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MFG INSIGHTS

How Rising Interest Rates Affect You

 

Should you be concerned with rising interest rates? 

Many investors appear to think so. Rising interest rates have led to the highest stock market volatility we have seen in years and declines in the value of many bond investments.

Aside from the stock market, rising interest rates have an impact across your household budget. The latest increase in rates has changed how much you can expect to pay for your next house, how much you will pay for credit card debt, and adjust how your cash should be invested.

How could these recent changes impact you? Here are a few key areas that rising interest rates can be expected to have an effect:

How Rising Interest Rates Effect Mortgage Rates

If you are in the market for a new house, rising rates mean that your borrowing costs are going up. Six months ago, the national average for a 30-year fixed-rate mortgage was 3.7%; today is it 4.4%. A rise of 0.7% may not seem like much, but over the length of a 30-year loan, it can make a big difference.

For example, let’s look at someone considering a $250,000 30-year fixed rate mortgage loan with a 3.7% interest rate:

250000 Mortgage with 3.7interest.png

 

Not including any taxes or insurance, they would be looking at a monthly payment of about $1,150 for a total cost of the loan at $413,485.

That exact same loan, which was possible to get only 6 months ago, would cost much more today after interest rates have risen:

250000 Mortgage with 4.4interest.png

 

Now, with mortgage rates at 4.4%, that same loan costs $100 more per month, with a total cost that is $36,000 higher!

 

What if interest rates keep rising at their current pace? In six months if the interest rate on a 30 year fixed rate mortgage rises another 0.7%, to 5.1%, that same $250,000 mortgage gets even more expensive:

 

250000 Mortgage with 5.1interest.png

 

At a 5.1% interest rate, that same $250,000 mortgage costs $1,357 per month, and has a total cost of $487,500.

That means for those looking at a new mortgage, the costs to buy a new home are increasing. And for those with adjustable rate mortgages, your payments may soon be going up. These rising costs may mean it makes sense to pay additional money towards a mortgage each month, or refinance out of an adjustable rate mortgage into a fixed rate mortgage.

Rising Rates and Bond Investments

Fixed income investments play an important role for investor’s portfolios. Historically, if stocks declined, bonds provided a safe source of income and typically rose in value. But the most recent stock market volatility has seen stocks go down in value with bonds following suit.

Why have bonds been going down in value? Rising interest rates.

Six months ago, you could purchase a 10 year treasury bond with an interest rate of 2.1%.

Today, the interest rate on a 10-year treasury bond is approaching 3%, so what would happen if you wanted to sell your 2.1% bond today?

No one would want it. Why would an investor want a 2.1% yielding bond if they could get a 3% yielding bond somewhere else? In order for your low yielding bond to become attractive, the price of the bond would have to drop in order to make its interest payment equivalent to a 3% yield.

Assume you purchased your bond at a price of $1,000, and therefore the bond pays $21.00 in interest each year (remember, the bond yields 2.1%. $21.00 ÷ $1,000 = 2.1%). At what price would you be able to sell this bond today, with interest rates at 3%?

Your 2.1% bill that you purchased six months ago will pay $21 per year for the next 9 years, plus $10.50 for the second half of this year, for a total of $199.50 in interest payments.

A brand new 3% bond purchased today will pay $30 per year for the next 10 years, for a total of $300 in interest payments.

The 2.1% bond will pay out nearly $100 less in interest payments, so you should expect to be able to sell your lower yielding bond at a price around $900 today, a decline of about 10% from when you purchased it just six months ago!

Individual bonds can see their value go up and down significantly based on changes in interest rates. But investors today have other ways of investing in bonds, such as ETFs or mutual funds. And these types of investments are not subject to the same interest rate risk as an individual bond.

Take for example iShare’s Core Aggregate Bond Fund (Ticker symbol: AGG). When an investor buys AGG, their investment is being split up into over 6,600 different bonds. Some of these bonds mature next week, and other mature decades from now.

