As the Fed has toyed with “the taper,” pre-retirees have gotten a clear lesson in how important interest rate movement is to their future financial security.
The taper, of course, refers to the gradual removal of Federal Reserve stimulus—most notably the monthly purchase of $85 billion of mortgage and other bonds. The Federal Reserve has been running this program since the financial crisis in order to keep long-term interest rates low.
The Fed has been hinting at a shift in policy since spring but so far has not altered its course, and the on-again, off-again plan to tighten the spigot has led to some big swings in key rates. The 10-year Treasury bond yield soared from 1.7% in early May to 3% by early September.
When long-term rates move substantially, so does the cost of guaranteed lifetime income purchased through a fixed annuity, which is an increasingly popular insurance product. As traditional pensions have disappeared and Social Security benefits have eroded, financial planners have moved clients into fixed annuities to provide income to cover expenses like rent and utilities in retirement.
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The surge in long-term rates was welcome news on this front. Short-term rates didn’t follow suit, leaving bank CDs and money market accounts with continuing pathetically low yields. But as long rates rose fixed annuities got cheaper, meaning that it cost less to secure the same amount of guaranteed lifetime income.
At the end of June, a 60-year-old planning to retire at 65 and live off a fixed annuity could have bought $1 of annual income for $16.34, according to BlackRock’s Cori index. By early September the same person could have bought $1 of annual income for just $15.48—almost entirely because long-term rates had risen and offered new investors a healthier, secure yield.
Is that a big deal? Look at it this way: If this 60-year-old had $250,000 to purchase a fixed annuity, it would have bought $15,300 of guaranteed annual lifetime income in June. By September, it would have bought $16,150 of guaranteed annual lifetime income. That additional $850 was a gift from the Fed, which essentially faked the markets into thinking that higher long-term rates were imminent.
Alas, since early September the Fed’s rhetoric has reversed. Recent employment and housing data suggest the economy is still struggling. Maybe the bond purchases will go on unabated into next spring, at least. Long rates are falling again and that $1 of retirement income costs about what it did back in June.
So what’s the point of this exercise? If you are nearing retirement, say aged 55 to 64, and planning to buy a fixed annuity to augment your income it pays to keep an eye on long-term rates. As they rise so does your ability to lock in greater future income, no matter what happens later on.
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Despite the spring surge, long-term rates remain historically low and that makes fixed annuities historically expensive. You see what a difference higher rates can make, so consider waiting if you can before buying a fixed annuity. Rates will rise in time, though no one knows how soon or for how long. The closer you get to retirement, the more important it is to lock up guaranteed income after long-term rates have moved higher.