Baby boomers have had to switch their retirement planning strategy drastically over the last decade. You can no longer rely on Certificates of Deposit and a mix of Treasury and corporate bonds to provide you with tens of thousands of dollars annually. You have to get creative when investing for retirement in a low interest rate environment.

Wealth Transfer In A Low Interest Rate Environment

Low interest rates transfer wealth from savers to borrowers. A great amount of wealth has been shifted from savers to debtors. This is an added tax on already pinched retirees.

A retired couple that used to make $50,000 in interest income in 2002 now makes about $10,000 on the same amount of principal. This could be viewed as a $40,000 annual stealth tax on retirees. Retirees now have to figure out how to either live on less or get more income to maintain their standard of living.

Young people generally make out in this environment, at least from a borrowing standpoint. Loans are now cheaper; not just mortgage loans either. Car loans, personal loans, and even the rates credit cards charge have all dropped. The rates on borrowing money to invest in the stock market have come down too.

While there advantages and disadvantages depending on if you’re a borrow or a lender, very low interest rates are troubling for the economy

Interest Rates Increase When Demand For Money Increases

Very low interest rates are troubling for the economy and your wallet. Low rates mean the demand for money is low. Period.

People think that low interest rates will stimulate the economy by making it cheaper to borrow money that will go into investing, capital projects (both gov’t and corporate), and spur consumer demand for goods. This is all well and good. The problem is that people can only put so much to work at low interest rates.

For example, low interest rates will help drop your monthly mortgage only once. Even if you have ten investment properties and refinance them all at lower rates, there is still a wall that will eventually be hit. Low interest rates may longer be effective.

Or people may not be able to take advantage of certain aspects of low interest rates. How many people do you know who are investing in capital expenditures and borrowing money to invest?

Most people that I run into and talk interest rates (okay, there are very few) think that interest rates are controlled by the Federal Reserve or simply the “government”. That’s simply not the case. The Fed can change the reserve interest rate around all they want. They can do quantitative easing until they’re blue in the face. Interest rates will move up if the demand of money comes back.

Fancy economists would draw a graph at this point to illustrate the supply and demand relationship between interest rates and the quantity of money.

interest rate supply and demand

As the demand for money increases (shifts to the right), interest rates rise. Demand for money occurs when the economy picks up.

As the supply of money increases (shifts to the right), interest rates drop. The interest rate is now farther down on the demand curve.

The Fed can manipulate the quantity of money by implementing various policies:

  1. Discount rate – The Fed could lower the discount rate which drives the short-term market rate down in most cases. This increases the money supply.
  2. Reserve ratio – They could lower the reserve ratio for banks which would allow banks to lend more money. This increases the money supply.
  3. Open-market operations – The Fed could go into the market and buy up Treasuries that they previously sold. This increases the money supply.

There are a couple of other things the Fed can do to try to change interests (e.g. twisting, signaling, etc.), but that’s about the limit of their toolbox.

That’s the monetary side. The government could do even more on the fiscal side to try to change the supply of money. They could lower tax rates or issue a tax credit like G. W. did back in 2008. That didn’t seem to have a lasting effect.

Imagine if the government deposited $10,000 into everyone’s bank account. Seem preposterous? This kind of stunt could happen if we’re ever on the cliff of another depression.

What exactly would depositing $10,000 into everyone’s bank account actually do? It would certainly increase the money supply temporarily. But it wouldn’t cause the country to be better off. Everyone would feel richer the day they looked into their bank accounts. Everyone would allocate their capital accordingly. Some would buy cars. Some would pay off debt. Some would go to Vegas no doubt.

It would likely spark a business cycle which would create inflation. It would likely be followed quickly by a recession, because there was only one shot of $10,000 instead of sustained rise in income.

This brings us back to the demand for money and the rising interest rates. Everyone seems to believe that rates will go up. After all, they’ve been low for so long. How could they not go up sometime soon? I used to think that too.

That is until I realized that the only thing that will bring a rise in interest rates is a greater demand for money.

The Fed raising the discount rate will not increase interest rates. They’re trapped. If the Fed tries to increase too quickly, it will lead to another recession or market interest will say no. They’re stubborn after all. You can’t go against what the market wants the price of money to be. 

Practical Solutions To Forever-low Interest Rates

There are several practical solutions you can implement to beat forever-low interest rates. You may be shocked by some of the recommendations for investing in low interest rate environments.

Those people that will enter retirement in the next ten years or are currently in retirement can:

  1. Keep a big long-term mortgage going into retirement if your living expenses are less than your normal income plus the income you would generate from investing instead of paying off a mortgage. The idea here is that interest rates are low and you should take advantage of cheap money and invest the difference. You should only use this tactic only if you invest the money into a diversified portfolio that you would otherwise would have paid off your mortgage. You can earn 8% or more and your cost of money will be less. Plus you’ll have the optionality that comes along with having more capital and you transfer the risk of a real estate crash to the bank that holds the mortgage.
  2. Take a 5/1 ARM cash-out refinance if you have enough money that you could comfortably payoff the mortgage when the rate adjusts. The idea here is that you can lock in very low rates for the next five years and invest the difference at a higher rate. Rates on a 5/1 ARM are lower than similar fixed rate loans. You believe that interest rates will stay low so even after five years, you simply go year-to-year. You also get the benefit of optionality that comes along with having more capital and you’re still transferring risk to the bank that holds the loan. This works best when you have so much money that it doesn’t matter if rates skyrocket in five years. You’re just trying to optimize your retirement.
  3. Invest in REITs, bonds, and income-producing stocks. If you think rates are going to stay low for the long-term, then you want to invest in asset classes that do well in low interest rate environments. This includes all types of income-producing real estate, corporate and Treasury bonds, and dividend stocks. All of these do well when rates are low and underperform in a rising rate environment. Notice I said underperform. They may still do ok as rates rise, but they won’t do as well as growth and cyclical stocks.
  4. Implement an aggressive allocation for your age. You can take on more risk if you believe interest rates will stay low for a long time. Rising interest rates put a drag on the stock market. A low interest rate environment will allow equities to continue to rise, all things being equal. The first step in seeing if you’re properly diversified and allocated is to use this free software or check with a fee-only financial advisor.

Interest rates will be low for a long time. The only thing that will increase interest rates is an increase in the demand for money.

I want soon-to-be retirees to get creative when investing for retirement in a low interest rate environment. Imagine a world where interest rates will be low for the next 20 years because it could become a reality. Understanding how to take advantage of a low interest rate environment is necessary for continuing to generate income in retirement.