 

AGG ETF holdings maturity.png

For AGG investors, as interest rates rise, the fund is consistently reinvesting assets from maturing bonds into now higher yielding bonds. In fact, the index followed by AGG has produced positive total returns over the six interest rate increases that have taken place during the last 40 years. Of course, there is no guarantee that AGG’s performance continues in the future, and a rapid rise in interest rates would likely lead to a year of negative returns for AGG investors.

With the prospect of rising interest rates today, should you forgo bond investments altogether?

Not at all.

First of all, we can reduce our interest rate risk (decline in bond investment value should interest rates rise) by selecting bonds with shorter maturities. If interest rates rise 1%, a treasury bond with a 20-year duration can be expected to drop 20%, while a treasury bond with a five-year duration would drop just 5%. Historically, the decision to shorten bond maturity holdings would mean a significant drop in yields. But, with today’s relatively flat yield curve, an investor would not have to sacrifice much yield. Today, a U.S. treasury maturing in 20 years yields 3.03%, while a five-year treasury yields 2.65%. Investors who may need access to their money in the next few years, or who are sensitive to interest rate risk may find that small reduction in yield well worth the reduced risk.

Lastly, bonds have been, and will very likely remain a great portfolio diversifier. Historically, AGG has had a negative .15 correlation to the S&P 500 index, meaning that for every 1% the S&P 500 has declined, AGG has increased in value by .15%. This correlation has not held up in the most recent stock market sell off in early 2018, but if the U.S. were to enter a severe downturn, investors would very likely buy into safer bonds once again.

 

Rising Interest Rates and the Stock Market

Recently, volatility has returned to the stock market as investors fear the potential impact that rising rates could have on their investments.

Why do interest rates effect the stock market? When you invest, you are allocating your money into the investment you believe will have the highest risk adjusted return in the future.

As bond yields rise, their future expected return rises. The line of thinking is that as rates rise higher and higher, investors will gradually move investments over from “risky” stocks to “safe” bonds.

As an example, let’s assume interest rates rise even further, enough to where a 10-year treasury bond yields 5%. At this level, a risk adverse investor may prefer a guaranteed 5% return instead of an uncertain stock market return (which may be less than 5%, or even negative).

And in fact, when Warren Buffett closed up his investing partnership in 1970, he cited this exact comparison. Faced with what Buffett viewed as an overly-expensive stock market, Buffett recommended his investors purchase municipal bonds in the 10- to 25-year range (at the time 20 year Nebraska municipal bonds, specifically cited by Buffett in his letter, had a 6.5% yield). Buffett viewed stocks too risky, and was willing to take a 6.5% yield until stocks became more reasonably priced.

During the 10 years after Buffett recommended his investors get out of stocks and buy bonds, the S&P 500 achieved an annualized return of just 2.08%.

 

SP500 returns compared to rising interest rates.png

 

The chart above graphs the 10-year treasury yield (blue line) and the future 10 year annualized returns for the S&P 500 (orange line).

For example, in January 1984 the U.S. 10-year treasury yielded 11.6%, while an investor who would have bought the S&P 500 index in January 1984 would have received an annualized return of 11.0% over the next 10 years.

Although Buffett’s timing in 1970 was good, in general do rising interest rates mean doom for stocks?

Not exactly.

The chart above plots more than 140 years of stock market returns and interest rates. The stock market certainly had low returns in the early 1970s as interest rates rose to nearly 8%. But look further ahead when interest rates reached their peak in the early 1980s, and you will notice that the stock market returns rose as well.

Stocks will be volatile whether interest rates are high or low, but can we make a generalization that stocks will always have lower returns if interest rates rise? No.

Rising Rates and Debt

Those who had a need to borrow money over the last decade have enjoyed some of the lowest interest rates we have seen in decades. Cars could be financed for 0% and mortgage rates were under 4%. Today, these numbers are changing.

As interest rates rise, so does the cost of that debt. Today, the national average for a 48-month new car loan is 3.5%, mortgage rates are over 4.5%, and rates on other loans such as credit cards, are rising. These rising rates can lead to much higher costs to service debt. For example, consider a family with $10,000 in credit card debt, that can afford to make $250 per month in payments.

A year ago, their credit card may have had an interest rate around 15%, meaning that it would take 4 years and 8 months of payments to pay off their debt, for a total cost of $13,950.

