I was recently asked an interesting question. Why is it that when interest rates change, the media only seems to focus on the impact for people with mortgages? What about retirees? Of course, savers and borrowers are affected in opposite ways when interest rates go up or down. While homeowners with mortgages have been feeling the squeeze over the last few months, retirees without debt have been rejoicing in the extra income.

Interest rates are the principal tool the Reserve Bank has to control inflation. In theory, the higher interest rates go, the less money is borrowed. Spending is reduced as a result of lower borrowing and tighter budgets arising from higher mortgage payments. So, for retirees, higher interest rates provide a double benefit of higher income followed by lower inflation. Falling interest rates usually indicate a period of slow economic growth requiring the stimulation of higher levels of spending. Of course, lower interest rates mean less income for retirees.

It’s interesting that the spending patterns of retirees aren’t considered in this analysis. That’s because retirees generally don’t use borrowed money to finance their spending, nor are they big spenders. However, retirees are becoming an increasingly larger percentage of the population and surely this must have some impact over time.

For retirees, the ups and downs of interest rate cycles mean interest income is uncertain and, at worst, negligible when interest rates are very low. However, uncertainty and risk need not be a problem if retired investors re-think the way they generate income.

Importantly, interest is not an effective source of retirement income. Bank deposits, while being low risk, provide a lower rate of return than other forms of investment and the interest income is taxable. The net return from bank deposits barely matches the rate of inflation, if at all.

A retirement portfolio needs to cater to both spending and investing, ensuring that sufficient money is available to spend when required with the rest invested to provide a good rate of return until it is needed to top up spending money. Money needed in the short term should be kept in a safe place - a savings account or term deposit, for example. Remaining funds can then be invested in assets that typically offer a higher rate of return than bank deposits, such as shares and/or property.

If money in the bank is thought of as spending money, then investors need not worry too much about what the interest rate is. The attraction of bank deposits is that they are a safe place to hold money in the short term until it is spent. This is a very important point to understand. The purpose of bank deposits is to hold money safely rather than to produce a return, although a return is an added bonus. Money in the bank should be split into a number of deposits with different maturities so that the funds can be accessed when needed. When the deposit matures is more important than the interest rate earned as availability of funds is more important than return.

Over the next year we will see interest rates gradually fall as inflation eases and the effects of economic restructuring kick in. When this happens it’s tempting to look for fixed interest investments, like bonds, that offer a higher return. When ‘shopping’ for interest rates, investors often overlook the importance of a security’s credit rating. A credit rating can range from AAA to D and indicates the likelihood of repayment in accordance with its terms of issuance.