The interest rate drop. What does it mean for you and your financial plan?

Traditionally, a cut in interest rates is seen as good news for borrowers and bad for savers, but in reality, the situation is not quite so cut and dry. So, the question is, what does this reduction ultimately mean for your financial plan and your life?

We are anticipating that interest rates will be lowered again in the future and while they may not return to the low levels we saw previously for some time, they will remain relatively stable. At present, the economy is strong and is likely to be able to suffer higher interest rates for longer.

Although the government does not set interest rates, it’s reasonable to assume that the new Labour government will not want a second wave of high inflation. This can happen if interest rates are decreased too fast, as it usually puts more disposable income into the public’s hands.

Additionally, the recent wage increases within the public sector could fan the inflation flames further, meaning that interest rate rises have to be handled and timed extremely carefully.

The short, medium and long-term impact of falling interest rates on your financial plan depends on where your money is held and what action you take. Fluctuations in interest rates can have a significant long-term effect on your money.

What impact could the fall in interest rates have on my investments?
Falling interest rates will not have a direct impact on equities, but it can be a positive influencer. The cost of any company borrowings may go down as a result of the reduction, meaning that they will have more cash to invest in the expansion of the business, ultimately leading to long-term growth for the company, and as such, potential investment growth. The effects of this may not be seen right away, but falling interest rates should generally be viewed as a good sign for investors.

That being said, investments, like equities, do come with risk and you could get back less than the value of your investment.

If you don’t already have an investment manager at Evelyn Partners, now is a good time to see how they could help you. We offer combined wealth management, meaning that your financial planner can work alongside one of our in-house investment managers. Your financial planner creates the strategy and structures your assets, while your investment manager builds your investment portfolio and makes sure it remains suitable. If you’d like to know more, speak to your financial planner.

What is the impact on cash?
Clients who are particularly risk adverse have benefitted from a temporary period of relatively high interest rates without much in the way of perceivable risk. Under the rules of the Financial Services Compensation Scheme (FSCS), if you hold money in a bank, building society and credit union, you will be compensated up to a limit of £85,000 (per person, per firm) if the firm fails.

Banks usually reduce their savings rates quickly after a BoE rate change, so cash holders are likely to see the impact of the reduction on their savings income almost immediately.

It’s important to note that while holding cash is lower risk than investing, where your capital is at risk of going down, cash is subject to inflation risk, which means the real spending power of your savings could be reduced.

Typically, a balanced investment portfolio will be recommended to meet your medium- and long-term goals, although this will ultimately depend on your attitude to risk. However, we find that many clients have a need for capital in the shorter term. With cash rates reducing, a managed cash and bond portfolio can provide a helpful solution to the need for cash while trying to retain some of the ‘real’ value of your money.

Bonds will react to interest rate movements, but their relationship is an inverse one. Therefore, if interest rates start to fall, bond prices usually start to rise. It is extremely important to have any bond portfolio carefully managed by a professional adviser to try to ensure that a positive yield in the bond portfolio can be maintained. 

What does this mean for pension annuities?
Annuity rates have been quite high over recent months relative to the last twenty years. We’ve been talking to a lot of clients with substantial pension pots. They’ve been receiving anywhere between 4.5 - 7.5% on an annuity, but we anticipate that there will be rising pressure on these rates and that they could fall for new investors in the not-too-distant future.

For people who have not yet purchased a pension annuity but are considering doing so to fund their future financial plans, the window of opportunity to take advantage of these higher rates is potentially shrinking. If you are considering using an annuity in your retirement, there has never been a better time to speak to your financial planner about your options. 

How will my borrowing be affected?
If you have any mortgages, whether it’s on a buy-to-let or residential property, or any other forms of borrowing, then you may have been making increased repayments due to the ongoing interest rate increases. Despite news of the reduction, this situation is not likely to be alleviated quickly.

It’s not currently believed that rates will fall as quickly or as steeply as they rose, and it’s well-known that banks do frustratingly take some time to pass on the rate reduction to borrowers. 

If you have a large pension pot, you’re aged 55 or older and your remaining mortgage is relatively low, one option could be to withdraw your mortgage redemption figure from your pension by taking a tax-free cash payment (up to 25% of your pension pot), pay the debt off and contribute the same monthly amount (the same as your previous mortgage repayment) into your pension to ‘replenish’ it.

The total annual amount of your pension contributions should not exceed the pension annual allowance. This is currently £60,000 or 100% of your relevant UK earnings (whichever amount is lower). If you withdraw any amount over your 25% tax-free limit, the money purchase annual allowance will be activated and your pension annual allowance will reduce to £10,000.

Your pension contributions will also benefit from tax relief, which will help to deliver the retirement income you need in order to fund your financial goals. In this instance, you would need to be careful not to breach pension tax-free cash recycling rules, which prevent large increases being made to pension payments after the tax-free cash has been withdrawn.

It’s also important to bear in mind that withdrawing funds from your pensions could reduce your overall pension income you might receive in retirement (subject to how much you pay back in). Furthermore, if you are planning on passing on your pension to reduce your overall inheritance tax bill, this tax liability could potentially increase following a withdrawal.

Tax treatment depends on individual circumstances. The rules surrounding pension tax relief are correct as of the time of writing, but they could change following Labour’s Autumn Budget on 30 October 2024.

Please note this option may not be suitable for everyone and withdrawing a significant lump sum from your pension could reduce your overall retirement income. Before taking any action, please speak to your financial planner for further guidance.

Over the past five years we have seen substantial volatility in the markets. Through 2022 and much of 2023, we experienced rising interest rates, and the outlook today is that this trend will continue to be reversed. Against a backdrop of an uncertain Autumn Budget, there is a danger of clients becoming ‘speculators’ instead of ‘investors.’

This can lead to knee-jerk reactions that could have good short-term implications, but not work out so well for your longer-term plan. It is the job of your financial planner to keep you on the right path, even with short-term bumps in the road. They will steer you in the right direction to achieve your financial goals.

Generally speaking, a reduction in interest rates can be a positive or a negative – it all depends on what you do about it. But the key thing to remember is that there are always options available to you.

For more information about what the drop in interest rates could mean for your financial plan, speak to your usual Evelyn Partners contact.

Source:

¹ UK Parliament, Interest Rates and Monetary Policy: Key Economic Indicators, 1 August 2024