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Higher loan rates for 401(k) borrowers; lower funding costs for pensions
updated on 1/4/2015
The Federal Reserve announced on Dec. 16, 2015, that it is raising its benchmark interest rates by a quarter of a percentage point after nearly a decade of keeping interest rates close to zero, with similar increases expected in the coming quarters. For 401(k) plan sponsors and participants, rising rates will bring advantages and some disadvantages, at least in the near term.
Rate hikes bring higher returns paid on savings. For many, that’s good news: Average five-year certificates of deposit have paid less than 1 percent interest since September 2012, according to financial research firm Bankrate. That’s been hard for retired Americans living on fixed incomes and others who rely on interest income to help cover their living expenses.
“Most money market funds have been paying investors .01 percent or less. Higher interest rates are not only good for the mutual fund families, but will be welcomed by plan participants who are risk-averse or close to retirement and have invested heavily in these funds,” said Robert C. Lawton, president of Milwaukee-based Lawton Retirement Plan Consultants.
But interest rate hikes can have unpredictable effects on the stock markets. While some see rising rates as a return to normality and a sign of economic recovery, which is positive for stock returns, others worry about higher borrowing costs for individuals and businesses, and those concerns can cause stocks to decline. Either way, higher rates often bring more stock market volatility.
Rate increases also mean that long-term bond funds—which are traditionally less volatile than stock funds—are likely to come under pressure, since the underlying value of existing bonds fall as new bonds are issued with higher interest payouts. That can cause a bond fund’s net asset values to take a hit.
But “the news may not be as bad as it seems,” said Rob Williams, director of income planning at the Schwab Center for Financial Research, an affiliate of investment firm Charles Schwab, in San Francisco. “Returns from bond funds come from two sources: interest payments that are paid out as fund distributions, and changes in price. Higher rates can boost interest payments and help buffer negative price returns,” he noted. Over time, as interest payments are reinvested, bond funds should see steady growth.
In the meantime, 401(k) participants who are strongly risk-averse may want to consider short-term bond funds (which are impacted less by rising rates), stable value funds or money market funds.
However, “nearly all 401(k) participants are long-term investors who should not be worried about daily, monthly or even annual fluctuations” in stock or bond fund prices, said Lawton, adding, “It is usually best for participants to stick with their savings and investment plan during periods of market change.”
Since rising rates also will bring an end to the historically low interest rates charged on loans, the Federal Reserve’s decision may not sit well with 401(k) plan participants who are thinking about borrowing money from their accounts, commented Marina Edwards, a senior retirement consultant at Towers Watson in Madison, Wis.
“Most 401(k) plans establish the loan rate using Prime Rate plus 1 percent, or whatever is specified in the plan documents,” she noted. Rising rates will mean “a higher payment made by the employee.” Plan participants who currently have loans from their 401k plan will not be affected by the higher interest rates.
Edwards also said loan-taking participants may actually view the higher rates as a way to get more dollars into their 401(k) since their accounts will receive the loan interest that they, in effect, pay back to themselves. However, she cautioned that participants should avoid taking out 401(k) loans if possible since “there can be risk of default, for example, upon a job change,” when the loan must be repaid in full.
Advised Edwards, “Employers should ensure that loan education is part of a broader education effort focused on helping employees make decisions that will improve their overall financial well-being.”
Higher interest rates are also expected to improve the funding situation for defined benefit pension plans. As interest rates trend higher, it lowers plan sponsors’ required contributions to achieve full funding because private-sector employers use an AA-corporate bond rate to calculate future pension liabilities.
“Pension funds must make sure their assets grow at a pace adequate to cover future liabilities. Low interest rates have made that goal difficult to achieve,” according to Bankrate.
“An increase in corporate bond rates in advance of the Fed’s recent interest rate decision, combined with a flat global stock market, contributed to keeping pension plans in roughly the same financial shape as the previous year,” said Alan Glickstein, a senior retirement consultant at Towers Watson in Dallas.
“It’s been nearly a decade since employers as a group have been able to fully fund their pension plans. If the Fed’s decision to raise short-term interest rates is the first move in a pattern of rising rates, generally we could see improved pension funded status in the coming year, depending of course on how the stock market responds,” concluded Glickstein.
Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow me on Twitter.
Related SHRM Article:
Explain 401(k) Plan Loans’ Upsides and Downsides, SHRM Online Benefits, February 2014
Effect of Fed Interest Rates and Market Results on Pension and OPEB Plans, Buck Consultants, January 2016
U.S. Corporate Defined Benefit Discount Rates Head Higher, Pensions & Investments, December 2015
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