How to Protect Wealth When the Fed Is Raising Rates
The low interest rate environment of recent decades appears to be on the way out. While rates may not currently be high by historical standards, they are nevertheless significantly above where they were just a year or so ago. With the Federal Reserve vowing to continue its campaign to raise rates to fight inflation, it seems clear that we have moved from a falling or stable interest rate environment to one in which rates are rising.
So, the question is,
Faced with rising interest rates in a high inflation environment, how can investors preserve, and even grow, their wealth?
First, let’s talk about diversification
One pillar of wealth preservation is diversification. Even when rates are falling or stable and growth assets such as stocks are doing well, it is not prudent to put all your eggs in one basket, as the saying goes.
Diversifying your portfolio becomes even more advisable when rates are rising and the stock market is plummeting. While investors may not necessarily want to give up entirely on more risky investments during such periods, assuming they are willing to withstand the higher volatility associated with them, emphasizing more conservative assets and financial products in their portfolio makes sense from the standpoint of wealth preservation.
Placing money in assets that aren’t impacted by the volatility of the stock and bond markets due to Federal Reserve rate hikes can provide income or growth of capital as well as wealth preservation.
For instance, tax-advantaged insurance products backed by companies with strong balance sheets can offer growth on your savings as well as access to cash as permitted by policy limits.
The following are some investment products and asset classes that can help you preserve your wealth when the Fed is raising rates:
- Guaranteed lifetime income annuities
- Universal life insurance
- Whole life insurance
- Variable annuities
- Precious metals
Below we take a look at each of these assets and how they can help preserve your wealth in a rising interest rate environment.
The saying ‘cash is not trash’ is often cited when riskier assets such as stocks experience high volatility. While cash may not offer the upside potential of other assets, it can be a good place to stash some funds when financial markets are unstable.
For instance, whether using a dollar cost averaging strategy or trying to “time the market,” having some cash on the sidelines can provide you with buying power to purchase more growth-oriented assets after they have declined substantially.
While it is true that over the long run the stock market has provided higher than average returns, the road to those returns can be an extremely rocky one. As a result, having some cash on the sidelines that you can use either to purchase equity investments such as stocks at a discount or some of the other assets mentioned below can be a good thing.
The downside to owning cash when rates are rising is that cash either doesn’t offer a yield or, if in a savings account or money market fund, typically provides a very low yield. While this is certainly better than losing money in stocks during a market decline, it can hurt your ability to preserve your wealth by earning a positive real return (one greater than the rate of inflation).
The Fed has declared that inflation is too high, and this means that leaving money in cash while inflation is running hot may generate a negative real return. As a result, having an excessive portion of your portfolio in cash can hurt your ability to preserve the purchasing power of your wealth during periods of high inflation.
So, with this in mind, let’s turn to some assets that provide much better returns than simply sitting on cash.
Guaranteed Lifetime Income Annuities
With improved health due to scientific and technological advances in the modern era, people are living much longer on average than was the case in the past. While this is good news, it does create what is known as longevity risk – the risk of outliving your income. If your portfolio is mainly in risky assets such as stocks, a market decline, such as the recent downturn in equities, can force you to either lower your standard of living in retirement or, in the worst case, run out of money altogether.
One asset that can help combat longevity risk is a guaranteed lifetime income annuity. These insurance products offer a fixed payment for as long as the annuitant lives.
While annuities can also be purchased that offer a guaranteed payment for a certain period, these are riskier because after that period the payment can fall substantially or even cease entirely depending on the principal amount available in the annuity.
Universal Life Insurance
Universal life differs from whole life in offering flexible premiums, which make this product suitable for those who anticipate their need for insurance may change in the future or who want the option to reduce the amount they pay in premiums if it becomes necessary.
The investment component of a UL policy can also be an attractive option for preserving and growing wealth due to the tax advantages insurance products offer.
From an investment standpoint, UL offers tax-deferred growth in a policy’s savings account, as do other insurance policies.
Many of these policies offer indexed investment subaccounts featuring caps and floor that give you the chance to participate in the growth of the stock market, while limiting both upside and downside potential.
Given the instability in the market currently, this can be an attractive option for investors who are interested in the ability to participate in some portion of the market’s appreciation, while avoiding downside risk.
