Shedding the fixed-rate shackles

Mary Walker grew up in Tulsa, Okla., during the 1930s. Images of families building huts from tin cans and showing up for food handouts at her family's home remain seared in her mind.

Now, many in her age group are learning to live with less once again.

The situation has hardly reached Depression-era hardship levels. But the Federal Reserve's 11 interest-rate cuts last year have fallen particularly hard on small savers and the elderly, who often rely heavily on CDs, money markets, and other fixed-income vehicles.

"Every time they cut interest rates, I'm taking a big cut in my pay," says Ms. Walker, who now lives in Katy, Texas, and lives entirely on Social Security and interest from her limited investments.

Generally touted as a needed boost to a sluggish economy, the lower rates are a boon to most borrowers. Home sales hit a record high last year, due primarily to unusually low mortgage rates.

But as rates for borrowing have plummeted, so have the rates of return on fixed-income investments. A one-year CD that a year ago averaged a 5.6 percent return now yields only 2.14 percent, according to bankrate.com, a website that tracks rates. Money markets went from giving investors more than 6 percent returns at the beginning of 2001 to an average of just 1.6 percent at the end of the year.

With Americans holding about $2 trillion in money-market funds, the Fed's rate cuts cost them nearly $100 billion in interest last year - enough to offset the last year's economic-stimulus package, says Peter Crane, vice president and managing editor at iMoneyNet Inc.

"The government tried to add stimulus with tax cuts, but they were not accounting for the antistimulus of rate cuts. Consumers are being paid on those rates, so the harm has been done." says Mr. Crane. "I'm praying the Fed stops cutting rates. It's hurting the economy."

"It's one of the real shames for retirees," adds Jonathan Pond, a Cambridge, Mass.-based financial commentator and author. "I would guess that the vast majority of them don't have mortgages. They haven't been beneficiaries, as their children have, of the declining-interest-rate environment. They've been victims of it."

The unattractive rates on old fixed-income standbys are leading many people - of all ages - to look elsewhere.

For young people and other small savers who have kept their savings in money markets because they were unfamiliar with other options, it may be a perfect time to learn about bonds, equity funds, or other, higher-yielding investments, say experts.

For the elderly, financial advisers caution against risky investments, but say there are strategies to boost yields.

To start, Mr. Pond suggests people shop around for rates. "If I can get 4 percent on a CD at a bank in Tombouctou, rather than 3 percent on the bank in my community," I'll take the higher rate, he says.

For seniors who own stocks, he suggests now might be the time to sell some. For people in the 15-percent tax bracket or lower, assets held for five years or more are taxed at an 8 percent rate - lower than the tax they'd pay on interest and dividends, he says.

Even so, Pond and others say the recent dive in rates reinforces their opinion that even senior citizens should own stocks and bonds as well as fixed investments. "This is what we tried to warn people about, with being too conservative," says Laura Addington, a financial planner and owner of Addington Financial Group in Greenville, Texas.

There's no rule of thumb for how much money should be allocated to each area, adds Ms. Addington, since individuals' circumstances vary so widely. But she emphasizes that diversification is as important for the elderly as for the young.

The dilemma many seniors and other small savers face now is what to do with CDs that are about to mature, and with other investments that are gathering little interest.

Walker, for one, is stumped - even though she's become savvy enough to help run a personal-finance class for women at her local AARP center. "I don't know what to do with [my CDs]. At 80, do I want to time them at five years? I've played this game of trying for the short term, the long term - you can't outguess it.... I'd love to buy utility stock, but I don't know."

The risk of buying stock is "not only a loss of prinicipal that would affect you now," warns Greg McBride, a financial analyst with Bankrate.com. "It can have a snowball effect,... where losses now can be magnified over a period of time."

To maximize fixed-income investments, Mr. McBride suggests a "laddered portfolio" in which investments mature at regular intervals.

"Just as you would diversify a portfolio of stock investments," he says, "it's the same thing when you're in fixed-income investments." That way, in a scenario when interest rates are low, as they are now, one is reinvesting only a small amount.

He also cautions people against locking up their money in long-term investments at today's rates. Though it won't happen immediately, interest rates will probably rise this year, he says. "You may want to stay short term so you have the ability to establish rungs in the ladder later on this year."

Short-term bond funds may also be attractive to the elderly, says Alan Papier, an analyst for Morningstar, a Chicago-based company that researches mutual funds.

While they're still relatively low-risk, they may provide more income than a money market does. He says investors should be aware, however, that their net assets can fluctuate, unlike those in a fixed investment.

As investors consider bond options, says Mr. Papier, they should take a careful look at a fund's expenses. They should also look at the fund's track record and decide how much credit risk they want to take.

Papier recommends a few specific funds as good alternatives to money markets or CDs, including SSgA Yield Plus fund (an ultra-short-term bond fund), Vanguard Short-Term Bond Index Fund (which tracks the Lehman Brothers one- to five-year government-credit index), and Strong Advantage fund (an ultra-short-term bond fund that has a bit more credit risk).

These funds, like many mutual funds, often have a minimum investment of at least $2,000 or $3,000, sometimes less if it's for an IRA. A "supermarket" like Schwab or Fidelity may offer a lower minimum than is advertised, says Papier.