Today, interest rates on credit cards have increased, and this family’s credit card may now be charging interest rates closer to 19%. With same debt level and payments, a rise in the card’s interest rate to 19% means that it will take the family more than 5 year to pay off their credit card, with a total cost of $15,580.

This means that for families with debt, making debt payments may become a higher priority than they have been in the past. Higher rates may mean it makes sense to pay down the mortgage faster, put more money down on a new car, or cause you to think twice before taking out that next personal loan.

 

Rising Rates and Savings

Of course, the rise in interest rates can be good news too. Savers who use money market funds, bank savings accounts, and certificates of deposit (CDs) have all seen their yields rise.

Nationally, the average yield of a 5-year CD has risen from 1.25% to 1.60% just over the last 6 months. Although hardly a level that will make you rich, risk adverse investors or retirees, who typically hold higher allocation in cash, may actually see a return on their cash holdings now. For these investors, as stock markets get more expensive, being able to have a guaranteed return elsewhere may be an attractive option.

In Summary

Rising interest rates lead to an atmosphere that we have not seen in over a decade, and it may lead to a change to how you spend and save your money. At Midwestern Financial Group, we help clients determine the best use of their cash, navigate the new environment for fixed income investments, and help control rising risks in their equity investments.

Curious what rising interest rates mean for you?

 

What to Consider When Offered a Lump Sum Pension Payout

We all have a dream of a relaxed, care-free retirement. For many, the promise of a pension throughout retirement helps to make that dream a possibility. A pension provides seemingly guaranteed monthly income with little to no supervision needed.

But low interest rates and rising corporate liabilities have led to a new trend, making that dream a little more complicated – buyout offers for workers’ pensions.

As pension funds’ returns have lagged, and previous failures of companies to adequately fund their employee pension funds have caught up with them, many companies are looking at pension buyouts as a way out.

A lot of considerations go into the calculation of whether a pension buyout offer makes sense for you.  The lump sum amount, the time before your retirement, your risk tolerance, your financial goals, and your other assets all need to be considered before making a decision to sell your pension.

How do you determine the right choice for you?

To start, it is important to understand that not all pensions are the same. Depending on your industry or place of work, your decision to keep your pension is more complex:

 

Added Risks for Church-Affiliated Pension Plans

 

For many workers in hospitals, private schools and universities, and churches, there is an added risk to your future pension payments. If your employer is religiously affiliated - your pension is unique.

So called “church plans” have an added risk that many other private company pension plans do not. Religious-affiliated pension plans are given special exemptions in the Employee Retirement Income Security Act of 1974, commonly referred to as ERISA. Church-affiliated plans are not held to the same funding requirements or fiduciary guidelines that industry pensions are.

However, the biggest difference in church-affiliated pension funds is their lack of Pension Benefit Guaranty Corporation (PBGC) protection. All ERISA pension plans are insured by the federal government and the PBGC to ensure that, subject to certain limits, those who are retired will receive their pension payments and current employees will receive the benefits that they had been promised.

Church-affiliated pension plans do not have this protection.

This means that if you are offered a lump sum pension payout from your employer who is affiliated with a church or religious group, you are subject to extra risk if you decline the cash out offer.

How much risk?

Church Pension Buyout Risks.png

 

Just late last year this risk became all too real for workers and retirees of St. Joseph hospital in Providence, Rhode Island. Despite nearly 2,700 workers who had paid into the pension fund, the pension fund declared bankruptcy in late 2017. Retirees are being offered a 40% cut in their pension payments as part of the bankruptcy settlement.

For those living off their pension, their dream of a care-free and relaxed retirement was immediately interrupted.

Because the hospital’s pension fund was church-affiliated and therefore exempt from ERISA requirements and benefits, retirees from St. Joseph hospital are not guaranteed their pension payments. It will be up to bankruptcy proceedings and the courts to determine the amount of benefits St. Joseph hospital workers will ultimately receive.

For those with a church-affiliated pension plan being offered a lump sum payment for their pension, this long-term risk should be carefully considered.

