Financial Planning in a Low Interest Rate Environment: The Good, the Bad and the Potentially Ugly

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1 Financial Planning in a Low Interest Rate Environment: The Good, the Bad and the Potentially Ugly In June of 2012, the 10 year Treasury note hit its lowest rate level in history when it fell to 1.62%. Since then, the rate has continued to drop but remarkably little has been reported on this subject. The financial sector, as well as the general public, seems to have grown accustomed to living in a low interest rate environment- yet few consumers have grasped the long term ramifications of what these conditions can have on their financial plan. As the financial markets in the U.S. face these historically low interest rates, it s critical for consumers to be aware of both the opportunities and challenges relating to their financial plans. By understanding the ramifications a low interest rate environment can present, consumers can work with their wealth advisor to ensure their financial plan is built to meet their goals and objectives. The Good Borrowing One of the more advantageous effects low interest rates can have on an individual s finances is the opportunity to borrow money inexpensively. Low interest rates function to speed up the velocity of money moving through an economy by incentivizing people to buy goods and services with low-cost capital. As a result, consumers can greatly enhance their financial plans by reducing the cost of borrowing within the plan. This can extend to a business owner who may be able to secure a line of credit to fund operating expenses or to a homeowner who can refinance a home and save hundreds of dollars that can either be saved or allocated to other expenses. As an example, someone with a current 30 year fixed mortgage of 6% on a $1,000,000 home would be paying roughly $5,995 a month on their mortgage payment. Refinancing at a current 30 year fixed rate of 3.75% would save that individual $1,364 per month, which is nearly $16,400 over the course of the year MARINER WEALTH ADVISORS Page 1

2 Trey Barnes, a Senior Wealth Advisor at Mariner Wealth Advisors, makes mortgage rates a topic he discusses with each of his clients. The current mortgage rate environment is providing a once in a lifetime opportunity for people to enhance their financial positions in the long term. As part of my planning process, I make sure each of my clients is aware of their options and help coordinate the refinancing or purchasing process as part of their ongoing financial plan. One concern that has been raised by investors and economists alike is the effect rising interest rates may have on the prices of homes still recovering from the 2006 housing bubble. Historically speaking, there is a very weak argument to be made about the statistical correlation between rising interest rates and home prices. In fact, in a 2011 article published in The Atlantic, Yale economist Robert Shiller provided an analysis studying home prices relative to interest rates dating back to The chart below demonstrates his findings, showing home prices and long term interest rates moving independently of each other over that time period 250 Long Interest Rate vs. Home Price Real Home Price Index Home Prices Long Interest Rate 50 Interest Rate Source: Robert Shiller 0 Wealth Transfer Another positive result of the low interest rate environment is the opportunity it has created to transfer wealth. As the Internal Revenue Service uses current U.S. interest rates to determine the tax treatment and value of financial gifts, many individuals are finding attractive opportunities to transfer assets to subsequent generations or to their communities through charitable giving. While some estate planning strategies work better than others in a low interest rate environment, some of the more popular strategies in this environment include, for example, intra-family loans, installment sales, grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs). Intra-family loans are popular strategies in low interest rate environments because they are a simple yet effective way to transfer wealth from one generation to the next without generating a gift tax. As an example of how these types of loans work, a grandparent may loan a grandson $2 million for the grandson to start a business. The interest rate for the loan is based on the IRS Applicable Federal Rate which is set each month. If the term of the loan is nine years, and the mid-term rate 2013 MARINER WEALTH ADVISORS Page 2

3 for the loan is set at the current rate of 1.09%, the principal and interest due at the end of the term would be $2,204,975. If the grandson is able to generate a 5% annual rate of return over those nine years, he will have $3,102,656 at the time the loan comes due. At this point, the grandson will then be entitled to keep the difference of $897,681 without any gift tax consequences. In addition to the wealth transfer properties of this strategy, intra-family loans offer an additional benefit over third-party loans by keeping the interest paid on the loan within the family, rather than being paid to a lending institution, such as a bank. Additionally, the family is able to avoid paying lending fees or pre-payment penalties generally built into bank lending agreements. Another of the more popular wealth transfer strategies in a low interest rate environment is the Grantor Retained Annuity Trust (GRAT). The concept behind a GRAT is for a grantor to transfer assets into a trust for a certain period of time, usually two to five years. The most favorable assets for these trusts are highly concentrated and volatile with high growth prospects over the short to medium term. During the term of the GRAT, the trust makes annuity payments to the grantor based on the Section 7520 rate, named for the corresponding IRS code. As the current Section 7520 rate is 1.2%, the trust would make relatively low payments to the grantor with the hope that the assets invested within the trust would grow at a greater rate. Once the term of the annuity expires, any remaining assets are transferred to the remainder beneficiary, which is typically a grantor trust for the benefit of the grantor s children. If the assets in the GRAT have appreciated at a rate higher than the 7520 rate, the assets pass to the remainder beneficiary free of gift tax. Again, the lower the interest rates, the more attractive this strategy becomes when wealth transfer is an objective. While both of these strategies and others like them have become popular in this environment, the clock is ticking to take advantage of such opportunities. If interest rates eventually rise, the ramifications for not taking action could have long standing ramifications for individuals wishing to transfer wealth to future generations. The Bad Bond Portfolios While home values may fluctuate independently of interest rates, the price of investment bonds is directly affected by changes in interest rates. And in terms of financial planning, one of the negative ramifications of low interest rates is the difficulty it presents in generating yield for investors in income producing portfolios. Traditionally, the fixed income portion of a portfolio is comprised of bonds. In order to achieve greater yield while utilizing bonds, an investor is faced with two choices: accept the risk of a longer maturity, or the risk of a lower credit rated bond. The risk in accepting a longer maturity on a bond is that if interest rates eventually rise, the price of the bond will go down. As we are currently experiencing historically low interest rates, most investors are highly skeptical of buying bonds with long maturities. The second way to increase yield within a bond portfolio is to accept credit risk, or bonds that have a lower credit rating (also referred to as high yield bonds). The main risk with high yield bonds is that if the issuer declares for bankruptcy, the bond holder may be faced with losing some, or all, of their principal MARINER WEALTH ADVISORS Page 3

