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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 2 3 4 5 6 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. AKRON: Leigh Gerstenberger -- (330) 384-7104 ASHTABULA/MENTOR: Ellen Forbus -- (440) 953-3617 CANTON: Bob Stark -- (330) 498-1551 CHICAGO: Dave Taylor -- (312) 775-4909 CLEVELAND: Tom Anderson -- (216) 694-5678 COLUMBUS: Curt Ramkissoon -- (614) 570-7570 ELYRIA: Dan Munro -- (440) 329-3269 MEDINA: Don Miksch -- (330) 764-7263 MICHIGAN: Ken Duetsch II -- (810) 768-4711 TOLEDO: Carrie Hartman – (440) 329-3429 WOOSTER: Jeff Hancock -- (330) 263-3202 VISIT US ON THE WEB AT FIRSTMERIT.COM/PRIVATEBANK This FirstMerit Whitepaper (“Whitepaper”) is for educational and informational purposes only. It is intended solely for current and prospective clients of FirstMerit Bank, N.A. (“FirstMerit”) and is in no way intended as financial advice, an offer, solicitation or recommendation for the purchase or sale of any investment or as an official confirmation of any transaction. Although the information within this Whitepaper is derived from sources FirstMerit believes are reliable, FirstMerit cannot guarantee or otherwise assure the accuracy or completeness of the information. The information set forth is provided as of the date of the Whitepaper, is subject to change and is not intended to influence any reader’s investment decisions. FirstMerit and its affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this Whitepaper. FirstMerit does not provide legal or tax advice. Readers of this Whitepaper should therefore review their circumstances with their legal and tax advisors. Any performance quoted is past performance and is not indicative of future results. Non-deposit trust products, including Mutual Funds, are not bank deposits or obligations, are not guaranteed by any bank, and are not insured or guaranteed by the FDIC, the Federal Reserve Board, or any other government agency. Investment in mutual funds (as well as non-deposit trust products) involves risk, including possible loss of principal. Investment return and principal value of shares will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Page 6 | FirstMerit PrivateBank | December 2015 Federal Funds Rate Increase: An Overview of Impacts and Strategies