Over the last 12 to 18 months, inflation has been bearing down on consumers and businesses. The Fed began aggressively hiking interest rates to try to slow inflation, and the jury is still out on where we are in the process of getting inflation under control. Higher inflation makes the cost of everything go up, but it also brings higher interest rates. If you’re a borrower, that’s not great. If you’re a saver or investor, this is presenting some opportunities that we’ve not seen in over 15 years with interest rates on money market accounts, certificates of deposit, treasury bonds, and fixed annuities looking very attractive.
A large number of people shifted their investments to more risky assets over the last decade or so as they have tried to reach for more yield or return due to the rate environment being at or near zero for so long. As people have aged and rates are more attractive again, it may be a good time to start reallocating your investments more accordingly to your risk tolerance and objectives For instance, if you were 45 years old in 2010 after the dust had settled from the financial crisis in 2008-2009, you may have been willing to be more risky with your investments trying to recoup your losses. This may have meant you reached for more yield on dividends in stocks or maybe invested in higher growth stocks to try to boost your return. A lot of people shifted some money to dividend stocks that may have been in fixed income previously, which exposed their principal to market volatility. Now, fast forward to 2023, you’re 58 years old, looking at your retirement options more closely, it may be a good time to shift a portion of your money to safer vehicles that are now paying over 5.00% on a fixed return. Maybe you have been 90%-100% stocks the last 12 years or more trying to get that extra return in the market. Now that rates have shifted significantly, a 5.00% fixed return on a portion of your money is starting to sound much better. You might want to look at shifting 20-40% of your investments to vehicles that can provide you with these safe, steady returns.
Maybe in 2010, you were 55 years old, and you had been in a balanced allocation typically 60% equities and 40% fixed income, but you shifted some more money towards assets classes that were a bit riskier which ended up making your allocation closer to 80% equities and 20% fixed income. Fast forward to 2023, you’re now 68 years old, possibly retired or very close to retiring. If you haven’t shifted you’re allocation at this point, you really need to have a conservation with your advisor. With rates where they’re at now, you should be considering scaling back your exposure to equities and developing a better fixed income strategy with a good portion of your funds. With the recent market volatility over the past year, you may have gotten caught off guard and now are concerned about your portfolio. Again, it’s time to talk to your advisor and start reevaluating your options.
Let’s look at some of those options that you can take advantage of right now. When thinking about fixed income, you have a few things to consider other than the rate itself. Usually you want to know how safe the vehicle is going to be and how easily accessible my funds will be if I need them. Money market funds are the most liquid fixed income vehicle. Up until recently, those money market funds have been paying next to nothing. Now, these funds are ranging from 3-5% annually. It’s important to understand how money market funds operate. Some are FDIC insured through financial institutions and are accessible at anytime. Other funds may be called money market funds, but they are actually money market mutual funds that use short term treasuries to provide the yield and liquidity. Their prices don’t fluctuate, but they are not FDIC insured. Both types of money market funds are dollar for dollar what you put in. You may be able to get higher yields on the money market mutual funds, you just don’t have the FDIC insurance. You just need to make sure you’re comfortable whichever one you choose.
Certificates of Deposit or CD’s are currently paying very attractive yields over 5.00 in the 6-12 month range with most brokered deposits. If you were to go to your local bank, you may not see that high of a yield currently. There are two types of Certificates of Deposit, ones at your local bank and ones through your brokerage account thus brokered CD’s. Both types of CD’s are FDIC insured. When you purchase a CD, you choose a term or time limit that you are willing to invest your funds to get a fixed rate of return. Let’s say your buy a 1 year CD with a 5.00% rate. Whatever dollar amount you put into the CD, your money will earn that 5.00% for the 1 year term. At the end of that term, your CD matures and you need to choose whether you want to reinvest for another term or take your money and use it elsewhere. If you want to cash your CD in early before maturity, typically the local bank charges a penalty such as 6 months interest. A brokered CD doesn’t necessarily charge a penalty for cashing it in early, you just have to sell it at what the market is willing to pay for it. That all depends on where rates are when you sell it. If rates have gone up, then your CD is worth less. If rates have gone down, your CD may be worth more. You may actually make money on selling your CD in that case. That’s the major difference in CD’s at the local bank versus brokered CD’s. Both are great tools, you just need to be comfortable with how they operate.
