Download Federal Reserve Raises Interest Rates

December 2015
Federal Reserve Raises Interest Rates
An Overview of Impacts and Strategies
Introduction
The long-anticipated and much-debated
increase in the Federal Funds rate has finally
arrived. As expected, the Federal Open
Market Committee decided to cautiously
dip its toe into rising-interest-rate waters rather than plunge in headfirst. The
modest increase announced on December
16, 2015, raised the Fed Funds rate from a
range of 0.0%–0.25% to a range of 0.25%–
0.50%, marking the first hike in almost a
decade. Symbolically, it trumpeted the Fed’s
belief that the U.S. economy has regained
its footing. It also represented the first
step in what most predict will be a slow
and gradual climb in interest rates over
several years.
In December 2008, the Fed, in an effort to
stimulate the economy in the midst of the
global financial crisis, lowered rates to near
zero, where it has remained as the economy
has gradually gained strength.
AUTHORS
So now that the inevitable has become reality,
questions abound: What effect, if any, will
this have on personal wealth? What modifications to estate planning, life insurance,
borrowing and investment strategies should
be considered? Does the rate increase present
opportunities that shouldn’t be overlooked?
GREG MCDERMOTT
Life Insurance Advisor
DANIEL CRAWFORD, CFA
Chief Investment Officer
AARON REBER
Head of Trust & Wealth Advisory
LORRIE SHAFFER
Private Banking Practice Leader
The following is a general overview of some
of the impacts and strategies that may apply
to your situation as we keep a watchful eye on
how the markets react in the months ahead.
in this overview
Assessing Fixed Income Portfolios . . . . . . . . . . . . . . . . . .
Evaluating Your Estate Plan . . . . . . . . . . . . . . . . . . . . . .
Reviewing Your Life Insurance . . . . . . . . . . . . . . . . . . . .
Borrowers Still Benefit…But Beware . . . . . . . . . . . . . . . . .
Final Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Page 1 | FirstMerit PrivateBank | December 2015
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Federal Funds Rate Increase: An Overview of Impacts and Strategies
Assessing Fixed-Income
Portfolios
Investing in bonds over the last
30-plus years has been a relatively
easy task. The bull market for bonds
began in September 1981 when the
yield on the 10-year Treasury peaked
at 15.8%. Since then, yields have
fallen steadily over the last three
decades. The 10-year Treasury note
currently yields approximately 2 ¼%.
Over this period, interest rates have
fallen while bond prices have appreciated, thus delivering total returns
greater than historical averages.
This minimal Federal Funds rate
has resulted in historically low
short-term yields on fixed-income
securities. This has led many
income-starved investors to reach
for yield, taking on additional risk.
The Fed’s increase in the Federal
Funds rate may push up interest
rates across the yield curve. Since
1994 there have been only three
periods of increasing Federal Funds
rates. Each of these periods had
unique factors that impacted the
way fixed-income securities reacted.
The stage is setting up for potential
negative total returns for fixed-income investors in mutual funds.
However, the Fed anticipates slow
and gradual rate increases, which
would allow the income to make up
for the decline in prices over time.
A more dramatic increase over a
shorter timeframe makes it difficult
for income to compensate for price
declines.
It has been more than 20 years since
investors have experienced a sharp
rise in rates and a significant drop
in the value of their fixed-income
portfolio. For the uninformed and
unprepared, it was a painful experience. There are several investment
strategies designed to deal with a
higher-interest-rate environment.
Page 2 | FirstMerit PrivateBank | December 2015
Investment Strategies in a Rising-Interest-Rate Environment
• Reduce fixed-income allocation in a portfolio to lessen direct exposure to
interest-rate risk
• Shorten the duration of the fixed-income portfolio to lower potential
loss of principal
• Maintain a conservative ladder of individual bonds to provide long-term
principal stability and offer the opportunity to reinvest into higher-yielding
securities as bonds mature
• Diversify within the fixed-income asset class through vehicles less sensitive to
interest rate changes, such as municipal bonds, high-yield bonds, and global
bonds
No one strategy is correct or perfect.
Each one manages risk a little
differently, and expected returns
will vary. Remember, fixed-income
securities play an integral part in an
investment portfolio by preserving
wealth, providing income, increasing diversification, and reducing
volatility.
• The first strategy in dealing with
rising interest rates is to reduce
a portfolio’s allocation to fixed
income. This will result in less direct
exposure to interest-rate risk in a
diversified portfolio. However, the
alternative asset classes where the
allocation is shifted have unique
risks of their own. Higher weightings
in stocks increase equity risk. Moving to cash entails loss of income
or the risk of not keeping pace with
inflation.
