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Interest rates have risen rapidly this year and with inflation running higher than the Bank of Canada target, more increases are sure to come. While much attention has been paid to the negative implications of higher rates, which raise the cost of borrowing, there are benefits as well.
The first question on the minds of Canadians is just how high rates are going to go, something Central bank governor Tiff Macklem addressed last week when he testified before the House of Commons Standing Committee on Finance.
According to Macklem, “Canadians should expect interest rates to continue to rise toward more normal settings … that neither stimulates nor weighs on the economy. We estimate this rate to be between two per cent and three per cent. Two weeks ago, we raised the policy rate to one per cent, still well below neutral.”
This suggests a neutral rate environment that is one to two percentage points higher than today. The prime rate at banks is 3.2 per cent, so line of credit and mortgage rates of over five per cent are feasible. This is a far cry from the sub-two-per-cent rates that were available in 2021 — suddenly the implementation of the mortgage stress test in 2018 seems more prudent.
One eventual benefit of higher interest rates is that borrowers will have a more realistic monthly payment for their debts. Although the mortgage stress test qualified a borrower based on a higher interest rate, borrowers have become accustomed to artificially low monthly payments with little interest.
If a five-year mortgage amortized over 25 years at two per cent renews at five per cent, the payment would need to increase by 30 per cent to maintain the remaining 20-year amortization. For the monthly payment to remain the same at the higher rate, the amortization would need to increase to more than 34 years (so, over 39 years in total). Canada actually had 40-year insured mortgage amortizations for less than a year between 2007 and 2008 but promptly reduced amortizations in response to the U.S. subprime mortgage meltdown, which set off the Financial Crisis.
Higher rates may cause a strain for highly indebted borrowers in the short run, but over time they may also help recalibrate housing budgets for borrowers based on real life monthly payments. This may also help stabilize the housing market, hopefully leading to a soft landing instead of a housing crash.
Besides borrowing, higher rates have an impact on investing, pensions, and retirement. 2022 has seen fixed-income investors get burned or cash in depending on their product of choice. The FTSE Canada Universe Bond Index is down 9.6 per cent year-to-date as of April 30. As interest rates rise, bonds fall, and when rates rise quickly, bonds fall quickly. The reason is newly issued bonds at higher rates are more attractive, so previously issued bonds with lower rates will fall in value. Meanwhile, GIC rates have surpassed levels not seen since 2010. Some institutions are offering five-year rates of more than four per cent.
A four per cent interest rate may not seem very compelling when inflation is running at a 31-year high of 6.7 per cent, implying a negative real rate of return. However, the Bank of Canada expects inflation to return to 2.5 per cent by the second half of 2023 and to its two per cent target by 2024. The point is, inflation, although more than just transitory, is still temporary, but higher fixed-income yields are likely here to stay. In the years to come, this will be a good thing for conservative investors.
Higher rates have an impact on pension plans as well. Declining rates over the past 30 years have driven pensions to invest in riskier assets to improve returns. In fact, in 1999, the Canada Pension Plan was invested entirely in government bonds. As of the fund’s March 31, 2021 year-end, only 23 per cent of net assets were invested in fixed income.
There are bigger benefits for pension plans and plan members as rates move higher. A pension’s funding status is impacted by interest rates. Rates are used to value a pension plan’s future liabilities, namely, payments to plan members. The presumption is that assets will be invested at current interest rates, so low rates today mean more assets need to be set aside for paying pensions. As interest rates move up, pensions with shortfalls will see their funding status improve and other plans may have their surplus padded.
Interest rates also have an impact on pensioners considering a lump-sum payment, called a commuted value, when they exit a pension plan, as well as those considering a buyback of past service.
Many pensions saw an increase in commuted value payouts to pension plan members who opted to invest their pension money on their own instead of receiving a future monthly payment. Some conceded huge tax bills on the taxable portion of their commuted value and may have used pension money meant for retirement for current spending. Depending how those payouts are invested going forward, they may or may not provide higher retirement income. Higher rates are likely to diminish commutation of pensions.
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Buybacks of service, on the other hand, are likely to increase. A pension plan member may be eligible for a buyback if they had a leave, including a maternity or paternity leave. Other scenarios include not participating in an employer’s pension plan or working for a related employer whose pension formula was less lucrative.
In the same way higher rates reduce today’s current pension funding shortfalls or commuted values, they also make it cheaper to buy back pensionable service. This could present an opportunity for plan members to enhance their pensions by writing a cheque or by transferring funds from a tax-sheltered account like an RRSP or a defined contribution (DC) pension plan.
Higher rates could also change the retirement income planning landscape by making annuities more appealing. As the prime rate spiked to over 20 per cent in 1981, demand for annuities rose during the 1970s and 1980s. However, low rates in recent years have significantly reduced demand for annuities.
When a 65-year-old buys a life annuity, it is like buying a 25-year GIC. If interest rates are low, the expected return (monthly payment) is also low. As interest rates rise, retirees may find annuities more appealing. Non-pensioners with pension envy can buy a pension from an insurance company in the form of an annuity. Annuities can simplify retirement income planning by locking in monthly payments and protect retirees against the risk of living too long.
Rates last started to rise in 2018 before falling again at the onset of the pandemic. They can be difficult to predict and can rise and fall with economic cycles, but given the Bank of Canada’s primary goal of inflation control and all the pressure pushing prices higher, continued increases seem quite likely. While higher rates do have some negative implications, there will also be good things to come from increasing interest rates.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.