How Do Interest Rates Affect Retirement Plans?

Interest rates in the United States are controlled to a large extent by the federal government. The Federal Reserve bank sets the rate for interbank lending, and interest rates on mortgages are based on the rates being paid on federal bonds. Changing interest rates can have a positive or negative impact on your retirement plans. Many people regularly meet with their investment advisers to tweak their plans any time rates change direction.

How Pension Plans Work

Traditional pension plans usually take the form of life insurance contracts called annuities. These plans are usually employer-funded, and you're guaranteed to get a certain monthly income payment based on your years of service. The insurance companies that sell these plans have to ensure they have enough cash on hand to cover this long-term cost. Rules exist that require these firms to invest your money in low-risk interest-bearing investments such as bonds.

When rates fall, pension companies lower payment guarantees on new accounts. The opposite occurs when rates are rising. The Fed's actions today could have a direct impact on the size of your future pension checks.

Understanding Inflation Risk

If you invest your retirement nest egg in an account that pays 3 percent interest, your account will grow in value by 3 percent every year. However, if inflation also increases at a rate of 3 percent, your spending power doesn't increase because everything costs more than it used to. When interest rates drop, inflation often outpaces interest rates, which means you actually lose spending power over the long term. If rates rise, your nest egg grows more quickly both in real terms and in terms of your eventual spending power.

Saving for Retirement

You can attempt to predict your retirement income needs by adding up fixed costs such as your mortgage and factoring in inflation. You can save for retirement by investing a set portion of your paycheck in your 401(k) or individual retirement account. The aim of the game is to save enough to reach your nest egg goal.

When interest rates rise, you don't have to invest as much because you get a higher yield on your money. When rates fall, you have to set aside more and more of your money each month just to keep your retirement plan on track.

Looking at Other Investments

When interest rates remain low for an extended period, you have to make a difficult choice between inflation risk and principal risk. You can keep your retirement money in low-risk accounts and take the chance that you'll lose spending power. On the other hand, you can move your money into riskier investments such as stocks. When rates are low, it becomes less expensive for U.S. firms to export goods, and this drives up company profits and share prices.

Unfortunately, stocks have no principal guarantees, so your short-term gains may be erased next time the stock market takes a dive. Faced with this situation, many investors choose to invest in a mixture of stocks and interest-generating instruments.

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