How Low Rates Are Ruining Your Retirement
Apr 3rd 2012 2:32PM
Updated Apr 3rd 2012 2:34PM
For years, interest rates have seemed to be as low as they could go -- and then have proceeded to go lower still. With most short-term investments paying little more than 0% and even rates on 10-year Treasuries just recently popping above the 2% mark, it's hard to imagine the possibility of further declines.
But even if rates don't fall any further, they're still taking a big toll on investors. Moreover, the impact goes well beyond those who desperately need to draw income from their investment portfolios -- and it could have an even bigger impact on long-term investors who don't make the right moves.
The plight of retirees and other income-hungry investors in the face of seeing their investment income evaporate is a tragic story. In many cases, households have faced the double-whammy of having breadwinners lose their job income at the same time that any savings they've been able to squirrel away had a big reduction in the interest it paid. To get the income they need, many conservative investors have taken risks they never would have dreamed of -- and while that's a gamble that has thus far paid off, the next downturn for the stock market will test their mettle and potentially create even bigger problems.
But the more subtle impact of low rates affects everyone. Unless you're in a position in which you can afford to invest everything in riskier assets -- and few people are -- then the investments you rely on for safety and stability are slowly but surely losing their value every day.
To get a better understanding of exactly what's at stake, consider what accepting a 2% return on a 10-year bond really means. Investing $1,000 in a bond, you'll get $10 payments twice a year, and then get your $1,000 back in 2022. That's not much income, but if you're a nervous investor, knowing that you'll get your principal back in full at the end of 10 years has some value.
But two factors will eat away at the value of that $1,000 bond. First of all, you'll have to pay tax on the interest payments you receive, so the $20 you get each year may turn out to be closer to $15 after taxes. And even more insidiously, inflation will eat away at the purchasing power of your $1,000 investment -- so that by the time you get your money back 10 years in the future, it will likely have lost more than a quarter of its intrinsic value, even with modest inflation rate assumptions.
Put another way, even if you reinvested your interest payments, you'd still end up losing money after considering inflation and taxes. Given that you want to see your money grow over time, a 2% yield on a bond clearly won't get you where you need to be.
Instead of accepting your fate, one way to address the situation is to figure out which businesses are benefiting from the current rate environment. The most obvious beneficiaries of low rates are the companies that are responsible for paying them to you: banks. JPMorgan Chase (NYS: JPM) , Wells Fargo (NYS: WFC) , and US Bancorp (NYS: USB) have all announced huge dividend increases following their successful passage of the Fed's recent stress tests, and the reason is simple: They've successfully used cheap financing from their customers to earn back big portions of the profits they lost from the mortgage meltdown. By investing in banks, you can hedge yourself against the devastation they're wreaking on the fixed-income side of your portfolio.
Another possibility is to protect yourself against inflation directly. One main driver of higher prices in the past has been the cost of energy. By putting a portion of your portfolio in the high-yielding energy stocks Chevron (NYS: CVX) and ConocoPhillips (NYS: COP) , your shares should rise alongside oil prices, earning you a profit you can use to offset your higher household expenses.
These aren't perfect solutions, as they increase your investment risk. But with rates so low, the alternatives are even less attractive.
Low rates act as a tax on savers, and we're all paying the price. But by taking steps to protect yourself, you can at least try to offset some of the cost of low rates and make the most of a bad situation.
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At the time this article was published Fool contributor Dan Caplinger doesn't want anyone's retirement ruined. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase and Wells Fargo; and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo and Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can bank on The Fool's disclosure policy.
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