New York -- Falling interest rates may be good for the economy in general. But they're bad news for people who live on income generated by their savings.
Last January, a one-year certificate of deposit averaged 7.3 percent interest. This year, it's down to 4.4 percent. That's a 40 percent cut. Holders of tax-exempt municipal bonds issued in the early 1980s at 10 percent are probably facing "calls" (forced redemptions), with rates on new munis at around 5.5 percent to 6 percent.
Interest accounts for 14 percent of all personal income received today. Those relying on it to pay their bills are in roughly the same position as the tens of thousands of working people who have had to absorb pay cuts.
Savers holding old bonds with double-digit interest rates will feel the sticker shock the most. Throughout the 1980s, the purchasing power of their income increased as inflation gradually subsided. When their bonds mature or are called, however, their purchasing power will drop sharply.
Even savers who are accumulating capital by letting their interest earnings compound may fall behind. After taxes, shorter-term bonds and CDs may not yield more than the inflation rate, which, in November, was running at a three-month rate of 3.6 percent.
If your savings are accumulating in a cash-value life insurance policy, however, be sure that you're paying a large enough annual premium. Your cash values are not building up as fast as they used to.
You may have to increase your premium, in order to maintain your policy's face value for the rest of your life.
Where's the best place for other savings that you want to keep absolutely safe?
* Consider U.S. Savings Bonds for funds you'll hold for at least five years. They're paying 6.38 percent today -- slightly higher than the 5.93 percent paid on the average five-year certificate of deposit.
Savings bonds have three big advantages over CDs: (1) The interest accumulates tax-deferred. (2) When taxes eventually are due, you'll owe only a federal tax, not a state or local tax. (3) The interest rate changes every six months, so if rates go up, so will the return on your savings bond. If rates fall, today's bonds guarantee you at least 6 percent. To get that rate, you must hold for at least five years, however. If you cash in earlier, you'll earn less.
* For current income, take a look at how much money you're keeping in short-term CDs or money-market funds. You should have no more there than you need to meet this year's expenses. The rest of your savings should be "laddered": Next year's expenses in a one-year CD; expenses for the year after that in a two-year CD, and so on. The longer the term, the higher your rate. You can also build ladders with Treasury securities.
* For savers in the 28 percent federal bracket and up, tax-exempt municipal bonds are more attractive than taxable bonds and even most tax-deferred annuities (because with annuities, taxes eventually are due). But buy only bonds that you can hold to maturity. For example, you might restrict yourself to bonds that come due in seven to 10 years, rather than 30-year bonds. If you have to cash in before maturity, you might not get all your money back.
* Savers shifted $63.4 billion into bond mutual funds last year, which returned an average of 17.2 percent. Part of that return was interest, part was capital gains. When interest rates decline, the market value of bonds goes up, and that's reflected in the share prices of mutual funds.
Conversely, the share prices of bond funds fall when interest rates rise. That will occur when the economic recovery finally takes hold. Furthermore, the dividends that bond funds pay investors are gradually declining, as the funds invest their inflows of cash in lower-rate bonds.
So bond mutual funds don't reliably preserve your capital. Unlike CDs, their prices and yields will fluctuate. Nevertheless, good funds with no sales charges, like the Vanguard Bond Market Fund in Valley Forge, Pa., should do better than CDs in the long term. If you need current income, mutual funds will send you a check each month.