By Thomas Henske
In advance of The Federal Reserve’s recent interest rate hike announcement, MDRT conducted a consumer study to gain valuable insight regarding expectations and knowledge of how potential increases would impact financial plans. Advisors can use these findings to start a conversation with their clients and prospects to help them navigate portfolio changes now, and in the future.
Although the majority (85 percent) of Americans surveyed say they are somewhat or very confident in their financial skills, only 55 percent of those without an advisor feel at least moderately comfortable explaining the implications of higher interest rates compared to 76 percent of Americans with a financial advisor.
While many survey respondents do not have financial advisors (73 percent), 67 percent of these consumers believe working with one would increase their understanding of interest rate implications. On the positive side, two-thirds of survey respondents who work with a financial advisor indicated that the relationship increased their understanding of interest rate hikes.
Here are a few ways advisors can incorporate important inflation-related risk factors like changing interest rates into each stage of the financial planning process.
Strategically allocate investment portfolios for interest rate increases
For most clients, investment portfolios come to mind first when interest rate increases are anticipated – they want to ensure their assets will sustain any shifts in the market landscape without losing substantial value.
MDRT’s interest rate study found that over half (53 percent) of consumers with a financial advisor worked with their professional to proactively prepare their investment portfolio for higher interest rates. When all respondents – those with and without a financial advisor – were asked about actions they would take if the Federal Reserve raised interest rates again in the near future, 27 percent said they plan to change at least one aspect of their financial plan, 26 percent plan to talk with a financial advisor and 41 percent plan to monitor the impact through news coverage.
- Bond investments
Bonds are most commonly utilized to hedge against stock market fluctuation, but are still subject to a less intense volatility. Generally, there is an inverse relationship between interest rates and bond pricing – when interest rates increase, bond values decrease. Incremental and steady economic changes do not typically lead to bond market fluctuations, however unanticipated changes like interest rates and rising inflation can hurt. When bonds lose value, it can happen quickly and typically as a response to more dramatic changes.
To safeguard client bond investments, first take a strategic look at the duration of the bonds being purchased. When interest rates are expected to rise, it is best to purchase bonds with the shortest duration. Short duration bond prices decrease at a lower rate when interest rates rise and are therefore less susceptible to major fluctuations.
Next, make sure bonds are acquired correctly to provide a stabilizing force to the overall plan. It’s ideal for clients to purchase bonds directly rather than investing through a fund, otherwise the added layer of security may be lost. When they are invested in a bond through a mutual fund, clients can be at the mercy of fund managers and potential liquidation. When owned directly, clients receive a set return on their investment based on the interest rate.
If clients are unable to own bonds themselves, consider alternative investment options that still lend a degree of flexibility and stability to their portfolio. Floating rate funds enable managers to make adjustments alongside market fluctuations plans. Unconstrained bond funds similarly limit exposure to interest rate fluctuations and may protect retirement nest eggs in exchange.
- Asset allocation and product investments
The equity market will likely respond to increased interest rates, as the changes impact the economy and inflation. Depending on interest level and overall strategy, there are a few similarly attractive investment options in addition to bonds which rise with interest rates, including:
- Treasury Inflation Protected Securities offer a low interest rate opportunity to guarantee a return
- Commodities such as energy, precious metals, livestock and meat, and agriculture
- Retail property rent
Plan for interest rate increases in retirement and long-term planning
Interest rate hikes are equally as important to overall financial planning, although clients may not immediately make the connection since the effects are long-term. Respondents in MDRT’s interest rate study were unclear how they’d be impacted by increases – 32 percent believe increases will negatively affect their finances, while another 39 percent believe increases will both positively and negatively affect their finances. Just 12 percent said a rate hike will positively affect their finances while 17 percent said it would have no impact. Interestingly, younger Americans ages 18-29 are more likely (42 percent) to state that higher interest rates will negatively affect their finances compared to Americans ages 29 and older.
Help clients understand how the domino effect from interest rate increases can shift the overall economy and almost certainly raise inflation. With this shift, overall income needs for retirement and goals-based financial plans must be adjusted.
It’s important for clients to consider how the economy and inflation will change once they retire, and evaluate shifts in their spending habits and needs. For example, retirees depend on services like house cleaning or landscaping more often than goods, and the inflation rate is generally higher on the cost of human labor than the rising cost of goods. Determine which types of services your clients may need during retirement to include the anticipated cost in their plan.
To offset the risk of volatility in long-term retirement investments, as opposed to more immediate investment portfolios, clients may be interested in interest-sensitive life insurance products. Whole and Universal Life policies may offer competitive and favorable rates for qualified clients following rate changes. Interest rate changes have a substantial impact on a client’s overall financial health. As a trusted partner, it is important that financial advisors make sure they understand how changes impact their plans, and to augment as needed to minimize risk.
Thomas J. Henske, CFP®, ChFC®, CLU®, CLTC, CFS, CTS, CES Partner, is one of eight partners nationwide for Lenox Advisors, Inc. Tom developed a revolutionary program called Money-Smart Kids that provides tools and information to foster independence, good judgment and responsible habits in children of all ages. He is also a 17-year member MDRT with three Court of the Table qualifications.