Interest rates will rise substantially in the next few years. Many current financial planners and portfolio managers are ill prepared for this likely scenario.
Background on Interest Rates:
- Interest rates have been abnormally low since the 2008 financial crisis. The average 2021 10-year interest rate was 1.45%. The average 10-year Treasury bond interest rate between 2011 and 2021 was 2.11%. The average 10-year interest rate during the 2008 to 2010 financial crisis was 3.38%. By contrast, the average 10-year treasury rate stood at 4.71% between 2000 and 2007, 6.67% between 1990 and 1999, 10.59% between 1980 and 1989, 7.50% between 1970 and 1979 and 4.97% between 1963 and 1969. See this chart by Macro Trends for annual data.
- The Federal Reserve Board has been tremendously accommodative over the last three years due to COVID with the current discount rate at 0.25%. However, the Fed taper program is ending and most market participants are expecting three increases in the discount rate next year.
- The Federal Reserve Board has control over the interest rate at the discount window but does not control long-term interest rates, which are affected by inflation and inflationary expectations. The primary determinant of inflationary expectations and long-term interest rates is wage inflation. Price inflation cannot occur for a sustained period unless the cost of creating goods and services increases. Wages are the major source of the cost of goods and services.
- Many analysts believe that inflation is peaking. I am less sanguine. Many people concerned about COVID have left the labor force. This trend could accelerate because of the CDC decision to reduce the quarantine period for people exposed to COVID. Older people who left the workforce early due to COVID may not return. The decline in both legal and illegal immigration has reduced labor supply. My forecast is for sustained wage and price inflation regardless of what happens to the supply chain. Note, that these factors impacting labor supply are not directly controlled by monetary policy.
This increase in inflation will inevitably lead to higher interest rates.
Consequences of higher interest rates:
A prudent investor considering bonds compares current interest rates to historic ones and assumes some sort of movement towards the mean. This analysis suggests there is currently very little upside and substantial downside in holding traditional fixed-income assets or fixed-income funds. Treasury bond interest rates will inevitably rise creating real financial hardships for investors, retired people living on 401(k) funds and borrowers.
- The increase in long-term interest rates will lead to a decline in the value of the bonds and losses for investors who sell their bonds after interest rates rise. The increase in interest rates will also decrease the value of bond funds held in 401(k) plans. During the 2008-2010 market downturn the decline in the value of stocks was somewhat offset by an increase in the value of bonds dampening the market downturn. The next financial collapse could involve decline of stocks and bonds in tandem.
- The increase in bond yields will not simply result in a loss of real return to investors. The actual market value of the bond and the amount received by the investor will fall when the asset is sold. (I heard an analyst on CNBC state that the loss for investors stemming from an increase in rates would only be in real terms because the investment would not keep up with inflation. This is categorically false. An increase in rates even if only to the pre-2008 levels would lead to substantial nominal losses.)
- Bond holders who hold a bond to maturity will receive face value for their investment. However, many bonds held in ETFs or mutual funds like VBMFX, have no maturity date. Investors regularly sell shares in bond ETFs to fund consumption in retirement and the value of these shares falls when interest rates rise.
- The cost of credit and loans moves with interest rates. The interest rate on federal student loans has been explicitly linked to the 10-year Treasury rate over the last decade. A rise in student debt rates induced by the increase in Treasury rates will reduce household spending and the ability to save for retirement.
A potential solution for investors:
- A person concerned about inflation should consider purchasing up to $10,000 a year in I-Bonds from the U.S. Treasury. The return on I-bonds is the sum of a nominal interest rate and the inflation rate. People who cash in an I-bond less than five years from their purchase date will forfeit 3 months interest. The current nominal interest rate on an I-bond is low but the current return from inflation is substantial. Also, people who purchased I bonds when interest rates were high have both a high nominal interest rate and returns from inflation.
- Investors should purchase I-bonds up to the allowable limit every year. Investors purchasing an I-Bond will not experience a capital loss when rates rise. Go here for a discussion of I-Bonds.
Hint 6: The Excel FV function is used to calculate the future value of a dormant 401(k) or IRA when the only difference between the two accounts is the level of fees.
