starting with knowing how your retirement funds are invested.
The breakdown of your retirement account
It’s recommended to allocate 60% of your retirement account assets in stocks, and 40% in bonds. Among those stocks, you may have a combination of mutual funds and index funds that hold a small portion of a lot of different companies—big and small, national and international. Your share of bonds is also likely divided amongst various types,such as treasury bills and money market accounts that contain numerous bonds with various maturity dates.
This division of assets is called diversification. Diversification is meant to protect your portfolio from diminishing in value. When stocks are steadily rising, 60% of your portfolio benefits from that growth. If the stock market dips, only 60% of your portfolio takes a hit, while the remaining 40% remains safely tied up in bonds. Not all stocks and bonds are affected equally, which is why it’s advised to invest not only in both but also in a variety of investment types.
Of course, this is the standard breakdown for a retirement account, but your portfolio may vary depending on how much risk you are willing to take on, and how much time you have until you plan to retire—AKA when you’ll need the funds.
The more time you have or the more growth you need, the more equity-heavy your portfolio will be; the less time you have or the less risk you can tolerate, the more bond and cash-heavy your portfolio will be.
Regardless of what your portfolio looks like, however, it will always be affected by a rise or fall in interest rates.
Rising interest rates
As interest rates rise, the economy responds in a number of ways that affect stocks and bonds. Higher interest rates mean:
Better interest on the money held in a savings account
Better yields on new bonds and fixed annuities
A drop in price for currently held bonds
It is more expensive to borrow money
Let’s dive into these effects of higher interest rates and how they trickle down to impact your retirement plan.
Pros of rising interest rates
First of all, as interest rates rise, it becomes more attractive to hold money in a high interest savings account. Savings accounts are always a “safe” spot to hold your money but they do little to protect it against inflation or help it grow. However, when interest rates are high, you can earn much more on the funds you have set aside. If you’re nearing retirement or already retired, a higher interest rate makes a savings account a good place for money you’ll need in the near future.
Higher interest rates also mean better yields (the amount of interest you’ll earn) on new bonds. If you purchase a bond from a bank or a corporation, you’ll be guaranteed a higher rate of interest (more future money) than before.
This all sounds good, so far, but higher interest rates have a negative effect as well.
"It’s recommended to allocate 60% of your retirement account assets in stocks, and 40% in bonds."
Cons of rising interest rates
While high interest rates are great when you’re securing new bonds and fixed-rate annuities, they also create less demand for the bonds and fixed-rate annuities you already own, causing them to fall in price. When this happens, your funds held in a money market account (remember, this is an account that contains a basket of bonds with varying maturity dates) will lose value.
Another con to rising interest rates is the increased cost of taking out a loan. Borrowing money is less attractive at high interest rates because it means the borrower will pay more in interest. This can clearly be seen with the effect of interest rates on mortgages — purchasing a home with a 30-year mortgage at a 1% interest rate is much more affordable than purchasing a home with a 30-year mortgage at a 6% interest rate.
It’s not just prospective homeowners who borrow money though. Businesses also rely on loans to fund new projects that lead to economic growth. When interest rates are high, it is more difficult for individuals to make big purchases and for businesses to grow. This can cause both consumer spending and business growth to stall, in turn causing investments in stocks to experience lower rates of return during times of high interest rates.
When interest rates are rising, it may be a good idea to set aside funds for immediate use in a high-interest savings account, and invest in bonds and/or in company stocks that are less dependent on loans. Some examples include companies with a lot of cash flow and those that aren’t in home or auto industries.
Falling interest rates
As interest rates fall, the economy responds in a number of ways that affect stocks and bonds as well. Lower interest rates mean:
It is less expensive to borrow money
Lower interest on the money held in a savings account
Lower yields on bonds and other fixed-rate annuities
Pros of falling interest rates
When interest rates are low, both individuals and businesses are better able to borrow money, which stimulates increased spending and growth. This is why, in times of economic depression or recession, the central bank tends to lower interest rates in order to make it easier for both individuals and businesses to make spending decisions that will stimulate the economy.
