How Higher Interest Rates Impact Your 401(k)

Interest rates have a significant impact on both the economy at large and the stock and bond markets in particular. The Federal Reserve Bank sets interest rates based on its view of what’s best for the economy and every quarter it makes an announcement regarding the plans.

Interest rates can also affect your 401(k) plan in many different ways, depending upon the investment choices that you hold inside it. Knowing how this critical economic factor can impact the performance of your retirement plan can help you to bolster your investment returns and avoid potential losses that may be triggered by interest rate changes. (See also: How Does the Bond Market React to Changes in the Federal Funds Rate?)

Of course, one of the most obvious ways that a change in interest rates impacts your 401(k) is the amount of interest you earn from any investment choice that pays either a guaranteed or a floating rate of interest. When rates rise or fall, so will the interest rate of the money market funds in these plans, as well as the rates that are offered in guaranteed accounts of any kind.

The key rule to remember when it comes to bonds and other fixed-income instruments is that when rates rise, bond prices in the secondary market will fall, and vice versa. This is due to the fact that a bond buyer in the secondary market is not going to pay full price—or the par value of a bond when it was issued—for a bond that is paying a lower rate when new bonds that are issued are paying higher rates. Therefore buyers will demand a discount from the par value before they will buy the older bond in order to make up for this difference. So if you own mutual funds that invest in bonds inside your plan, then a rise in interest rates will probably cause the share price of your funds to drop slightly, while the interest or dividends that they pay out may rise as new holdings that pay higher rates are added to their portfolios. (See also: How to Rebalance 401(k) Assets.)

Interest rates have a different kind of impact on the stock and equity markets. When the Fed lowers rates, this makes it cheaper to borrow money, which can spur businesses to take out expansion loans and thus grow the economy. The markets react favorably to this change and will usually rise on any day when the Fed announces that it will either lower rates or leave them unchanged. (And markets will usually rise higher when rates are lowered.) Stocks will also usually continue to perform better during periods of low rates, although there is no guarantee or protection against corrections or recessions. When rates are high, stocks tend to fall somewhat out of favor because of the more attractive options that are available from issuers of bonds and CDs.

There is a close relationship between interest rates and inflation—the two are unable to materially diverge from one another. Although one may rise or fall a bit faster than the other, they generally move in tandem over longer time periods. While rising interest rates may increase the yield that you receive from your bond and cash holdings, your purchasing power will also likely erode at some point because prices will also start to go up. And if you elect an irrevocable pension payout from your 401(k) plan, then the purchasing power of your monthly payments will also erode as inflation rises.

There are several things you can do in your 401(k) plan to protect yourself against changes in interest rates. If it looks like rates are going to rise, then a short-term bond fund may be a good idea because it won’t invest in long-term obligations that will consequently drop in price. You may also consider moving some of your appreciated equity positions into short-term bonds or cash for a time, because the markets will often pull back when rates start to rise. (See also: Retirement Savings: 401(k) vs. Stocks.)

If they start to fall, then beefing up your equity holdings might be wise. It may also be a good time to look at locking in a current rate on some longer-term fixed-income offerings. If you are looking at taking a lifetime annuity payout from your plan, then most financial planners would encourage you to choose an option that has a built-in cost of living  rider.

Interest rates impact all facets of our economy, including your retirement portfolio. But these changes don’t have to mean losses for you if you understand how they work and what you can do to position yourself to profit from them. For more information on interest rates, visit the Federal Reserve website or consult your financial advisor. (See also: 401(k) Rollovers: The Tax Implications.)