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Why Higher Interest Rates Could Hurt Retirees

Tom Sightings

A lot of retirees complain that it's hard to get a reasonable amount of income from their retirement accounts because interest rates are so low. A 10-year Treasury bill pays less than 3 percent interest. The average stock in the S&P 500 yields less than 2 percent. And if you want the safety of a bank CD, you get less than 1 percent interest.

To put it in perspective: If you're flush with a $1 million nest egg, and you invest it in a secure 10-year U.S. Treasury note, you'll earn barely $20,000 a year. You'll make less than that if you keep it in a bank CD. And to add insult to injury, you are likely to have to pay some income tax on that interest.

It's also hard times for retirees who want to buy an annuity, since the payout depends at least in part on current interest rates. But here's the good news: the main reason for the paltry interest rates is low inflation. According to the Bureau of Labor Statistics, inflation has been virtually zero for the past year -- kept down by the decline in energy prices toward the end of 2014. But the Federal Reserve has stated that it wants inflation to increase, and sure enough, the latest figures show that inflation bumped up 0.4 percent last month. Wages are beginning to rise due to a better employment picture, as well as some political pressure, and we've all heard about higher food prices due to drought, floods and disease.

Whatever the merits of higher wages for workers, and potential benefits of higher inflation for the overall economy, what retirees need to remember is that low inflation is a retiree's friend, while high inflation hurts retirees more than any other group. How so?

Retirees don't have a job. Low inflation negatively impacts workers, putting downward pressure on salaries and tightening up the job market. But it's good for people on a fixed income, and most retirees are on a fixed income. Social Security is indexed to inflation, but not necessarily to your personal rise in costs. The lower the inflation rate, the more likely that Social Security benefits will not be devalued. Most pensions -- even for those lucky enough to have one -- are not indexed to inflation. And while low inflation hurts workers, they are better protected against high inflation since pay scales generally rise with increases in inflation. Remember those old cost-of-living raises you used to get? Currently, retirees aren't missing out on much, because they hardly exist anymore.

Most retirees do not have income-producing assets. If you own rental property, you can raise the rent if inflation goes up. But only about 5 percent of retirees own rental property. The rest of us rely on savings that are squirreled away in savings accounts, or invested in bonds or bond mutual funds, and the returns on those assets typically do not increase with the rate of inflation.

The majority of retirees own their own home, but it doesn't matter very much. Most retirees own their own home. If inflation goes up, then the value of their house goes up with it. But for retirees this hardly matters. House inflation is a good thing for younger people, who ride the wave to greater affluence over a long period of time. But retirees have a shorter time horizon. They just need someplace to live, and if they're not going anywhere, it doesn't really matter what the cash value of the house is.

Most retirees do not owe a lot of debt. Inflation helps out people with large debts, because the higher the level of inflation the more it depreciates the value of the debt, as people pay off the balance in ever-cheaper dollars. The higher inflation is, the faster the debt gets devalued. But most retirees no longer carry a big mortgage -- about two-thirds of retired homeowners have no mortgage at all -- and they are not looking to borrow money to start a business or finance their education. So retirees do not benefit from the debt reduction that automatically goes along with higher inflation.

Many retirees find it hard to live on the low interest rates they get from their savings. There's no doubt the situation cramps their lifestyle. Yes, higher interest rates would put more money into the pockets of a lot of retirees. But the inflation that goes along with higher interest rates could reduce the purchasing power of retirees.

Tom Sightings blogs at Sightings at 60.