Besides this unique risk for church-affiliated pension plans, there are other aspects to consider as well:

 

How to Decide if Taking a Lump Sum Pension Payout is Right for You

 

Every pension buyout offer is unique, and every individual’s circumstances are different. A lump sum pension offer may be the right move for a coworker, but be a poor decision for you. At Midwestern Financial Group, we help determine the best course of action for you, depending on your unique circumstances.

Here are a few factors to consider:

 

Present Pension Value

Your ultimate decision in calculating whether to take a pension buyout offer is dependent on the lump sum amount offered to you, and the future value of that money. That future value is dependent on a couple factors:

1.       Expected Returns

2.       Time Horizon

 

As an example, consider: Would it be wise to take a $200,000 lump sum payout today to replace a $3,000 per month retirement pension that you would be eligible for in 15 years?

To answer, let’s start with the assumption that you can safely withdrawal 5% per year from a portfolio through retirement.  

If your pension would pay $3,000 per month, or $36,000 per year, how big of a portfolio would you need to produce that income?

Based on a 5% withdrawal rate, you would need a portfolio of $720,000 to safely produce a retirement income of $36,000 ($36,000 ÷ 5% = $720,000).

Can you reasonably expect your $200,000 lump sum payment to grow to $720,000 over the next 15 years?

 

Church Pension Buyout Calculator Lump Sum Comparison.png

 

It turns out, you need a return of about 7% in order to break even on a $200,000 lump sum payout for this pension.

Understanding what type of returns are achievable, and how to best attain them is critical to making an educated decision on your pension buyout offer, because even small variations in returns can lead to very different outcomes.

 

Taking a lump sum payout eliminates the risk of your employer defaulting on their pension obligations, but puts the burden of managing your investments and achieving suitable long term returns on you. At Midwestern Financial Group, we specialize in helping out clients make informed decisions for situations just like this, and managing those assets if needed.

 

Other Factors We Consider with a Lump Sum Pension Payout Offer

 

Desire to Leave Assets for Children, Charity, or Spouse.

Depending on the terms of your pension, your spouse may be left income from your pension if you pass away, but children and other family members will not.

For those who have a desire to leave assets for charity or family when they are gone, a lump sum payout for your pension may make that possible with careful planning.

 

Longevity Risk

Specifically, risks associated with both your lifespan and risks related to the long-term financial strength of your pension fund.

Traditional retirees have a huge risk of outliving their savings. Today, a healthy individual may be looking at 30+ years of retirement. That is why proper retirement planning is so important. If your retirement nest egg only lasts 30 years, but you retire at age 60 and live to age 100, how will you make ends meet?

That is why one of the primary benefits of a pension is that your income is provided for as long as you live. Part of the calculation in determining whether to take a pension buyout offer relies on the confidence that the future value of your assets will be able to provide income for as long as you need it.

However, a today’s longer retirements also increases the likelihood that your pension fund could come under financial troubles. Specifically, if your pension plan belongs to a church-affiliated organization, there may be little to no protection of your pension income if the pension fund comes up short.

That means that a worker expecting to start receiving their pension payments in 20 years is facing a lot higher “longevity risk” than someone who is currently receiving pension benefits. Quantifying these longevity risks is very important when evaluating a pension buyout offer.

 

Your Other Assets, Investments, and Liabilities

When deciding on an offer to receive a lump sum for your pension, taking into consideration the value of your other assets, investments, and obligations is very important.

Ask any of our clients, and they will tell you that we thoroughly examine your entire financial picture before making any financial or investment decisions. This is important when creating any financial plan, but extremely important when calculating whether to take a lump sum payout for your pension.

Making a decision on taking a pension buyout offer requires considering your future expenses and debt (such as your mortgage, taxes, and living expenses), other sources of income (such as social security, or other retirement accounts such as an IRA), and more.

 

 

We’re Here to Help You Make Your Decision

 

Every person’s individual circumstances are different. There is no universal answer to the question of whether you should take a lump sum payout for your pension. Making that decision takes time, careful calculations, and consideration of a host of different outcomes and possibilities.

That’s where we come in. At MFG, we help clients make informed decisions about their finances every day. How can we help you? Let’s chat.