The situation: Finance tip #6 considers potential benefits realized by rolling over funds from a high-cost 401(k) to a low-cost IRA. The retirement account is not accepting new contributions. The person at age 50 will either leave $500,000 in a 401(k) or move $500,000 to a Roth for 15 years. The pre-fee annual rate of return on both the 401(k) and the IRA is 6.0 percent. The 401(k) has an annual fee of 1.3 percent. The IRA has an annual fee of 0.03 percent.
Question on use of Excel: How does one calculate the value of the retirement account after 15 years?
This calculation can be completed with the FV function. The FV function has arguments – Rate, Nper, Pmt, Pv, and Type.
- The Rate is .047 for the 401(k) and 0.057 for the IRA.
- The Nper or holding period is 15 for both accounts.
- The PMT is 0 for both accounts. (The worker is no longer making contributions.)
- The PV is the initial account balance, $500,000.
- The type is 0 because the $500,000 exists in the account at the beginning of the period.
- FV(0.047,15,0,500,000,1) is $995,796.
- FV(0.057,15,0,500,000,1) is $1,148,404.
Remember to go to finance tip 6 for a more complete discussion of factors impacting the choice between a high-fee 401(k) and a low-fee IRA.
Employees changing jobs with funds in a high-cost 401(k) need to consider rolling funds into a low-cost IRA.
Tip #6: An employee leaving a firm can substantially increase retirement wealth by moving
401(k) funds to an IRA. Be careful though! Protections against creditors are stronger for 401(k) plans than for IRAs in many states.
Examples of potential gain from rolling over assets in a high-cost 401(K) to a low-cost IRA:
Example One: A worker leaving her firm at age 50 can keep $500,000 in 401(k) funds in the firm-sponsored retirement plan that charges an annual fee of 1.3% or can move the funds to a low-cost IRA that charges an annual fee of 0.3%. The return on assets prior to fees in both the 401(k) plan and the IRA is 6.0 percent per year.
What is the value of the account at age if assets remain in the high-cost 401(k) and if assets are rolled over into the low-cost IRA?
- Account value of high-fee 401(k) plan is $995,796.
- Account value of low-cost IRA is $1,148,404.
- Gain from rollover is $152,609.
Example Two: A worker changing jobs at age 30 can keep $20,000 in the firm 401(k) or move the funds to a low-cost IRA. The annual fee for the 401(k) is 1.3 %, the annual fee for the IRA is 0.3%. The underlying returns prior to fees for both assets in the 401(k) and assets in the IRA is 8.0%.
What is the value of the account at age 60 if the person keeps assets in the high-cost 401(k) or moves funds to a low-cost IRA?
- Account value of high-cost 401(k) plan is $139,947.
- Account value of low-cost IRA is $185,140.
- Gain from rollover is $45,194.
Note: The impact of financial fees on the future value of the account can be calculated with the FV function in Excel. The arguments of the FV function are the rate of return after fees, holding period in years, and the initial balance in the 401(k) plan.
- Most roll overs from 401(k) plans to IRAs occur when a worker leaves a firm for another employer. Some firms allow for some in-service rollovers.
- Some workers, in need of cash routinely, disburse funds from their 401(k) plan. The disbursement of funds from a traditional 401(k) plan prior to age 59 ½ can lead to penalties or tax. A roll over of funds from a 401(k) plan does not lead to additional tax or any financial penalties.
- One motive for moving funds from a 401(k) plan to an IRA is the desire to place funds in a Roth account when a firm only offers a traditional retirement plan. The act of rolling over funds from a 401(k) to an IRA and the act of converting the new conventional IRA to a Roth IRA are separate and do not have to occur together. Conversion costs are lowest when a worker has low marginal tax rate. Several future posts will examine the costs and benefits on converting traditional retirement accounts to Roth accounts.
- The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy. Whether IRAs are protected from creditors is determined by state law. ERISA, a national law, provides protection against creditors for 401(k) plans. This difference can persuade some people to keep funds in a 401(k) plan, rather than covert funds to an IRA. Go here for a state-by-state analysis of protections against creditors for owners of IRAs.
- The calculations, presented above, of greater wealth from the rollover assumes identical pre-tax returns for the high-cost 401(k) plan and the low-cost IRA. Most financial experts believe that low-cost passively managed funds tend to outperform high-cost funds. Interestingly, Warren Buffet, probably the best active investor of all times suggests passive investing in low-cost funds is generally the better approach.
