Your 401(k): Handling Interest Rate Ups and Downs

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Updated on Thursday, February 6, 2020

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With any change in the economy or your life situation, it is a good idea to review your investment portfolio, particularly your 401(k) plan, to make sure your investments are structured to meet your needs at retirement. This is especially true when interest rates are rising so you can take maximum advantage of those high rates. There’s also benefit to checking on your investments when rates are down; certain investments will actually be worth more and you can make a profit by selling or simply enjoy your higher-earning investments.

Interest rates rise and fall based on changes in the economy. The Federal Reserve (the Fed) may lower rates to support the economy when it’s going through a weaker patch and may choose to raise interest rates as the economy begins to gain strength.

Either way, there’s no need to panic. We’ll help you understand what happens to your 401(k) investments in either situation.

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What to ask yourself when reviewing your 401(k)

A 401(k) is a savings vehicle that many companies make available to help their employees save for retirement. For tax year 2019, you have until April 15 to contribute up to $19,000 of your earnings into your 401(k) on a pretax basis, meaning anything you contribute is not taxed until you withdraw it, usually at retirement. For 2020, you can contribute up to $19,500.

Some companies match employee contributions up to a certain limit that varies by employer. These contributions are not taxable to you until you withdraw them. Companies offer employees a variety of 401(k) investment options. Some larger companies allow employees to choose from a dozen or more mutual funds, including various stock, bond and real estate funds.

While any time is a good time to review your 401(k) investments, a rise (or fall) in interest rates is a particularly good time to make certain your 401(k) investments meet your needs based on your age, years until retirement and risk tolerance, among other factors.

Virtually all 401(k) plans offer one or more fixed-income investment options. These typically include both government and corporate bonds of varying maturities. For example, a fund might offer a mutual fund that invests in short-term Treasury bills, one that invests in long-term Treasury bonds and one that invests in corporate bonds. Some companies might even offer a fund that invests in so-called junk bonds that pay a higher rate of interest in return for the risk of investing in low-quality bonds.

What to expect when rates rise

An increase in interest rates will eventually have an impact on the types of fixed-income funds in a 401(k). A fund that invests in short-term Treasury bills will react quickest to this change. When the bonds that the funds hold mature over the subsequent year, the fund manager will reinvest the proceeds in bonds that pay a higher rate of interest.

A corporate bond fund, on the other hand, includes bonds with varying maturities. It may take time for the fund to invest its assets in bonds that pay higher interest, as most fund managers spread their investments over maturities between one and 30 years so that at least some bonds are always maturing to potentially be reinvested at a higher rate.

A rise in interest rates also will affect the price of existing bonds in a portfolio. Say the corporate bond fund you own has an XYZ Company corporate bond that pays 4% interest. As market interest rates rise, the value of that bond will decline to a point where the current yield on that bond is closer to the market rate. Since most fund managers anticipate that interest rates will rise, they have structured their portfolios to minimize the impact that an increase will have on the fund’s value.

Let’s return to reviewing your 401(k) investments. When you started your job, you probably picked a mix of investments and haven’t made any changes. That’s fine if you started your job two years ago. But if you have been working for the same company for 10 years, a review is a good idea.

Let’s say that when you started working for the company at age 30, you were single and invested 90% of your 401(k) in stocks and just 10% in bonds. Now, fast-forward 10 years. You got married. And while retirement is still at least 25 years away, it is something you can begin to see on the horizon. It might be a good time to increase your fixed-income allocation to add greater stability to your 401(k) returns — especially if interest rates are rising.

What to expect when rates fall

It’s important to keep in mind that interest rates also can fall. The bad news is this typically happens when the economy isn’t doing so well. The good news is your higher-rate fixed-income investments will be worth more. You can choose to sell them and take the profit or hold them and enjoy earning a rate that’s higher than the one currently available.

Investing when interest rates are falling requires a different strategy. Young investors with many years until retirement who have the bulk of their 401(k) investments in stock should be able to ride out a period of low interest rates without significant impact.

Older investors who see retirement on the horizon or are already retired will find falling interest rates more problematic. Their investments may be concentrated in fixed-income vehicles, or they may be seeking solid long-term fixed-income investments to pay them the retirement income they need. Since nobody can predict how long rates will continue to fall, buying fixed-income investments with staggered maturities, sometimes called a bond ladder, is the best way to make sure you always have money available to take advantage of rising interest rates when they happen.

What’s ahead for 2020

The general expectation for 2020 is that market interest rates will continue to decline. The Federal Reserve has put the federal funds rate on an indefinite pause since its series of three rate cuts in the second half of 2019. In response, banks lowered their own rates and continue to do so overall.

If the Fed does make a change, it is largely expected to be another rate cut rather than a rate hike. This is thanks to outside risks to the economic outlook, namely weaker global growth, trade negotiations and the recent coronavirus outbreak. The Fed’s three rate cuts in 2019 were designed to support the U.S. economy in the face of these threats. If they continue to weigh on the economy, which is performing pretty well on its own, the Fed will be more likely to cut rates to continue that support.

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