Treasuries are another useful tool in your fixed income strategy. These are bonds backed by the US government. You can by short term ones under a year, or longer term increments in 2, 5, 10, 20, or 30 years if you wanted. There are some tax advantages to owning treasuries as well. You typically don’t have to pay local income taxes on the earnings you make on Treasuries. These are bonds and the prices do fluctuate with the rate environment. If rates go up the price of the bond goes down and vice versa similar to the brokered CD. Before you buy longer term Treasuries, you need to understand if you have to cash them in, you could be taking a big hit on your principal you invested. The longer your maturity, the greater the volatility in the bond price if rates change. As long as you hold them to maturity, you will get your original principal back, you just have to make sure you don’t need those funds until that time period is up.
Fixed Annuities are another great tool to take advantage of especially during this higher rate environment. Annuities are backed by the Life Insurance company that offers the product. They are not backed by FDIC or the Government like the other vehicles we discussed. Life Insurance is regulated on a state level. Most states do have some type of additional backing by their state to protect investors if the life insurance company becomes insolvent. States operate differently, so it’s best to ask your agent or advisor on how that would work in yours. There are all different kinds of annuities. People typically want to lump them all together, but they all work differently. The simplest and easiest to understand are fixed annuities. They operate much like a certificate of deposit from the stand point that you invest your money for a designated term, you earn a certain rate each year, then when you are out of surrender, which is basically like a CD’s maturity date, then you can take your funds and reinvest or withdraw them to do something else. Annuities have their own tax advantages as well. You can own Fixed Annuities in a Retirement account or outside of a retirement account. If you own them outside of a retirement account, your earnings actually accumulate tax deferred, similarly to a retirement account. You do not have to pay taxes on those earnings until you withdrawal them from the annuity. There are a few other rules you need to understand with annuities, as well. Most fixed annuities allow you access to the interest each year, and/or allow you to withdraw 10% of the value of the annuity penalty free. They do allow you some access penalty free during your surrender period, but typically if you take more than the free amount, they have hefty penalties for doing so. There’s also another rule on the earnings of the annuity. You must be 59 ½ before you withdraw the earnings or you will be penalized by 10% on the earnings you take out. Again, you just need to make sure you are aware of these rules and make sure that it fits your situation before you allocate funds to an annuity.
There are different strategies you may choose to implement with fixed income, but I prefer one of the simplest called Laddering. Laddering is something that is probably more suitable when you’re closer to retirement or in retirement. When you’re younger in your 20-40’s, you typically are not going to have that much exposure to fixed income unless it is through a mutual fund or ETF in your retirement account. Laddering is where you allocate certain buckets of your money towards different maturities based on the need for the funds. Each investment vehicle can help accomplish your different types of goals. Money Market funds allow the most liquidity and are best used for funds you think you may need within a 12 month time period. They are great vehicles to keep your emergency funds that way you are earning some money while your funds are setting in the account, plus you have access to them in case of an emergency. For funds that you don’t need for a year or so, then a CD may be a good way to go. When it matures in a year you can re-evaluate your situation and reinvest or move to the money market fund until you decide otherwise. For money you may not need for 1-3 years, Treasuries may be a good option. If you can put your money somewhere for a little longer, Annuities may be a great option for you to lock in a higher rate for longer, have tax deferred accumulation, and some access if need be. Laddering helps reduce your interest rate risk in case rates continue to go up, you will have money coming due in the short term to reinvest at the higher rate. You also have money allocated towards the longer maturities that you were able to lock in for longer, so if rates do go down, you have a good portion that is benefitting from the higher rate you locked in for longer. You just have to make sure you understand where you put your money, and know how to access your funds with the least amount of penalties if any.