- Factors other than transaction costs can impact the decision to rollover 401(k) funds or stay. Some 401(k) plans allow investors to purchase an annuity at retirement. The existence of automatic enrollment from a 401(k) plan to an annuity could induce some workers to keep funds in a 401(k) rather than roll over funds into an IRA.
Maximize the employer matching contribution then save additional funds in an IRA!
Tip #5: A worker at a firm with a 401(k) plan that has high fees should maximize receipt of the employer match and divert additional funds to a low-cost IRA.
- Worker has access to a 401(k) plan that matches contributions equal to 5.0% of salary.
- The 401(k) plan has an annual fee equal to 1.3% of assets.
- Vanguard and Fidelity offer a deductible IRA with an annual fee of 0.3% of assets.
- Choice One: Contribute 10 percent of income to a 401(K)
- Choice Two: Contribute 5% percent of income to a 401(K) and 5.0% of income to an IRA.
- The person earns $75,000 per year for 35 years.
- The return on investments prior to fees is 6.0% per year.
- Contributions are bi-weekly
- Choice One: Wealth at Retirement $998,933 all in a 401(K).
- Choice Two: Wealth at Retirement $1,083,089, with both 401(K) and IRA.
- Additional wealth from diverting funds to an IRA is $83,876.
Concluding Remarks: Many financial advisors ignore fees and recommend maximizing contributions to a 401(k) plan. A better solution is to maximize the employer match and divert additional savings to a low-cost IRA.
Tip #2: New entrants to the workforce, facing unprecedented levels of student debt, should prioritize debt reduction over saving for retirement.
Most students with substantial student debt should reduce or forego retirement savings until their debt levels become manageable. Students entering the workforce with substantial debt could reasonably forego saving for retirement for the first three years of their career. Potential advantages of pursuing a debt reduction strategy and the creation of an emergency fund over saving for retirement include:
- Reduced lifetime student loan interest payments
- Improved credit rating and reduced lifetime borrowing costs
- Reduced likelihood of raiding retirement plan and incurring penalties and tax
- Increased house equity and reduced stress associated with debt
Discussion of advantages of rapid student loan reduction at the expense of saving for retirement:
- The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt. Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.
- A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716. Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months. The new total student loan repayments are $33,837, a total savings of $13,879.
- A second borrower with three student loans — a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065. The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271. This is a total lifetime savings of $54,362.
- The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.
- The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.
- Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt. The monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage. The analysis also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages. Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.
- A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.
- Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs. Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties. A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely withdraw 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds. New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties.
- Note from Tip #3 that people using Roth IRAs or Roth 401(k) plans are less likely to pay penalties and taxes on disbursements on retirement savings because the initial contribution to a Roth can be disbursed without penalty or tax. People with debt should start saving for retirement through relatively small contributions to Roth accounts rather than large contributions to traditional plans.
- Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments. A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021. The Urban Institute reported the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019. A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade. Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.
These problems will worsen if borrowers don’t start focusing on debt reduction over saving for retirement because many in the new cohort of borrowers are starting their careers with higher debt levels.
Concluding Thoughts: Many financial advisors stress saving for retirement over debt reduction. Fidelity, a leading investment firm, says young adults should attempt to have 401(k) wealth equal to their annual income at age 30. Workers without debt and with adequate liquidity for job-related expenses can and should contribute. Their returns will compound overtime and they will have a head start on retirement.
The Fidelity savings objective is unrealistic for most student borrowers with debt. The current cohort of people entering the workforce has more debt than any previous cohort. Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009. The decision by a new worker with student debt to go full speed ahead on retirement savings instead of creating an emergency fund and rapidly retire student debt can and often does lead to disaster. The young adult choosing retirement saving over debt reduction pays more on debt servicing, invariably falls behind on other bills, pays higher costs on all future loans, and often raids their retirement plan paying taxes and penalties.
Tip number 3: Most households use traditional retirement accounts instead of Roth accounts. The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA. According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.
More people should choose a Roth retirement plan over a traditional one. People should use Roth accounts in the following circumstances.
- Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
- Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
- Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
- Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
- Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.
- Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.
- Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½.
- The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
- Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
- One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary.
- Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
- Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA. Workers with income above these contribution limits should contribute to a Roth IRA. Other workers should use a backdoor IRA.
Readers should remember to open their Roth IRA early in life as explained in financial tip number one.
Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.
- People who open a Roth IRA early in life have a long investment horizon. The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
- A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year. The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year. This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
- Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
- The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65. This is not always possible. The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time. The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
- All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.