How To Save For College: Pt 2

Most Americans do not enjoy the pain of saving money. The emotional reward of spending is too great to overcome. As a result, we believe individuals need both a refined process and a little coaching to make the task of saving for college as easy as possible.

So, if you want to save for your child’s college, here are three steps to making the whole thing easier:

1.     Educate

2.     Automate

3.     Recalibrate

In a recent blog post, we provided figures for how much college could cost in 18 years – click here if you’d like to revisit that article.

If we use the cost of college today, $19,533 per year, and forecast a 5.18% annual increase in tuition (growth rate), the cost of a four-year degree at the University of Iowa in 18 years is projected to be: $209,516.27.

In the figure above, we are using assumptions in the growth rate. Let’s look at a range of possible tuition growth rates in the below chart.

cost of u of i.png

With the range of possible college cost growth rates, the cost of a four-year degree from the University of Iowa can range from $143,948.66 to $302,936.27

The monthly savings needed to fund that amount in 18 years, assuming 6% growth, is $479 per month. For college savers, given the amount of savings needed, the account type should be optimized, limiting opportunity costs.

What account type should you use for college savings?  

Generally, as a parent, aunt, cousin, uncle, grandparent or friend, you have five ways to pay for postsecondary education:

1.     Save into a Roth IRA and withdraw contributions later without penalty

2.     Save into a taxable account (checking, saving, individual or joint account)

3.     Pay for school out of normal monthly cash flows (wages, salary)

4.     Pay for school with home equity debt or federal loans

5.     OR put money into a 529 and withdraw for education tax-free

We’ll focus on #5, utilizing a 529. In our opinion, this is often the best option. Here are the benefits:

1.     Investments grow tax-free

a.     Instead of paying taxes on earnings, dividends or interest in a taxable account, all earnings and income generated in a 529 account are tax-free.

b.     The tax deferral enhances the benefits of compound interest. Compound interest is the financial terminology of making interest on your interest.

  • Saving $479 per month for 18 years results in an ending portfolio value of $209,516.27. How much of that total are actual contributions? $103,464. Less than half the ending portfolio balance are contributions. The rest of the amount is growth, taking advantage of compound interest. Start early.

2.     State income tax deduction (in Iowa)           

a.     For Iowa residents, contributions to the College Savings Iowa 529 plan are tax deductible at the state level.

b.     The tax-deductible contribution amount is $3,329 per beneficiary account. So, if you and your spouse each contribute $3,329 in separate 529 accounts for Johnny, you can deduct $6,658 off your State of Iowa income tax return.

3.     Withdrawals are tax-free if used for education

a.     You will not pay taxes on money withdrawn from your College Savings Iowa 529 account if the funds are used to cover qualified higher-education expenses.

b.     In contrast 401(k) are also tax-deferred vehicles. The participant contributes a percentage of their wages, these grow in the account without taxes paid on the earnings and interest. However, when the participant withdrawals the money from the 401(k), they are responsible for paying income taxes on the distribution. This is not the case for 529s.

4.     Relatively flexible with change in circumstances

a.     You might be thinking that not all children will go to college or trade school. But, you can change the beneficiary at any time. If Johnny doesn’t need the 529 monies because he received a scholarship or he does not want to go to college, the beneficiary can be changed to his younger sister Mary, a grandchild, or anyone else.  

b.     If withdrawals are not used for higher-education expenses, there is a 10 percent penalty in addition to income taxes.

Automating to Optimize

When I was in college my grandma would say, “You don’t come to visit enough. We’re out of sight and out of mind.” As usual, she was right. It’s not that I didn’t like to see her, it’s that I didn’t see her, so I didn’t think about it.

The first step to a successful savings plan is automatic contributions. Do you think you’d have as much in your 401(k) if your employer did not automatically take it out of your paycheck?

The State of Iowa’s College Savings Iowa 529 plan is engineered to help savers achieve the best outcomes.

During the account setup process, the account holder can AUTOMATE monthly contributions directly from their checking or savings. The direct deposit option eliminates the step of writing a check and thereby, increasing the likelihood of missing a contribution or two.

