Struggling with Low Interest Rates
By: Source: AARP Bulletin Today Date Posted: April 2002
It's an economic paradox: The lowest interest rates in decades have unleashed a wave of consumer spending on automobiles and homes, helping bring an end to the recession.
But there's one group that's missing out on this—those older Americans who have seen the rock-bottom returns on certificates of deposit (CDs) and savings accounts sharply reduce their monthly income.
"We're sort of the silent majority," says Onis Cox, 69, of Edmond, Okla. Since he retired from his aerospace job in 1993, Cox has seen rates on the CDs he buys fall from about 8 percent to 2.6 percent.
"As our interest income has declined, we've had to cut way back on spending," Cox says. "We're having to draw on savings, our principal, just to meet necessary expenses, such as repairs on our home.
"Other spending can't be done," he adds. "We're not giving our house a needed paint job, nor are we replacing our aging car. And travel, any kind of trip, is out of the question."
A lot of older people are in the same boat. A disparate group, they include longtime retirees who no longer have the option of returning to work. They include better-off retirees seeing their nest eggs shrink. And they include low-income individuals who depend heavily on interest income from passbook savings accounts.
Different as they are, they have one thing in common: Their situation contrasts with that of younger people now using low interest rates to snap up homes and cars at a record clip. "If you're a borrower, these are great times," says James Knaus, a certified financial planner in Troy, Mich. "But if you need income from your investments, these are not great times."
NO RELIEF IN SIGHT
The picture isn't likely to improve anytime soon. Even though the economy appears to be on the mend, there is little expectation that the short-term rates controlled by the Federal Reserve Board will rise much, if at all, before summer.
"With the economy on the verge of recovery, the easing cycle that began in January 2001 is now probably over," Bruce Steinberg, Merrill Lynch's chief economist, said in a recent note to clients. "The first tightening move by the Fed is unlikely to occur until late summer at the very soonest."
This is anything but good news for many Americans 55 and older. They are the population group most likely to depend on low-yielding savings accounts, finds a 2000 study by the Consumer Federation of America (CFA), a Washington advocacy group.
The median value of all savings accounts in 2000 was $2,000, reports the CFA. But for people ages 55 to 64, the average was $3,000. Savers 65 and older were even more frugal, holding accounts with a median value of $4,800.
It's no mystery why those who have put their money in CDs and other interest-rate sensitive products are getting less income. The average rate on a one-year CD, for instance, was 2.1 percent in early February, according to Bankrate.com, compared with 4.6 percent a year earlier.
"We've seen short-term rates drop very dramatically," says Greg McBride, a financial analyst for Bankrate. "This is easily the lowest since we've been collecting the data," since 1984.
Even worse, rates on money market accounts, where many park spare cash in an effort to earn somewhat more interest than paid on traditional passbook savings accounts, have fallen to record lows.
INVESTMENTS COMING UP SHORT
Unfortunately, it is short-term investments that are the savings vehicles of choice for people like Milton P. Semon, 79. "I just had a 20-month CD come due a few weeks ago," says Semon, a retired jeweler from Milwaukee now living in the Sun City West retirement community outside Phoenix. "It paid 6 percent. The best I could do [in a new CD] was 3.5 percent for two and a half years."
Semon, and many like him, are unhappy for another reason. Usually, when interest rates are falling, stocks are rising. This time around, though, both interest rates and the stock market took a synchronized swan dive. That means many older Americans are sustaining losses of both their principal and their income.
Of course, low interest rates do have a positive side. They reflect the fact that inflation is under control and, experts remind, inflation is no friend to those living on fixed incomes.
Even so, large numbers of older Americans have seen declining interest rates erode their earnings. What can they do to gain more income?WHAT YOU CAN DO ABOUT IT
In truth, the options aren't enticing, especially for those who crave security and fear losing money. You can either take on more risk or lock up your money in higher-yielding CDs or bonds for longer periods.
But be careful. With interest rates now rising ever so slightly, now is not the time to, say, buy a two-year CD averaging 2.83 percent to replace a one-year certificate. If rates do rise, you'll miss out on the chance to lock in a better rate.
That's why some financial planners suggest "laddering" CDs. This strategy involves investing money in CDs of varying terms, spacing them out as if they were rungs on a ladder—from, say, one year to five. When the one-year CD is up for renewal, you replace it with a five-year CD, and so on.
The idea is to get the best blended rate between the lowest rate on the shortest-term CD and the highest rate on the longer-term CD, without tying up your money too long. "A laddered portfolio is essentially protection from the volatility of interest rates," says Bankrate's McBride. "This is not a time to be loading up long term."
A LOW-RISK STRATEGY
If security is your primary concern, there are only a few alternatives to the safety and guaranteed returns of CDs. These include various forms of debt issued by the U.S. government, which come with the full backing of the Treasury and are therefore considered the safest investments:
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Treasury securities are available in many forms and maturities. Treasury bills, with a $1,000 minimum, are short-term investments issued in four, 13- or 26-week maturities. The bills are bought at a discount to their face value, the difference representing the interest that is paid at maturity.
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Treasury notes are intermediate-term securities, offered in minimum investments of $1,000 and two-, five- and 10-year terms. Interest is paid semiannually.
Treasuries are available from most banks and brokers. They are also packaged in mutual funds, though investors should be careful to make sure the fund doesn't hold other investments that aren't as safe. Yields on Treasuries have recently run from about 1.75 percent for the shortest term to 5 percent for the longest.
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Savings bonds. The federal government issues the conventional EE bond and is pushing its Series I bond, which costs as little as $50 at most banks and pays both a fixed interest rate and an additional inflation adjustment every six months. You buy a bond with a face value of $50, for example, and the interest accrues monthly until you sell it.
Savings bonds must be held for six months before they can be redeemed; if they are cashed before five years is up, there is a three-month interest penalty. The so-called combined rate for Series I savings bonds issued from November of last year through April is 4.4 percent.
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TIPS. Another investment that's gaining in popularity is the Treasury inflation-indexed security (TIPS), which, like the Series I bonds, has both a fixed interest rate and an adjustment for inflation. Unlike Series I bonds, they are marketable securities that can be traded like stocks and purchased through mutual funds such as Vanguard's Inflation-Protected Securities Fund.
PROS AND CONS OF GREATER RISK
A variety of bonds and bond mutual funds offers greater returns than CDs, with risk increasing as you move away from government Treasuries toward short-term bond funds and those that invest in corporate debt.
But several risks are inherent in these investments. Among them: Inflation could eat away at your returns, for example, or the company whose debt you purchase could default on its obligations, leaving you holding the bag. Two options:
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Short-term bond funds typically outperform money market funds, but because they invest in bonds close to their maturities, they tend to fluctuate less than longer-term bond funds. Their one-year returns recently averaged about 6 percent, according to Morningstar.
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Balanced or equity-income funds. Another alternative for those willing to risk losing some principal is one of several balanced or equity-income mutual funds that invest in a mixed portfolio of stocks and bonds, or just in stocks that produce income in the form of dividends. The income from the dividends or bonds helps cushion any potential loss on the value of the stock itself.
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