What Interest-Rate Cuts Mean for Your Retirement Portfolio

Key Takeaways

• When we see yields go down, we do see a direct impact on savings instruments. You don’t want to overdo the savings bucket because the yields there will tend to be pretty ephemeral; the really great yields that we’ve had recently may go lower. If you are interested in locking in what are still pretty decent yields on offer today, think about something like a certificate of deposit.
• For Bucket 2, which primarily consists of investment-quality bonds and bond funds, the net long-term effect is that when yields decline, the return potential for that portion of the portfolio also goes down. There is a little bit of a benefit in terms of when yields go down, when interest rates go down, that pushes up bond prices.
• In the bond versus bond fund argument, I would tend to be a little bit more on team bond funds, because with a bond fund, I’m automatically getting a diversified basket of individual bonds. The key is just to make sure that you are matching the bond fund’s duration to your expected holding period.
• Falling interest rates are a net positive for the economy, but if the Fed is reducing interest rates because they’re seeing economic conditions weakened, that can be bad news for stocks. When it comes to the implications for equities, it is a wait and see. The key point here is just to make sure that you’re diversified across different types of stocks, across our style box, of course, but across geographies and sectors as well.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Joining me to discuss what interest-rate cuts mean for your retirement portfolio is Christine Benz; Christine is Morningstar’s director of personal finance and retirement planning and host of The Long View podcast. She’s also author of a new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement.

Great to see you, Christine.

Christine Benz: Susan, it’s always great to see you.

Will Interest-Rate Cuts Affect Retirement Spending?

Dziubinski: All right, so let’s look at this through the framework of the Bucket approach to retirement planning. Let’s start with Bucket 1, and this is where you recommend that retirees hold their spending money. So this is all sort of in short-term instruments. So, high yields have been great news for this particular bucket. Falling interest rates, probably not so much, right?

Benz: That’s right. For Bucket 1, the cash bucket, I typically recommend that people think about holding one to two years’ worth of portfolio withdrawals in that bucket. So it’s highly liquid, you’re thinking about CDs, savings accounts, high-yield savings account, money market, mutual funds kind of falling into this bucket. And so when we see yields go down, we do see a direct impact on these savings instruments. It tends to happen pretty quickly, where we’ll see yields decline when interest rates go down. And so, to me, that indicates a couple of things. One is that you don’t want to overdo the savings bucket because the yields there will tend to be pretty ephemeral; the really great yields that we’ve had recently may go lower and lower still. So you don’t want to overdo it. And if you are interested in locking in what are still pretty decent yields on offer today, think about something like a certificate of deposit. You can buy CDs all the way up to five years in terms of their maturity. So if you wanted to try to lock in what are still fairly high prevailing yields, that would be something you’d want to keep in mind. You would just want to keep in mind that that’s not necessarily going to be super liquid in terms of your ability to access those funds. So you wouldn’t want to set up a five-year CD if you’re funding your regular cash flow. So it’s kind of a balancing act.

How Falling Interest Rates Affect Bonds and Bond Funds

Dziubinski: And then Bucket 2, this primarily consists of investment-quality bonds and bond funds. So talk a little bit about what falling rates could mean for that.

Benz: Right. And so for this bucket, I typically say, think about maybe five to eight years’ worth of portfolio withdrawals. The net long-term effect is that when yields decline, it means that the return potential for that portion of the portfolio also goes down. But you do see a little bit of a benefit in terms of when yields go down, when interest rates go down, that pushes up bond prices. Because if a bond, an older bond, has that higher yield attached to it, people want to pay more for it. So it pushes up bond prices. Bonds are more of a beneficiary when yields go down, but over the long term, it does reduce the return potential on that portion of the portfolio.

Bonds vs. Bond Funds

Dziubinski: Staying with Bucket 2 for a minute, where do you fall on the bond versus bond fund argument? And does it matter whether rates are falling or rising? What’s your take on that?

Benz: This has become a hot topic and certainly was in this period where interest rates were going up. Poor bond-fund investors saw their bond prices go down, even though they were able to partake of higher yields that came online. If you buy a bond and hold it to maturity, you’re going to get that coupon payment. And so that’s one reason why I’ve been hearing a lot of financial advisors, other experts, saying that, “Well, the way to go with bonds is to think about buying that individual bond and holding it to maturity.”

The issue, and one of the reasons why I would tend to be a little bit more on team bond fund, is just simplicity—that with a bond fund, I’m automatically getting a diversified basket of individual bonds. By the time I go out and purchase all of these individual bonds and vary them across the maturity spectrum, across the credit-quality spectrum, I have very different bond types, I end up with something that looks and feels a lot like a bond fund, but I’m managing it. And I don’t know how to manage a bond fund.

So I think that that’s one reason why I would tend to recommend a very low-cost bond fund for most investors. I think that it’s a pretty good mousetrap. The key is just to make sure that you are matching the bond fund’s duration to your expected holding period. So if I have a short holding period, say fewer than three years, I’d want to be in some type of a short-term bond fund. If I have a slightly longer time horizon holding period, like three to 10 years, I could potentially hold like an intermediate-term bond fund. So I think that that’s super crucial just to be careful about what types of bond funds you own depending on your spending horizon.

How Falling Interest Rates Can Affect Stocks in Your Retirement Portfolio

Dziubinski: Let’s move on to Bucket 3. And this is what you refer to as sort of the growth engine of the Bucket strategy. This is where equities are. Talk a little bit about the implications for Bucket 3 with interest rates falling.

Benz: Well, it’s kind of a wild card, I would say, Susan. In a lot of ways, falling interest rates are a net positive for the economy and that it makes it easier for consumers to borrow, for businesses to borrow. It makes it cheaper for them to borrow, and it kind of greases the skids for the whole economy. On the other hand, if the Fed is reducing interest rates because they’re seeing economic conditions weaken, sometimes that can be bad news for stocks. So it really is wait and see when we think about the implications for equities.

But one of the big reasons why we did see equities thrive for a couple of decades there was the fact that we had very low interest rates and arguably the alternatives to stocks just weren’t that great. We could get there again, and that could be a really positive tailwind for stocks. I think a key point here is just to make sure that you’re diversified across different types of stocks, across our style box, of course, but across geographies and sectors as well. You don’t want to be clustered in that large-growth square of the style box, which has recently been hit a little bit hard by the equity market selloff.

Dziubinski: Christine, thank you for the perspective today. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch 4 Ways to Take Control in an Uncertain Market for more from Christine Benz.