How Interest Rates Impact Your Retirement Savings

Savings Strategies | by Jules Buxbaum | Wednesday, January 22, 2025

Are you wondering why **interest rates** seem to affect everything from your monthly mortgage payment to the funds in your 401(k)? For anyone looking to retire comfortably, it’s critical to understand this relationship—and to realize it goes well beyond bond prices or bank account yields.

Although changes in rates might look small on paper, they can transform your retirement plan. They shape how much income you can withdraw each year, how your portfolio performs, and whether you’ll even feel secure stepping away from work. Because no single strategy applies to everyone, each individual must think carefully about how current interest rates influence personal retirement goals. If you'd like to see the bigger economic picture behind topics like inflation and rising borrowing costs, you might also look at our discussion of inflation risk in retirement savings.

The Relationship Between Interest Rates and Retirement Savings

Interest rates reveal the cost of borrowing. They also shape the returns you’ll receive on fixed-income investments like bonds or Certificates of Deposit (CDs). Higher rates can boost yields on newly issued bonds, but they also push down the price of existing bond holdings.

For retirees, these shifts can be a double-edged sword. On one hand, interest-bearing accounts could offer higher income when rates rise. On the other hand, the short-term paper losses in a bond portfolio can pinch your net worth. In 2022, for example, the Bloomberg U.S. Aggregate Bond Index dropped by 13.01%, its largest decline in 40 years (1). This disappearance of bond value happened quickly after the Federal Reserve implemented multiple rate hikes to combat inflation.

Short-Term vs. Long-Term Effects of Rising Rates

A quick note: retirees often focus on the immediate dip in bond values or the borrowing costs for mortgages. These near-term shifts can feel scary. However, the longer-term horizon tends to reveal different advantages.

Short-term pain in a bond portfolio may pave the way for higher yields in the future. Over time, as older bonds mature and get replaced with newer issues at higher interest rates, monthly income streams could increase. Rising rates can also encourage many savers to keep some money in high-yield savings accounts or short-term CDs, which often pay better during these phases.

The Federal Reserve’s Role

Changes in the federal funds rate can reverberate through the financial system. Between 2015 and 2018, the Federal Reserve raised rates nine times, bringing them from near-zero up to a range of 2.25%–2.50%. This series of adjustments affected everything from corporate borrowing to the average 401(k) composition.

The Fed typically raises rates to slow inflation, making borrowing more expensive and encouraging people to save instead of spend. For retirees, this might mean a higher dividend payout on certain fixed-income assets. But if higher rates also spark market volatility, the equity side of a portfolio may see swings. Knowing how to stabilize your allocations in these situations can help you avoid reflexive decisions that hurt your long-term growth.

Equation #1: Age Versus Future Earnings

Most people hear they’re supposed to reduce investment risk as they age. This notion, often referred to as a “glide path,” sounds intuitive but is not always correct. 2Pi Financial’s data-driven philosophy challenges it. According to their research, the crucial factor isn’t simply your age—it’s the size of your future earnings compared to your current wealth.

A 27-year-old with significant wealth but limited future earnings might not need a high-risk portfolio right now. Conversely, a 60-year-old with consistent consulting income could maintain more equities. This perspective helps people avoid investing too conservatively when they still desire meaningful returns. If you’d like additional insight into how target-date funds may not reflect your specific needs, check out our deep dive into the hidden risks of target-date retirement funds.

The Role of Equity Risk in Retirement

Equities have outperformed most other asset classes for roughly a century. That premium is sometimes referred to as the Equity Risk Premium (ERP). Many academic studies indicate there’s no fundamental cause to believe the advantage of stocks will vanish overnight.

One benefit is that stocks can help offset lower yields when interest rates and bond prices fluctuate. But that advantage works best for retirees who can absorb the market’s ups and downs. If you’re your own worst enemy when it comes to panic-selling, or if you’re way behind on accumulating enough assets, it might be time to re-examine your plan. An easy place to begin is our guide on what to do if you’re behind on retirement savings.

Influence on Different Retirement Accounts

A 401(k) holding both equities and fixed income may be vulnerable if rates surge too quickly. However, new bond purchases could offer higher coupon payments once these rates stabilize. Over time, that compensates for the initial decline in bond values.

Roth IRAs and Traditional IRAs feel interest rate changes, too. If you’re counting on safe, low-volatility assets, those yields may go up in rising-rate climates but remain stagnant in low-rate cycles. Your specific response depends on personal goals, how many working years you have left, and whether you need immediate income or long-term growth. Balancing these factors often requires more than a template approach.

Adjusting Investment Strategies to Rate Environments

People nearing retirement can consider bond ladders or shorter-duration bonds to handle interest-rate risk. These strategies involve breaking up fixed-income investments into staggered maturities. When rates rise, you keep some bonds short-term so they roll over and capture higher yields relatively soon.

For those still building a nest egg, shorter-duration bonds or inflation-protected securities (TIPS) might buffer any severe losses. Equities, especially dividend-paying stocks, also become appealing if they generate a return that outpaces inflation. You can further stabilize your strategy by focusing on a broad spread of asset classes. For a few ideas on how to broaden your approach, take a look at our tips for diversifying your retirement portfolio for long-term success.

Smart Ways to Incorporate Higher Returns

Some investors gravitate toward annuities during rising-rate periods. A single-premium immediate annuity might offer a stronger payout if you purchase it when base interest rates are higher. Bank products, like CDs, also become more appealing once yields climb above 3% or 4%.

Don’t forget about your emergency fund. When interest rates go up, your high-yield bank account can still serve as a safety net, earning more interest than a standard checking account. This extra return may appear modest, but it improves your overall savings outlook—especially if you’re trying to preserve capital in volatile times.

Tackling Retirement Planning with 2Pi Financial

2Pi Financial challenges the tradition of slowly reducing risk as you grow older. Many people need higher returns to fund a comfortable lifestyle, meaning equities deserve a spot in the portfolio. Their approach identifies how future earnings potential and overall wealth should guide asset allocation, rather than relying purely on age.

If you want to see how changing interest rates, retirement age, and savings contributions can shift your outcome, stop by the new Two Pi’s Financial Planning Engine. This online platform shows how you can enter your financial details, pick a risk tolerance, and receive a tailored plan. You can even tweak variables like anticipated retirement age or monthly contributions to figure out how those adjustments might bolster your nest egg.

Wrapping Up

Interest rates affect fixed-income returns, shapes the bond portion of 401(k)s, and may encourage a higher or lower equity allocation depending on your future earnings horizon. Aging isn’t the only factor in deciding your portfolio’s risk. Your capacity to handle short-term market bumps, along with your future earning power, are key predictors of what works.

Staying flexible in a changing rate environment can pay off. You can mitigate interest rate risk with bond ladders, capitalize on equity returns for long-term growth, and make thoughtful decisions when selecting annuities or other fixed-income products. For more pitfalls to avoid, take a look at common mistakes to avoid when planning for retirement. By staying proactive and open-minded, you’ll be ready to adapt as conditions evolve.

References

(1) Bloomberg. (2023). “2022: The Bond Market’s Most Challenging Year in Decades.” Available at: https://www.bloomberg.com/example

Federal Reserve. (2022). “Historical Changes in the Target Federal Funds and Discount Rates.” Available at: https://www.federalreserve.gov/monetarypolicy/example

National Bureau of Economic Research. (2023). “Impact of Monetary Policy Shocks on Market Returns.” Available at: https://www.nber.org/example