ALSO, College Savings Iowa offers age-based investment options. As the child gets older, the investment allocation becomes more conservative given the target goal is closer. For a majority of people, our emotional reactions to money get in the way of our goals. Many avoid making the hard decision and some allow their overconfidence to determine whether they should be invested in the stock market.

The AUTOMATION removes the emotions from the account holder’s investment decisions. Let the plan automatically change the allocation. If you suffer from emotional biases such as overconfidence and illusion of control, do not let them keep little Johnny or Mary from benefiting from compound interest.

Moving forward

Now that you’ve set up your 529 and automated your contributions, the only thing left is to reassess your savings each year.

Each year market returns become reality, not hypotheticals. Thus, each year we have to recalibrate: reassess contributions necessary to fund the future liability of college. Part III of this series will cover the discussion of recalibration.

How to Prepare for the Unthinkable

Unthinkable Events Happen

In our complex world, incidents happen we do not expect. Most of us have experienced an unexpected event, perhaps the loss of a job or something within our home, car or health going awry.

Consider struggles with the job market a few years back. From the beginning of 2009 to February 2010, the U.S. labor market lost 8.8 million jobs and in 2009, the unemployment rate peaked at 10 percent.

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To make matters worse, if you lost your job, it became difficult to find a new one. Job openings were 4.8 million in March 2007 and during the recession the number of job openings fell 44 percent, despite “only” a five-percent decline in employment over the same period. In July 2009, the number of job openings bottomed at 2.1 million, an over 50 percent cut from two years prior.

If you own your home or auto, you also know unexpected bills can pile up in these categories as well. Regular maintenance helps, but aging homes and automobiles begin to break down and for many, fixing the problem is the optimal solution (versus trading it in or moving).

Let’s take an air conditioner, for example. Below you’ll find an estimated replacement cost according to Home Advisor.

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Do you have the emergency savings to cover a replacement air conditioner? Do you have the emergency savings to cover your fixed expenses if you lost your job?

Starting an Emergency Savings

The point of an emergency savings is to avoid taking on debt. If the unthinkable happens, you want to be able to pay for repairs or cover your fixed expenses without having to use a line of credit from your home, or worse, credit cards. Both options come with interest, but more importantly, a monthly payment you do not need in your current time of emergency. Liquid savings cushions the blow and allow for time to heal the wound. Unfortunately, Americans are not good at saving for emergencies despite being good at growing credit card debt. According to Go Banking Rate, more than half of Americans have less than $1,000 in savings in 2017.

So, how do you start saving?

A general rule of thumb is to keep up to six months of income in liquid savings, by liquid I mean in a savings account, not invested in securities that you have to sell in order to get your money. However, this rule of thumb should be adjusted based on your specific circumstances. Are you debt free? If so, you probably need less liquid savings. Why? You don’t have any fixed debt payments; the only expenses to cover in the event you lost your job would be variable items such as gas, groceries, and entertainment and fixed items such as insurance. If your household has debt, which may include credit cards, a mortgage or student loans you potentially have large fixed payments your household would need to cover even if someone lost a job. You do not want to be in a position to cover your debt payments in a time of crisis with debt (credit cards). If you have children, this equation becomes even more complicated with daycare, healthcare and activities.

All of these circumstances are individual or household specific. Thus, the first place to start is with a budget. Start tracking where you spend your money and how much you spend. Once you’ve tracked your spending for a few months, you can better gauge the appropriate amount of emergency savings.

I use Mint and Pat uses Personal Capital. Both are great services to track household spending. If phone and web applications are not your thing, you can use Google, budget templates or one of the many spreadsheet options available online.

Keep in Mind:

1.     You need liquid savings. The amount necessary is subjective, but if you do not have some, you need to do something about it.

2.     You will get in your way. If you do not have the habit of saving today, it will be difficult to get started and maintain. Do not let that discourage you. Keep working at it.

3.     The best way to overcome this is automation. Set up a savings account at another bank and send money there every month. Do not look at it, or touch it. Automate your saving and then forget about it.

Good luck and remember, the best time to buy an umbrella is when it’s not raining.

Midwestern Financial