The interest rate hike announced today by the Federal Reserve is a major milestone for retirees, who have been caught between a rock and hard place ever since the Great Recession, with zero interest rates and higher-than-average inflation.
The Fed’s quarter-point hike in the benchmark federal funds rate is the first in nearly a decade, and it could mark the start of something good for retirees, who rely on bonds, certificates of deposit and money market funds to generate income.
Rates on these instruments have been near zero – and often negative after inflation – throughout the post-recession era.
Low interest rates have gone hand-in-hand with low inflation. However, inflation is higher for seniors, due mainly to the disproportionate impact of ballooning healthcare costs.
From 1985 to 2014, an experimental inflation measure of senior inflation (known as the CPI-E) ran 5.1% higher than what is reflected in the broad Consumer Price Index. according to research by J.P. Morgan Asset Management.
Today’s move will not ease the pain. The higher short-term rate already has been priced into the bond market and is not expected to boost interest rates on products like money market funds or certificates of deposit.
And the Fed signaled that it will be cautious about boosting rates further. If rates were, in fact, to rise in the neighborhood of 100 basis points over the next year, and if longer-term bond rates moved in lock step, seniors would get some relief.
“They’ve been earning zero on their cash, so seeing short-term rates move off of zero certainly is good news,” said Scott Thoma, investment strategist at Edward D. Jones & Co.
“No one is saying ‘all clear’ on a secular long-term rise – and rates can stay lower longer than most people think,” adds Tom Anderson, a wealth manager at Morgan Stanley and the author of “The Value of Debt in Retirement.”
A key issue for retirees is whether inflation is heating up. The Labor Department said this week that the Consumer Price Index advanced 2% over the past 12 months, and it was up 0.2 in November, the third consecutive month inflation rose by that margin.
If the trend continues, seniors can look forward to a cost-of-living adjustment (COLA) in Social Security benefits for 2017 after getting no raise for this coming year. The latest Social Security trustee report forecasts a 3.1% COLA next year.
Even if seniors are able to sock money away in CDs or money market funds with slightly better yield, inflation will take its toll. “If you are earning 1% and inflation is 1.5%, that’s no different than earning 1.5% if inflation is 2%,” notes Greg McBride, chief financial analyst for Bankrate.com.
On the other hand, significantly higher interest rates over the next year also could make long-term care insurance and some types of annuities more attractive, since insurance companies look to bond market returns as a key element of pricing.
Long-term care policy premiums have spiked dramatically in recent years, due in part to the near-zero interest rate environment. A 1 percentage point rise in long-term interest rates generally translates into a decline in policy premiums of about 10%, according to Al Schmitz, a principal and consulting actuary at Milliman, a consulting firm that works with insurers.
Significantly higher rates also could boost payout rates for income annuities, which are priced based primarily on a buyer’s life expectancy. But interest rates also play an important role.
Experts have long argued that immediate annuities (or single premium income annuities) and deferred income annuities should play a bigger role in the arsenal of financial products for retirees, since they provide guaranteed income for life. But a near-zero interest-rate environment has depressed payout rates.
Yet recently updated industrywide mortality projections reflecting greater longevity estimates could counteract any improvement in annuity pricing due to higher interest rates.
“The whole thing could wind up being a wash,” said Stan Haithcock, an independent agent who specializes in annuities and writes about them under the moniker “Stan the Annuity Man.”