• Shortening the duration of the
fixed-income portfolio results in a
lower potential loss of principal in
a rising-rate environment. Shorter
duration bonds decline less in price
as interest rates rise. Unfortunately,
this strategy results in less income
or yield offset by the preservation
of principal on a relative basis.
However, shorter-duration investments can be sold and reinvested
in higher-yielding securities in the
future. Floating-rate bonds offer
another alternative. These bonds will
reset to higher yields in a rising-rate
environment and carry very short
durations.
• Maintaining a conservative ladder of
individual bonds is a buy-and-hold
strategy that provides long-term
principal stability and offers the
opportunity to reinvest into
higher-yielding securities as bonds
within the portfolio mature. This
strategy entails higher transaction
costs and requires larger portfolios.
In addition, there is higher liquidity
risk should there be a need to sell a
bond quickly.
• And finally, another strategy is to
diversify within the fixed-income
asset class. Municipal bonds
produce tax-free income and are
typically less sensitive to interest
rate changes. High-yield bonds
may be utilized to increase income.
These higher yields bring increased
credit risk but are less sensitive to
rising rates. Global bonds may be
utilized as they are less sensitive to
U.S. interest rates.
Ultimately, investors need to
understand the inverse relationship
between fixed-income security
prices and interest rates. Then,
based on their risk tolerance,
investment objectives and return
expectations, they can identify and
implement an appropriate fixed-income investment strategy. Some
investors need a long-term form
of stability that fixed income still
offers. Others may want to minimize
the emotional stress of stock market
volatility or potentially a correction.
If an investor’s time horizon is short,
it is still best to remain in cash or
Federal Funds Rate Increase: An Overview of Impacts and Strategies
cash equivalents. For income-seekers, fixed-income securities offer
the best option for predictable cash
flow. Rising rates notwithstanding,
fixed-income securities continue to
be a viable asset allocation for many
investment portfolios
Evaluating Interest-Sensitive
Elements of Your Estate Plan
Interest rates play a key role in
certain tax-efficient wealth transfer
strategies. It’s important for highnet-worth individuals pondering the
transfer of wealth to family or charity to review which wealth transfer
techniques are sensitive to interest
rate changes and consider how the
forecast of a higher-interest-rate
scenario may positively or negatively
impact their plans. A review of a
few interest-rate-sensitive wealth
transfer techniques follows.
intra-family loans
When interest rates are low, intra-family loans can be an appealing
option that enables the transfer
of wealth at a low cost. Generally,
borrowers can gain access to
below-market interest rates, no
closing costs, and easier repayment
terms than a bank might offer. If the
borrower invests the borrowed money and investment returns exceed
the interest paid on the note, the
incremental gain is transferred to
the borrower without estate or gift
tax. This technique can be especially
powerful when combined with a
sale and purchase of an interest in
a highly appreciating family-owned
business.
An intra-family loan is not considered a gift as long as the charged
interest rate is at least as high as the
applicable federal rate (AFR) set by
the Internal Revenue Service. Since
the AFR is tied to the prevailing
interest rate, as rates increase this
technique may be less attractive.
Now is a good time to evaluate
this wealth transfer strategy,
Page 3 | FirstMerit PrivateBank | December 2015
Interest-Sensitive Wealth Transfer Strategies
•
In a rising interest-rate-environment, consider the benefits of Grantor
Retained Annuity Trusts (GRATs) and Charitable Lead Annuity Trusts (CLATs)
• In a declining interest-rate-environment, Qualified Personal Residence
Trusts (QPRTs) and Charitable Remainder Annuity Trusts (CRATs) are
approaches worth exploring
• When interest rates are low, intra-family loans can be an appealing option for
the transfer of wealth
including determining whether older
loans with higher rates should be
refinanced.
split-interest transfers
Split-interest transfers are wealth
transfer techniques that may offer
gift and estate tax benefits depending on the interest rate environment.
Generally, a split-interest gift
involves a transfer (or retention) of a
present right to benefits, such as an
annuity payment, and a future right
to the assets remaining after the
benefits are paid. The present value
of each transferred interest must be
valued for gift tax purposes, typically using Section 7520 of the IRS
code, which is 120% of the mid-term
AFR.
Split-interest transfers may thrive
or struggle depending on interest
rate levels. For example, Qualified
Personal Residence Trusts (QPRTs)
and Charitable Remainder Annuity Trusts (CRATs) benefit when
interest rates move northward,
while Grantor Retained Annuity
Trusts (GRATs) and Charitable Lead
Annuity Trusts (CLATs) tend to
perform better in low-interest-rate
environments.
With a QPRT (Qualified Personal
Residence Trust), a property owner
transfers a residence into a trust
and retains the right to reside
there for a number of years. After
the expiration of the term, the
remainder beneficiaries of the trust
become fully vested in the property.