Increased consumer spending and increased business growth contribute to a greater return on investments in stocks.
Cons of falling interest rates
Low interest rates benefit stock holdings, but they can hurt more conservative investment options such as bonds and savings accounts. For example, returns on retirement money held in a savings fund that is dependent on interest such as a GIC or HISA will take a hit.
This can put retirees and soon-to-be retirees in a pickle. While stocks may perform well during this time, they are still a higher-risk option that this group of people can’t afford to take, and retirement funds held in savings accounts and bonds won’t afford them good enough returns.
When interest rates are falling, it may be a good idea to invest more in stocks, which have the possibility of delivering much higher returns than bonds and savings accounts that offer little returns in periods of low interest rates.
"When interest rates are low, both individuals and businesses are better able to borrow money, which stimulates increased spending and growth."
Why do interest rates change?
In Canada, interest rates are set by the Bank of Canada as a tool to manage the economy.
The Bank of Canada typically adjusts interest rates on eight predetermined dates throughout the year, but it does have the power to make changes in unique and emergency situations such as during the financial crisis of 2008 or the coronavirus pandemic just last year.
As we briefly touched on earlier, when the economy is doing poorly, the central bank lowers interest rates to make it easier for people to take out loans and use credit. This helps stimulate the economy because people and businesses have more access to capital.
When the economy is doing well or improving, the central bank tends to raise interest rates to prevent inflation and sustain growth.
You can monitor current interest rates on the Bank of Canada’s website, and also view yields on treasury bills, bonds, and money market accounts.
Should you change your retirement plan when interest rates change?
So, if interest rates are changing, what should you do?
As with all personal finance questions, the answer is personal. While you should heed good advice, your retirement plan shouldn’t be based on a specific standard or model plan. Instead, it should be tailored to your age, target retirement date, level of risk tolerance, and personal goals.
With your uniqueness in mind, consider these tips before making changes to your retirement plan:
1. Understand volatility
First, it’s important to understand that in any market condition and over the course of your investment period, there will be volatility. Volatility is the upward and downward movements of the market that cause your returns to rise by significant amounts sometimes (when we all love being investors) and fall by significant amounts other times (when being an investor isn’t near as fun).
Remember diversification? Your retirement portfolio is made up of a variety of assets including stocks and bonds so that it is at least partially shielded from these fluctuations and its potential consequences.
Stock market volatility is normal and interest rates rise and fall, so you shouldn’t let either of these factors play too much into your retirement plan.
2. Be patient
Rate changes also won’t immediately impact your portfolio. In most cases, the effects of a rise or fall in interest rates won’t filter down to your retirement account for a couple of years. So, don’t make any rash decisions. Take your time, talk to your financial advisor or KOHO’s Financial Coach, and decide if it makes sense to switch up your asset allocation.
3. Consider your timeline
The amount of time you have between investment and retirement should impact what you invest in and whether you should alter your investments when interest rates change.
The closer you are to your retirement date, the closer attention you should pay to interest rates and how they could affect your portfolio. At this time in your life, the amount of money in your retirement account is your livelihood, and if you have been investing in your account for decades, small changes in interest rates could have big consequences.
Wherever you are at in your investment journey, it’s always a good idea to reassess where your money is invested in every so often and make sure the mutual funds, individual stocks, and bonds you picked out initially are still performing well for you.
The bottom line
A rise or fall in interest rates will affect your portfolio no matter what. However, if you have chosen to invest heavily in either stocks or savings, or you’re closer to retirement, you need to be more careful. A rise in interest rates could severely hurt an equity-heavy retirement plan, while a fall in interest rates could severely hurt a savings-heavy retirement plan. When you diversify, you safeguard your portfolio against a major impact from a shift in interest rates.
If you understand where your retirement funds are invested and how a rise or fall in interest rates could affect them, you’re on the right path to a financially stable retirement.
Ally Streelman is a storyteller whose work spans money, wellness, travel, and more with the chief goal of empowering readers. When she’s not stringing together sentences, you can find her immersed in a new city, cookbook, or novel or encouraging women to take hold of their financial journey.