4 Bill Greiner, Chief Investment Officer at Mariner Wealth Advisors, describes consumers search for yield as an evolution. He explains, uncertainty tends to lead investors toward high yield bonds as opposed to maturity extension. The reason for this is that most investors see high yield bonds as an asset class they are renting for a period of time while interest rates are low and, if the credit doesn t default and the maturity isn t longer than two to five years, investors can sell out of the class and get out whole. As investors become more comfortable with the risk associated with high yield bonds, they may also become more comfortable looking outside the traditional sphere of the fixed income asset class for other asset classes that produce more yield. Mr. Greiner has seen this shift fairly recently, just in the last six months or so we ve seen the incorporation of equity substitute for fixed income exposure. So you re seeing people buying more dividend yielding stocks and the utilization of certain kinds of investment vehicles that, normally speaking, most people wouldn t think about using, such as convertible bonds and convertible preferreds that have become very popular. Mr. Greiner also notes that this type of investor behavior is cyclical. As rates begin to move higher and bond yields begin to rise, investors may once again return to the traditional bond instruments that offer more safety and protection of principal while also providing more attractive yields. Life Insurance Policies As a best practice, it s always important for individuals to perform an annual analysis of their life insurance portfolio with their advisor to make sure their policies and related carriers remain in good standing. This is especially important now as insurance companies are among the sectors that have been most negatively impacted by the extended low interest rate environment. In fact, in a 2012 Towers Watson survey of life insurance company CFOs, the most cited concern of respondents (45%) was a prolonged low interest rate environment similar to Japan s posed the greatest threat to their business. One of the primary reasons that extended low interest rate environments adversely affect life insurance companies is that many of the guaranteed policies sold are very sensitive to interest rates. While some policies, such as variable life, place more risk on the policyholder by investing in the equity markets, universal and whole life policies are more conservatively invested in interest bearing debt instruments. As a result, low interest rates make it more difficult for life insurance companies to fund guarantees within contracts because the guarantees cost more than the interest rate income can produce. The problem becomes further compounded the longer the low interest rate environment lasts. HIGH Interest Rate Sensitivity by Life Product LOW Fixed Annuities Universal Life, Guaranteed Investment Contracts Deposit Liabilities, Variable & Indexed Annuities Whole Life, Term Life Variable Universal Life, Group Life, Retirement Savings 2013 MARINER WEALTH ADVISORS Page 4

5 The Ugly.Potentially As was mentioned previously, low interest rates serve to speed up the velocity of money working through an economy. As this takes place, inflationary pressures begin to emerge. While inflation, in and of itself, is a by-product of an otherwise healthy economy, too much of it can cause negative ramifications to consumers. For example, as inflation increases, the costs of goods and services go up, and if household income does not keep pace, quality of life goes down. To combat inflation, the Federal Reserve monitors the Personal Consumption Expenditures (PCE) price index, which measures the records of thousands of consumer prices across the economy. If the inflation rate rises above the Federal Reserve s target of 2%, the center bank will typically react by raising interest rates, which reduces the money supply and works to slow the velocity of money. For investors that may have settled for the relative safety of lower yield bonds, rising interest rates can have a devastating effect on a portfolio as bond prices decrease. Bonds that already yielded historically low rates continue to lose value as interest rates increase, resulting in considerable damage to an investment portfolio that was built to provide safety in bonds. So what steps can investors take to protect themselves against these potentially negative inflationary effects? As interest rates begin to rise and inflationary pressures build, labor markets also tend to expand to meet consumer consumption demands. This results in commodity prices going up as a reflection of raw materials being used to create products. The beneficiaries of these demands tend to be emerging markets as they are rich in the natural resources necessary to create many of the products consumers demand today. An example of this global supply chain would be lithium being mined in Chile to create cell phones, which will be built in China and ultimately sold across the United States and Europe. To benefit from these trends, having exposure to emerging market equities becomes more important so as to act as a hedge against rising inflationary pressures. Conclusion While low interest rates have been a blessing for many business owners seeking inexpensive capital or consumers loooking to buy or refinance a home, the extended low interest rate environment can cause unforeseen complications to a financial plan. Careful consideration needs to be paid to everything from life insurance policies to investment portfolios to ensure that a client s goals and objectives are being protected in the face of the current environment and inflationary pressures that may lie ahead. Should you have any questions regarding your financial plan or strategies relating to the current interest rate environment, don t hesitate to contact your advisor or visit our website at MARINER WEALTH ADVISORS Page 5

6 Mariner Wealth Advisors is an independent, national wealth advisory firm that provides unbiased financial advice focused on meeting client needs. Mariner s expert wealth advisory teams help clients achieve and maintain financial peace of mind preserving the wealth they have created and building a legacy for future generations of family and business leaders. The information contained herein is not intended to be personal legal, tax or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. There is no guarantee that any claims made will come to pass. The opinions and forecasts are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information that this opinion and forecast is based upon. Opinions expressed are subject to change without notice. Mariner Wealth Advisors ( MWA ) is an SEC registered investment adviser with its principal place of business in the State of Kansas. MWA and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which MWA maintains clients. MWA may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by MWA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about MWA, including fees and services, please contact MWA or refer to the Investment Adviser Public Disclosure website ( Please read the disclosure statement carefully before you invest or send money MARINER WEALTH ADVISORS Page 6