How Higher Interest Rates Impact Your 401(k)

Interest rates are a key variable for the economy and the stock and bond markets in particular. In the U.S., the Federal Reserve is the central bank that sets the federal funds rate, which influences other interest rates, to meet its mandate of promoting stable prices and maximum employment. The Federal Reserve holds regular meetings to discuss—and announce—any changes in interest rate policy.

Interest rates can also affect your 401(k) plan. Knowing how this critical economic factor can affect the performance of your retirement plan can help you bolster your investment returns, and to avoid potential losses that could result from changes in interest rates.

The Issue With Fixed Income

One of the most obvious ways a change in interest rates affects your 401(k) is the rate of interest you earn on money market investments that pay either a guaranteed or a floating interest rate. As the federal funds rate rises or falls, so will the interest rate of the money market funds in a retirement plan.

While money market funds will offer higher returns as 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.

As interest rates rise, so do yields on bonds, which are the inverse of the price of the securities. For bonds issued previously at a higher yield, the price in the secondary market will decline to match the yields on newly issued debt with the same maturity. 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.

If you own mutual funds that invest in bonds inside your 401(k) plan, a rise in interest rates will likely lower their share price and net asset value. On the other hand, the income of these funds would likely rise over time as they add new holdings paying higher rates to their portfolios.

Stocks and Stock Funds

Interest rates also play a key role in the price and performance of equity markets. Lower interest rates promote economic growth, while the increased borrowing costs associated with higher rates tend to slow it. Because corporate profits are correlated with economic growth, lower rates provide a tailwind for stocks, while higher ones can slow profit growth and hold down earnings multiples.

Note, though, that interest rates don't rise and fall in a vacuum: what's prompting rates to move tends to matter more to stock market investors than the move itself. Interest rates declining because the economy is falling into a recession may not provide enough lift to stocks to offset downward pressure from the contraction in economic activity.

Interest Rates and Inflation

Interest rates and inflation tend to move in the same direction. While interest rate moves may lag changes in the inflation rate, they generally move in tandem over time. Though rising interest rates may increase the available yield on your cash and bond holdings, accompanying inflation will tend to erode the purchasing power of your 401(k) savings.

What You Can Do

There are steps you can take to limit the downside in your 401(k) plan from changes in interest rates. If interest rates are rising, a short-term bond fund is likely to weather the increases better than one with a longer average duration in its bonds portfolio. You might also consider moving some of your allocation to stocks 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, it may be a good time to look at locking in higher rates by adding longer-term fixed-income offerings. Stocks can do better too as rates fall and the equity risk premium declines, provided rates aren't dropping ahead of a recession that could sap profits and share prices.

The Bottom Line

Interest rates affect many facets of the economy, including your retirement portfolio. Understanding the effects of rate moves on investment assets and reacting accordingly will help you maximize your 401(k) plan's investment returns.