Indexed Universal Life policies with the option to invest in subaccounts that track the performance of a sector of the stock market, such as the S&P 500 or NASDAQ indexes, will often offer caps that restrict the total appreciation the subaccount can realize in any one year. This means that the return you can realize from your investment is capped at a certain percentage, no matter how much the relevant index rises.
For instance, if your cap was 8%, and the index being tracked rose 12%, you would only receive 8% for the time period in question. The benefit of a cap and floor system is that the floor offered in conjunction with a cap limits your subaccount’s participation in any market decline by guaranteeing a return level, typically at least 0% and sometimes even a slight positive return of 1% or so.
As a result, these policies give you the potential to earn positive returns when the market recovers, while protecting your principal in the meantime.
Whole life insurance
In times of high market volatility, the steady accumulation of investment value in the savings account of a dividend paying whole life policy can help preserve and even increase your wealth.
Given that the cash value of a whole life policy can be accessed via policy loans, these policies provide a tax-advantaged way to build up savings that you can access as needed over time.
As long as the amount withdrawn from the savings account does not exceed policy limits, the death benefit associated with the policy is not affected.
Another benefit of building up funds in the savings portion of a whole life account during times of rising interest rates is that the interest credited to your savings during such periods is likely to rise to reflect these higher rates.
This, combined with the tax advantages of saving funds within an insurance policy, helps whole life policies provide both wealth preservation and steady wealth creation.
Typically, life insurance policy loans can be taken out without triggering immediate tax consequences up to the adjusted cost basis, making these policies even more attractive from a tax-adjusted return perspective.
Furthermore, the amount credited to your whole life savings account is not subject to the ups and downs of the market, making these policies a welcome refuge from market risk if you need insurance protection as well as wealth preservation.
While the investment portion of a variable annuity is subject to market risk, these policies typically include a guaranteed death benefit amount which matches the principal you invest and ensures that your beneficiaries will get no less than the amount you invest in the product upon your passing.
Additionally, these products will often offer investment caps and floors, where you can invest in a market-linked subaccount with certain restrictions.
These restrictions are similar to those found in some UL policies, and generally limit your total upside if the market rises, while offsetting that by offering a floor, typically from zero to 1 or 2 percent. The floor protects your investment in the variable annuity from declining in value even if the market should plunge.
Thus, variable annuities with these features offer the ability to protect your principal during market downturns, but without the insurance component which UL offers.
A primary reason that some financial advisors recommend keeping a portion of an investor’s portfolio in precious metals such as gold and silver is the historical ability of these commodities to serve as inflation hedges.
When excessive amounts of currency are created by a government or central bank, this debases the value of the currency, which typically results in a corresponding increase in the price of silver and gold.
The Federal Reserve typically raises rates when it fears inflation is getting out of hand, as is the case currently. The rising prices associated with inflation are often seen as a sign of excessive monetary creation, and thus gold and silver generally do well during inflationary times.
However, these commodities can be extremely volatile as investors try to gauge whether the Fed will be successful in reining in inflation. This has occurred over the past year or so, as gold and silver prices have gyrated wildly in response to headlines about rising inflation and the Fed’s stance on its interest rate policy.
In addition to their volatility, precious metals do not pay dividends or credit interest to their holders in the same way that a whole or UL policy or annuity policy will.
As a result, as an investment these commodities are best suited either for speculators trading them based on the latest twists and turns of monetary policy and inflation numbers, or for those who don’t need to generate income, at least in the short run, and want to hold them as a hedge against inflation over the medium or long-term.
Shelter From the Storm
The Fed has shown no sign that it will relent anytime soon in its campaign to keep inflation in check by raising rates. The sharp fall in the stock market in recent weeks shows that the Fed’s tight money policy is having a negative impact on risk assets.
As a result, the assets described above can serve as safe havens for investors focused on wealth preservation during the market instability set off by rising rates. Some of them can also provide growth on your investment, as well as pay out income.
Which, if any, of these assets is right of you will depend on your individual financial situation and investment goals. For investors looking to pivot to a more conservative stance with at least some portion of their finances, the current rate raising posture of the Federal Reserve means that the time is right to evaluate whether these investments deserve a place in your portfolio.