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Make clients aware of the implications of rising rates

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What goes up, must come down. And after nine long years, what goes down must come up.

After falling since 2008, interest rates are finally starting to creep up. The Federal Reserve has clearly stated that it will raise rates as the economy continues to strengthen. So far, key interest rates have moved very little, so while the timing is in doubt, there’s wide agreement the trend is finally up.

This is a good news-bad news situation for clients: the good news is that many of them are looking for income, which higher rates can deliver. But for holders of existing products with fixed rates, this is not good news.

Interest rates peaked back in 1981 when the 30-year U.S. Treasury bond yielded over 15%. But then they declined – with lots of ups and downs along the way – to 2.1% last year. Today, they are around 3%. Consumers and FAs have become used to living in a down interest environment. In fact, the majority of FAs in the industry today have never experienced a prolonged increasing rate environment. And after the most recent Fed meeting, experts are pretty confident another rate hike is coming in June, and yet another later in the year. Now is the time to understand what this means both for existing clients and their portfolios, and what products and services will make the most sense in this new world.

First, according to basic economic principles, when interest rates rise, the price (or market value) of fixed-income securities falls. And the longer time-frame to maturity, the steeper the fall. This means that bonds and mutual funds with long maturities will fall, while T-bills and shorter-term investments will better hold their values. Consequently, some investors may want to consider decreasing their fixed-income holdings and/or shorten maturities. This is why many experts recommend bond ladders, where investors have positions in three-month Treasury bills or CDs, some in six to nine months, and the balance in one-year obligations. When one “bucket” matures, the proceeds are reinvested at higher rates. Remember too, this same principal would apply to fixed annuities. Fixed annuities will act just like bonds of similar maturity. If an investor owns a fixed annuity with a five-year market value adjustment feature and sells prior to the end of the term, they could get less than their initial investment (other penalties or guarantees not withstanding). Of course fixed annuities have other features and benefits (like tax deferral). But aside from those considerations, a fixed annuity with a 3% interest rate for five years will be worth less if investors can later get 5% with the same terms.

Bonds, indexed products and annuities all have specific reactions to rate changes.

Indexed and variable annuities are a different matter. Most indexed annuities are designed to give up some portion of gains in return for risk reduction. This can take the form of a guaranteed small return or 100% return of principal as long as the product is held longer than a specified time. Equity indexed annuities, with their returns tied to widely known indices (like the S&P 500) can give investors the opportunity to get some participation in a rising equities market. Historically, some sectors of the economy like banks, real estate, home builders, and other financial services companies tend to do pretty well. Similar to fixed annuities, variable annuities can grow tax-deferred, have no regulatory limit on contributions, and offer different income options during an income phase. Unlike fixed annuities, the values of variable annuities are tied to performance of the underlying subaccounts, which can include equity, fixed income, and alternative funds. The annuity’s value is impacted by rising interest rates to the extent that it impacts the asset classes of the sub-accounts that the annuity owner chooses to invest in. Some variable annuities offer optional living benefit features (aka riders) that provide certain protections for payouts, withdrawals, or account values against the possibility of investment losses and/or unexpected longevity. The point is, VA’s with the right subaccounts can weather a rising interest rate environment and even do quite well.

There are also thousands of ETFs and mutual funds. From gold to so-called “alts” that can invest in anything from art to oil, and some products that go up when the underlying investment goes down. It’s no easy task for an FA to design a strategy and the products that will deliver for every client.

With the impending fiduciary rules about to hit and the potential for rising interest rates makes it imperative that FAs talk to their clients now. Explaining how these forces may impact their investments and their goals is a critical task that FAs must take head-on. Communicating and adapting to a changing world is what being a professional adviser is all about.

Paul A. Werlin, president of consulting firm Human Capital Resources, is a regular contributor to Bank Investment Consultant.

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