Interest rates have a significant impact on both the economy at large and the stock and bond markets in particular. The Federal Reserve Bank sets interest rates based on its view of what is best for the economy and holds regular meetings to discuss— and announce—any potential changes in interest rate policy.

Interest rates can also affect your 401(k) plan in many different ways, depending upon the investment choices that you hold inside it. Knowing how this critical economic factor can impact the performance of your retirement plan can help you bolster your investment returns and avoid potential losses that may be triggered by changes on the interest rate front.

The Cash Factor

Of course, one of the most obvious ways that a change in interest rates impacts your 401(k) is the amount of interest you earn from any investment choice that pays either a guaranteed or a floating rate of interest. When rates rise or fall, so will the interest rate of the money market funds in these plans, as well as the rates that are offered in guaranteed accounts of any kind.

Key Takeaways

  • Changes in interest rates can affect the economy and move financial markets.
  • Knowing how rates affect stocks and bonds can help you better manage your 401(k) retirement plan.
  • While bond prices can see losses in periods of higher rates, stocks often perform well when rates move lower.
  • When interest rates begin to move higher, the time might be right to move some money to short-term bond funds or cash.
  • Adding to equities can make sense when rates are expected to fall, remain low, and bolster the economy.

While money market funds will offer higher rates when interest rates increase, the key rule to remember when it comes to bonds and other fixed-income instruments is that when rates rise, bond prices in the secondary market will fall, and vice versa. This is due to the fact that a bond buyer in the secondary market is not going to pay full price—or the par value of a bond when it was issued—for a bond that is paying a lower rate when new bonds that are issued are paying higher rates. Buyers will thus demand a discount from the par value before they will buy the older bond in order to make up for this difference.

So if you own mutual funds that invest in bonds inside your plan, then a rise in interest rates will probably cause the share price of your funds to drop slightly, while the interest or dividends that they pay out may rise as new holdings that pay higher rates are added to their portfolios.

Stocks and Stock Funds

Interest rates have a different kind of impact on the stock and equity markets. When the Fed lowers rates, this makes it cheaper to borrow money, which can spur businesses to take out expansion loans and thus grow the economy. The markets react favorably to this change and will usually rise on any day when the Fed announces that it will either lower rates or leave them unchanged.

In addition, stocks can continue to perform better during periods of low rates, although there is no guarantee or protection against corrections or recessions. When rates are high, stocks can sometimes fall out of favor because of the more attractive options that are available from issuers of bonds and CDs.

Interest Rates vs. Inflation

There is a close relationship between interest rates and inflation—the two are unable to diverge from one another materially. Although one may rise or fall a bit faster than the other, they generally move in tandem over longer time periods.

While rising interest rates may increase the yield that you receive from your bond and cash holdings, your purchasing power will also likely erode at some point because inflation will push prices up. And if you elect an irrevocable pension payout from your 401(k) plan, then the purchasing power of your monthly payments will also erode as inflation rises.

What You Can Do

There are several things you can do in your 401(k) plan to protect yourself against changes in interest rates. If it looks like rates are going to rise, then a short-term bond fund may be a good idea because it is less likely to invest in long-term obligations that will consequently drop in price. You may also consider moving some of your appreciated equity positions into short-term bonds or cash for a time because the stock market will often pull back when rates start to rise.

If interest rates start to fall, then beefing up your equity holdings might be wise. It may also be a good time to look at locking in a current rate on some longer-term fixed-income offerings. If you are looking at taking a lifetime annuity payout from your plan, then most financial planners would encourage you to choose an option that has a built-in cost of living rider.

The Bottom Line

Interest rates impact all facets of our economy, including your retirement portfolio. But these changes don’t have to mean losses for you if you understand how they work and what you can do to position yourself to profit from them.