Here’s How Fed Rate Hikes Will Affect Your Retirement Plan – For Good And For Bad | Smart Change: Personal Finance

(Ryan Downie)

The stock market fell this week after the August consumer price index indicated inflation was higher than expected. Coupled with a decent employment report, these inflation figures have opened the door for continued rate hikes by the Federal Reserve. The rate hike will have a handful of major impacts across different asset classes, and investors need to understand how they all fit together in a retirement plan.

Your 401 (k) will decline in the short term

Rate hikes are devastating the stock market.

It’s not always a perfect relationship, but the stock market tends to move in the opposite direction of interest rates. When recessions hit and unemployment rises, the Fed usually cuts interest rates. This stimulates economic growth and encourages investors’ risk appetite, which drives stocks up.

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Inflation usually rises if expansionary conditions persist long enough. The rigidity of labor markets raises wages and strong consumer sentiment gives firms pricing power. To fight inflation, the Fed raises interest rates. As the cost of borrowing money rises, businesses withdraw hires, real estate slows down, and consumer spending falls. All of these signs are signaling investors to reduce portfolio risk, and stocks usually collapse.

If you’ve been watching the market since the start of the pandemic, then you’ve seen all of this unfold in real life. A sudden drop in economic activity triggered aggressive action by central banks, which flooded economies around the world with liquidity. This supported trading activity and employment and fueled an 18-month bull market.

YCharts US Unemployment Rate Data

Low interest rates and high employment, combined with other factors, resulted in exceptionally high inflation in early 2022. Consumer prices exceeded wages, which has become a threat to economic stability and has forced the Fed to raise rates. As expected, the stock market reacted with high volatility and losses across all major indices. Growth stocks suffered greater losses than value and dividend stocks.

This is the most immediate and visible impact of a tight monetary policy for most pension plans. Equity positions have come to a halt and it is impossible to tell if we have hit bottom yet. There is a possibility that all future hikes are already priced into stock valuations and that the Fed’s upcoming announcements will cause no further damage. However, any indication that monetary tightening will exceed expectations is almost certain to push equities lower. Slow economic growth is likely to act as a further drag on equities in the coming quarters.

Investors need to prepare for greater volatility in their retirement accounts. Do not sell stocks temporarily lower unless necessary. If you have more than 15 years to retire, it is still worth investing for growth. If you’re approaching retirement, make sure you’ve established the correct allocation of bonds and other low-volatility assets.

Income yields are going up

The stock clearance sale will sting for retirees, but there is an important upside: higher rates on savings and fixed income investments. This is a reversal from the lowest rates of the last decade, which has created a serious challenge for retirement planning.

For much of the 2010s, bonds did not generate the same interest as they used to, and rates on savings accounts and CDs were low, along with the average dividend yield across major equity indices. Retirees had to accumulate more assets to generate the same amount of investment income. The issue was so acute that many financial planners are calling for a downward revision of the 4% rule.

This problem only got worse in the aftermath of COVID-19. Interest rates on Treasuries and corporate bonds have fallen to historically low levels and dividend yields have also fallen.

Moody’s Seasoned Aaa Corporate Bond Yield YCharts data

The Fed’s actions this year reversed these impacts. Bond yields are returning to pre-pandemic levels and dividend yields are also rising. We are still far below historical average levels, but a lot of pressure has been relieved.

Inflation and economic stagnation are certainly areas of concern for retirees, but it’s not all doom and gloom. From an income yield perspective, the Fed rate hikes represent a significant improvement. This is good news for people who have not earned an income from work.

Growth opportunities are back on the menu

Nobody wants to see big losses on their 401 (k) statement, but it’s really important to recognize the difference between realized and unrealized returns. For long-term investors, last year’s losses are only temporary and a 401 (k) is a long-term account for most people under 50.

In twenty to 30 years, this market correction will be a twist on the radar. Young investors shouldn’t panic and sell stocks today. Instead, it is better to continue to accumulate resources and allocate them for growth. Growth stocks have suffered a setback over the past year, which has enhanced the opportunity for long-term returns. The risk has been significantly reduced now that valuations are cheaper.

Think of this as a sale, where the exact same stock can be bought at a discount that wasn’t available 12 months ago. Fed rate hikes have created an interesting opportunity for some investors.

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