Higher interest rates at the time
of the transfer and longer-term
trusts generally mean a lower
value of the remainder interest
and correspondingly lower gift tax
obligation. While the interest rate
impact is an important part of this
technique, it needs to be balanced
against the term of the trust. If the
grantor dies before the term of the
trust has expired, the property will
be included in the grantor’s estate at
its value on the date of death.
Not all split-interest transfers fare
well in a rising-interest-rate environment. Indeed, GRATs tend to lose
their tax planning appeal. With a
GRAT, the grantor transfers assets
into a trust while retaining the right
to receive annuity payments from
the trust for a fixed period. At term
end, the remaining value in the trust
is passed to the beneficiary as a gift.
Essentially, the interest rate used
to value the remainder interest in a
GRAT creates a hurdle rate. If the
trust assets perform better than the
hurdle rate, more assets pass to the
beneficiary without gift tax. The
lower the interest rate, the lower the
hurdle and the easier it is for highly
appreciating assets to outperform.
However, should the trust assets
underperform the interest rate,
the beneficiaries receive less than
anticipated when the trust was
created, in which case an outright
transfer of property would have
yielded better results. It is easy to
see why a lower or declining-interest
-rate environment favors this wealth
transfer strategy.
Federal Funds Rate Increase: An Overview of Impacts and Strategies
It’s important to recognize that
interest rates are only one factor
to consider when analyzing these
highly complex wealth transfer strategies. Determining which strategy
is best for you should begin with a
thorough analysis by an experienced
trust advisor, attorney, tax consultant or other wealth management
professionals.
Reviewing Permanent Life
Insurance Policies a Necessity
Declining interest rates over the
last three decades and the Fed’s
quantitative easing policy have had
a direct impact on life insurance
companies, as low bond yields have
affected insurers’ earnings, cash
flows and the ability to meet policyholder guarantees in many of the
products they sell. Bonds and other
fixed-income investments comprise
more than 80% of invested assets
among leading insurance companies.
When these investments underperform, interest-sensitive life policies
can be severely affected. Case in
point, many universal and whole life
policies purchased in the ’80s and
’90s have not lived up to their initial
billing.
When selling these permanent
policies, insurance companies used
then-current assumptions to illustrate future performance in terms
of dividend rates (for whole life) and
interest credit rates (for universal
life). The belief was that the higher
rates would hover near their historic
averages well into the future.
At the time these policies were
sold - when rates soared north of
10% - no one could have predicted
the financial crisis of 2008 and the
subsequent near-zero interest rates
that followed. Thus, illustrations of
the future worth of these policies
presented a much rosier picture than
what has actually transpired. Based
on outdated assumptions, some
policyholders, expecting healthier
returns, have instead found lower
Page 4 | FirstMerit PrivateBank | December 2015
More about Intra-family loans
• These loans allow for the transfer of wealth tax-free to younger generations
• Important to assess risk of default on the loan
• Document the loan’s amount, term, interest rate and repayment schedule in a
formal written contract
• In the event a lender dies with an intra-family loan outstanding, a
written contract will help the executor of the estate account for the
outstanding debt
• Often automatic monthly payments from the borrower’s bank account are
established
• To construct an intra-family loan that will stand up to IRS scrutiny, legal and
tax advisors should be consulted
dividends, higher premiums and
an increased number of premium
payments needed to reach the cash
value to sustain the policy.
The above highlights the need to
have permanent life insurance policies, particularly ones that have been
in place for some time, reviewed on
a regular basis by an insurance advisor. Policy owners should take the
time to grasp the structure of their
life insurance policies, understand
how performance affects value,
and receive updated illustrations,
with downside scenarios, based on
current interest rates, premiums and
charges. Further, the advisor can
review all available options, assess
risk tolerance, and discuss alternate
strategies, including diversifying life
insurance holdings by choosing two
or three quality carriers rather than
depending on a single insurance
contract.
Certain products with non-guaranteed elements, such as whole life
insurance with a term rider, are particularly vulnerable to dividend loss
in low-interest-rate environments
and should be subjected to periodic
reviews. Additionally, this extended
period of low rates has spawned new
products less sensitive to interest
rate changes, such as variable
universal life and indexed universal
life. These policies, driven by stock
market performance, show more
impressive – and often over-promised – investment rate of return
illustrations, while also presenting
greater potential market risks
for policyholders. From an estate
planning perspective, we recommend gaining a full understanding
of the risks involved and proceeding
with caution, as unforeseen market
pullbacks can drastically affect the
future value of these policies.
