Full disclaimer: The pumpkin shown above is thinking about GIC interest rates from 1982.
With October here, leaves are turning quickly and falling to the ground. For the first time in years, however, interest rates aren’t following suit. The Bank of Canada has pushed rates up twice in a relatively short time period, bringing us up from historic lows. If they continue to rise, it will put us in a different financial climate for the next few years.
Effect on fixed-income investments
The major short-term effect of rising rates will be an increase in GIC and bond interest rates, and a corresponding rise on lending rates. The impact on you depends on what kinds of investments you hold. It’s good news if you have a renewing GIC, but not so good if you have debt. If you own any bonds or related fixed-income investment funds – well, that’s potentially a mixed bag. For example, for investment funds that invest in bonds or fixed income (for illustrative purposes only):
When new bond offerings have higher rates, the market value of existing holdings will drop. Why? Well, if a $1,000 bond paying 2% over 10 years and interest rates on GICs rise to 3%, bond cannot be sold on the market for $1,000. Instead, the price offered would drop below $1000. The interest doesn’t change – just the bond’s market price. If the bond is sold for less, the effective interest rate is higher. If the bond is held to maturity, it will miss out higher interest rates until it does mature.
If you have a defined-benefit pension plan where your pension is based on an amount multiplied by your years of service, the commuted value of these pensions will drop in a higher-interest-rate environment. Currently, commuted values are quite generous – because in a low-interest environment, you need more principal to generate retirement income. You’ll only care about this if you’re leaving work prior to retirement in the next couple of years.
The impact to life insurance policies
Over the long term, rising rates will generally be positive for dividends on participating whole life insurance. If you have a whole life policy, interest rates have a major effect on the annual dividend, and with time, these should rise with rates. Most insurance companies smooth out their dividends; however, to limit the impact of sharp changes in interest rates, any change in participating dividends will likely take a few years to fully implement. In the meantime, policyholder dividends may drop or hold as the new rate levels are phased in.
In general, however, higher interest rates are generally good news for insurance companies themselves. If rates continue to rise, you can expect to see the industry as a whole expanding product lines – a significant change from the last 10 years where many small insurers began to limit lines of business because of the risk and capital requirements needed in a low-interest-rate environment.
Charitable Donations of Life Insurance
You can donate an existing life insurance policy to charity in your lifetime and potentially receive a tax credit for the fair market value of your insurance (as opposed to its cash value). In this situation, you pay an actuary to work out what the “replacement value” of your life insurance policy would be if you were to reacquire it at your current age and health status. In many situations, the value to acquire the policy could be significantly higher than what you originally paid for the policy so the charity can issue you a larger tax receipt relative to the cash value of the policy.
Like the commuted value of pensions and all other things being equal, a fair market valuation of an insurance gift is likely to be higher in a low-interest-rate environment than a higher one.
So what should you do?
Well, don’t panic for starters! As you can see, rising rates are a mixed bag, with some positives and some negatives. If portfolio holdings are diversified, in many cases, rising rates’ positive and negative attributes can potentially cancel each other out. If portfolio holdings are focused in one area, there is a potential for more volatility. Each situation depends on your investment goals and investment risk profile.
As always, your best bet is to review your financial and estate plans and make sure nothing you’ve read here will affect your plan.
The information provided is accurate to the best of our knowledge as of the date of publication, but rules and interpretations may change. This information is general in nature, and is intended for informational purposes only. For specific situations you should consult the appropriate legal, accounting or tax advisor.