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Interest Rates Are Low Until You Do the Math
Posted By Allan Roth On May 1, 2014 @ 3:49 pm In Money Talk | Comments Disabled
I often hear that interest rates are awful and that it’s the worst time ever for retirees needing to live on fixed income. Yet when you look at after-tax, inflation-adjusted returns, a different picture emerges.
Many people smile when I tell them that back in 1980 they could have earned 12 percent on a 10-year U.S. Treasury or certificate of deposit (CD). Depositing $10,000 would have returned $1,200 a year. But if a third went to taxes, that gain would have been $800, or 8 percent.
The problem then was that inflation was about 13 percent that year, so if you made 8 percent and it costs 13% more to buy what you need to live on, your spending power actually declined by about 5 percent. That means you could buy about 5 percent less stuff than you could have the year before.
What ultimately matters is the after-tax inflation-adjusted real return. Last year, some CDs were paying as high as 3 percent, earning about 2 percent after taxes. By comparison, the consumer price index rose only 1.5 percent, so one could at least be slightly ahead in spending power. In real terms, interest rates today are actually much better than they were back in the day when we’ve convinced ourselves we could have earned high income.
Remember that money is stored energy to give us the freedom to do what we want with our lives. We can’t take it with us and the reality is that fixed income is more about protecting at least a portion of your savings from market swings and less about providing a significant after-tax adjusted income. To boost returns you’d to need to invest in stock funds, but that expected real after-tax return comes at a price – taking on risk
My advice is to keep most of your fixed income in instruments backed by the U.S. government, such as U.S. Treasuries or CDs backed by the FDIC (banks) or NUCA (credit unions). When you hear someone tell you how interest rates will change in the next year, remember that top economists have a track record of predicting the direction of interest rates far less than 50 percent (the expected outcome of a coin flip). Thus, the decline in rates so far this year, when top economists were adamant that the U.S. tapering in buying back our own bonds would cause an increase, is not part of a recent phenomenon of being wrong.
While no one knows how rates will change in the future, it may be a good thing for retirees that rates and inflation are both low. If rates do increase, it will almost certainly be because inflation also increased. That’s likely to lead to lower after-tax real returns.
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