Life Insurance Review Guidelines
• Have your permanent life insurance policies, particularly ones that have been
in place for some time, regularly reviewed
• Receive updated illustrations, with downside scenarios, based on current
interest rates, premiums and charges
• Consider diversifying life insurance holdings by choosing two or three quality
carriers
• Certain products with non-guaranteed elements, such as whole life insurance
with a term rider, should be subjected to periodic reviews
• Understand the risks of less interest-sensitive products such as variable universal life and indexed universal life
Federal Funds Rate Increase: An Overview of Impacts and Strategies
It is also advised to look at “premium financing proposals” of life
insurance policies with the same
level of scrutiny. Premium financing
allows individuals with illiquid
assets to borrow funds from a
third-party lender to acquire large
death benefit amounts while paying
only the loan interest. While illustrations of this technique are often
attractive to buyers, they seldom
show the impact of increases in loan
interest rates, declines in investment
performance, loan repayment and
exit strategies if the lender does not
renew the note.
This leaves us with one final question: Will this modest rise in interest
rates benefit your life insurance
policy? Given the financial strains
carriers have felt in recent years,
the answer is “not immediately.”
Insurers will likely be deliberate
in increasing policy credit rates,
possibly delaying this action until
product spreads have returned to
originally targeted levels.
Borrowers Still Benefit…
But Beware
While the size of the initial rise in
the Federal Funds Rate is hardly
earth shattering, it does signal an
upward trend that will have an
immediate effect, albeit small at
first, on consumer and commercial
borrowing, credit, and savings.
In general, consumers are likely
to see savings account balances
generate more interest, but large
spikes are unlikely as the Fed moves
cautiously in fear of disrupting
the growing economy. Variable
credit card rates could start to inch
up, so now may be a good time to
reduce variable-rate debt and take
advantage of zero-interest balance
transfers and introductory credit
card rates while they may still be
available. And with mortgage rates
influenced by Treasury yields, we
may see a rise in rates, though this
Page 5 | FirstMerit PrivateBank | December 2015
Borrowing Concerns and Strategies in a
Rising-Interest-Rate Environment
• For borrowers with a line of credit denominated in U.S. Dollars with a
floating rate, higher borrowing rates could ultimately impact the value of
this collateral and their access to credit. Strategies to consider include:
ɖɖ Maintaining a floating rate on the existing line of credit
ɖɖ Converting debt to a fixed-rate loan for an intermediate term
ɖɖ Locking in a longer-term fixed interest rate through a mortgage
or interest rate swap
ɖɖ Paying off the debt
• With your private banker, discuss the nature of your debt, the makeup of its
supporting collateral, and whether a borrowing strategy is still viable
could be tempered by the Fed’s
expected cautious approach.
A rise in the federal funds rate
impacts the prime rate and, subsequently, market interest rates,
which has an effect on financing of
commercial mortgages, projects and
equipment. Again, today’s still-low
rates and the Fed’s “wait and see”
attitude could keep down the price
of financing well into the future for
companies and government agencies
looking to obtain financing, but
be wary of the potential for higher
borrowing rates as the economy
continues to grow.
line of credit, converting debt to a
fixed-rate loan for an intermediate
term, locking in a longer-term fixed
interest rate through a mortgage
or interest rate swap, or paying off
the debt. As the economic climate
changes, your private banker is
available to provide wise guidance
in evaluating your balance sheet and
weighing borrowing costs against
portfolio returns.
Over the last several years, many
individuals and businesses have
financed purchases, at record-low
rates, through loans collateralized
by securities or illiquid assets. For
borrowers with a line of credit
denominated in U.S. Dollars with a
floating rate, higher borrowing rates
could ultimately impact the value
of this collateral and their access to
credit. Consider sitting down with
your private banker to discuss the
nature of your debt, the makeup
of its supporting collateral, and
whether a borrowing strategy is still
viable.
For those in this situation, there are
several borrowing strategies that
may be explored, including maintaining a floating rate on the existing
Federal Funds Rate Increase: An Overview of Impacts and Strategies
Final Thought
No, the sky isn’t falling. But it’s certainly prudent to keep your eyes trained on the shifting clouds during this uncertain
time. What’s clear, though, is that opportunities exist to take advantage of still-low rates, as well as prepare to benefit
from, or mitigate the impact of, higher rates yet to come. Your FirstMerit PrivateBank Client Advisor will connect you
to FirstMerit specialists who will help you evaluate how the Federal Funds Rate change and subsequent increases may
affect your wealth, offering timely, informed guidance and individualized strategies focused on protecting, growing and
managing your money as the Fed dives deeper into raising rates. Whether you require portfolio management, trust
services, private banking or insurance review, be assured that FirstMerit PrivateBank can provide you with high-level
advisement on any of the topics discussed herein.
for additional information or questions,
please contact your firstmerit privatebank advisor.
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Page 6 | FirstMerit PrivateBank | December 2015
Federal Funds Rate Increase: An Overview of Impacts and Strategies