Concluding Thoughts: Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA. Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax. My view, expressed here and in several future posts, is that the Roth IRA should become the default option.
The current cohort of students is entering the workforce with substantially more debt than the previous cohorts of student and the growth of both the number of people with student debt and the average debt level have been consistently upwards. High student debt burdens are leading many student borrowers to forgo saving for retirement, delay starting a family, or put off purchasing a home.
Some Democrats have urged President Biden to cancel up to $50,000 in student debt for all people with student loans. Most economists believe that a widespread cancellation of student debt would be an inefficient and regressive subsidy. Many student borrowers with debt could repay their loan without financial assistance and an indiscriminate loan relief program would allocate resources away from other pressing concerns. Most economic analysis supports the view that indiscriminate student debt cancellation programs would do very little to stimulate the economy.
Several papers including one by the New America Foundation one discussed in Inside Higher Education and my own work published by NASFAA have focused on reforming Income Driven Repayment Plans. Current Income Driven Repayment (IDR) programs offering debt relief and linking debt payments to income have many problems.
- The programs may incentivize some students to increase the amount they borrow.
- Some students that commit themselves to an income linked loan may have been better off with a traditional loan.
- Some student borrowers enrolled in IDR programs struggle to meet other financial priorities despite the benefits of the programs.
- A large portion of applications for loan discharge have been rejected by the Department of Education as discussed in this CNBC article.
The memo presented here discusses ways to provide meaningful debt relief through modification of standard loan agreements instead of expansion of IDR loans or the creation of indiscriminate loan discharges.
- Discharge 40 percent of the initial loan balance after receipt of 60 monthly payments on 10-year loans and 72 monthly payments on 20-year loans.
- Encourage partial interest payments for people in economic hardship rather than total payment forbearance.
- Eliminate Interest charges on all loans on the scheduled loan maturity date.
- Allow and facilitate collection of outstanding student loans after maturity of the loan by the IRs through federal tax returns.
Benefits of the Proposal:
The proposal presented here eliminates many of the uncertainties and problems associated with current programs offering student borrowers debt relief. It offers students some assistance early in their careers allowing households to save for other priorities. It does not create an incentive for students to increase the amount they borrow and contains incentives to facilitate quicker repayment of student debt. The partial discharge of debt and the elimination of interest charges should reduce the number of people entering retirement with outstanding student debt.
- The current system does not provide any loan forgiveness for 10 or 20 years. The earlier debt relief in this proposal allows borrowers to pursue other financial objectives and may facilitate refinancing to lower-interest rate loans.
- Many borrowers are unaware of any problems with their loan for 10 or 20 years when they apply for loan forgiveness. The revised program will uncover problems with loan forgiveness applications after 60 months of payments for 10-year loans and 72 months of payments for 20-year loans.
- The current system incentivizes many borrowers to pick the IDR program as soon as they leave school even though this choice can lead to higher lifetime loan payments if circumstances change. The revised program assists borrowers with standard loans reducing reliance on IDR loans.
- IDR plans create an incentive for some people to borrow more than they otherwise would because they anticipate low life-time loan payments and complete loan forgiveness. The alternative loan forgiveness terms presented here will always result in higher repayments for people who borrow more.
- The loan discharge offered in this program occurs earlier for people making all payments on time, creating an incentive for student borrowers to prioritize student loan payments early in their career.
- The existence of financial assistance for student borrowers with 10-year loans will reduce an incentive for borrowers to take out long-term loans and will speed repayment to the Treasury.
- One study found the number of American over 60 with outstanding student debt quadrupled between 2005 and 2015. The elimination of interest charges at loan maturity proposed here should reverse this trend.
- The elimination of all interest at the loan maturity creates an incentive for borrowers to allocate payments to other debts charging interest. This problem is mitigated by requiring a minimum payment on student debt outstanding after the loan matures collected by the IRS through the federal tax return.
Student debt is creating financial hardships for many borrowers and existing IDR programs often fail to provide meaningful debt relief. Problems associated with student debt will worsen because of the growth of debt. Most student borrowers can repay and manage their student debt with limited financial assistance. An indiscriminate large discharge of student debt would impose costs on taxpayers and divert funds from other pressing priorities.
The program outlined here provides limited quick and efficient debt relief to student borrowers without the distortions caused by existing programs or proposed large-scale debt discharge proposals.