Choosing short-term commitments in your retirement investments

The Federal reserve rate cuts have hurt the retired, with lower CD and money market rates making it difficult for retirees to earn the magic 4%. The 4% interest level is a number used widely by financial planners and investors for a “sustainable’’ retirement nest egg. Now that rates are less than optimal, retirees should avoid locking in for now.

Currently, the difference between a one year and 5 year CD is just about .55% per year, a very small difference from just 6 months ago when the contrast was much greater. The differential between short term and long term grew smaller last fall when banks began to favor the idea of lower Federal Funds rates. Now that the difference is so small, investors should avoid locking in any significant amounts of money for longer than one year.

Go for the short term

An investor with expiring CDs should instead turn in favor of short term CDs rather than long term. In a historic perspective, it is likely that the Federal funds rate will turn upward when inflation worries run rampant. This cycle usually follows a very short period with extremely low rates; a quick look back to the last market downturn in 2001-2002 would suggest that a very steep increase in rates follows after a very quick fall in rates.

Historic interest rate movements

The best advice for a retiree would be to look for 1 or 2 year CDs with a favorable rate. While there isn’t much to like about a 2.90% return, interest rates are expected to increase. In 1992-1994, investors watched as the rate stood around 3.0% for two years, then quickly rebounded to 6% by 1995. An investor who favored short term rates in the ‘92 slowdown was able to put more money in CDs when the rate topped in 1995. Again in 2001, the Fed rate was dropped from 6% to 1% in 2004 then rebounded to 5% in just a year and a half. You’d be kicking yourself if you locked in for 5 years at a rate of 1% only to see an increase in yield by 400% in just a short time.

The 2 year CD rates are around 3.5% for many banks, although those hurt by the credit crunch such as Countrywide bank are paying as high as 4.01%. At this point, it might not be a good idea to be loaning money to Countrywide, and thus, settling for a lower rate with a lesser amount of risk to liquidity is the much better option.

How to time it

Its safe to assume that rates will not be at these historical lows for long. After periods of low rates, the Federal Reserve board will begin to worry about inflation and again raise the rate back to a 5% – 6% area in a very short time. Throughout history, the cycle has been the same: lower rates quickly, bottom out for a year or two, then rush back up to their norms in just one more year.

Continued lower rates

The FRB is still looking to lower the rate around a half a percent more before calling it quits and letting the market work. Bernanke has favored lower rates, but insists that only a few more rate cuts are in the plan. In this case, we’re already starting to see a modest bottoming out before the rates are sent upward again.

At any rate, there is very little risk of investing in a 2 year CD. The difference between a 2 year and 5 year is negligible at the least, and thus, locking in for the long term is probably the worst investment to make. A basic look at the odds and previous downturns would suggest that we’re near our bottom and can only get better from here. Keeping rates low spurs inflation, while raising them protects from hyperinflation. At the current moment, the best investment is in a 2 year CD to maximize the return in this current bottom, and to allow yourself the liquidity when rates do rise. At that point, it will be anyone’s game, and 6 month CDs are best in times of heightening rates as banks are slow to price in upticks in the interest rate and very quick to price in a downward cycle. For now, 2 years should be your longest horizon.