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Retirees brace for rising rates

The Fed's easy money policy has undoubtedly put the U.S. economy on firmer footing. Rock-bottom interest rates contributed to the recovery in the housing market and bolstered investors' appetite for stocks, among other benefits.

But the central bank's long-running stimulus program also exacted a toll on millions of American retirees.

For years now, retirees, who tend to rely heavily on savings and favor bonds as an asset class, have been saddled with paltry rates on Treasurys and on certificates of deposit, money market accounts and other savings vehicles.

And now that the Federal Reserve is paring back its massive bond-buying program, many retirees are bracing for more volatility in the bond market as rates climb from historical lows. When interest rates rise, bond prices generally decline and vice versa.

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"Next to 2008, this is probably the most challenging time for seniors," said Robert Fross, a partner with Fross & Fross Wealth Management.

Read MoreChoosing bonds vs. bond funds

"The Fed has bailed out the U.S. economy on the backs of seniors," he added. "Working people generally don't have much invested in the fixed-income market and have gotten loans at all-time-low rates as a result of Fed policy."

Still, Fross and other financial advisors who work with retirees aren't exactly alarmed about the prospect of rising rates. They say a gradual return to more normal rates is likely to cause some short-term pain for bond investors but will ultimately benefit savers and push up yields on funds investing in government and high-quality corporate debt.

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Retirees take on risk

In recent years, yield-starved retirees have taken on more risk in an effort to ensure they don't outlive their nest eggs. They have dialed up their allocation to stocks, particularly equities paying fat dividends, and to high-flying, fixed-income asset classes, including high-yield bond and bank-loan funds.

"Assuming we don't have a high-inflation environment, rising rates mean that current retirees will eventually see a greater yield in their bond portfolios," said Jason Brooks, a certified financial planner and president of Indelible Wealth Group. "They won't have to chase after yield anymore."

Read MoreFed says 6.5 percent threshold is 'outdated'

In the wake of the financial crisis, many retirees and other types of investors have shed stocks and flocked to bonds, long perceived as a safe, even dull, asset class. As the Fed scaled back its quantitative easing program over the past year, many advisors have been reminding their clients that bonds carry risk, too, although they still play an important role in a well-diversified portfolio.

"Even when rates are low, you still see a flight-to-quality as a result of volatility in the stock market," said Sean P. Smith, an investment manager with Accredited Investors based in Edina, Minn. "Bonds offer a return profile that is a lot different than the stock side of a portfolio."

In a rising-rate environment, advisors say it behooves retirees to stay focused on their objectives and risk tolerance and, provided they've planned accordingly, avoid making radical changes to their portfolios based on fear.

Diversification is key

At the same time, there are steps investors can take to mitigate the risks associated with rising rates. If they haven't already, investors ought to ensure their bond holdings are well diversified.

Diversification generally reduces volatility and can also boost returns, although advisors have differing views as to whether riskier bets, such as junk-bond funds, are right for retirees.

Those who argue in favor of exposure to junk, or high-yield, bonds note that the asset class tends to be less sensitive than other types of fixed-income investments to fluctuations in rates. They also argue that the risk of default among issuers is low, given the improving economy.

Read MoreKeep bonds but stay alert: Advisors

Detractors say that the yield on junk bonds, relative to the yield on Treasurys with similar characteristics, doesn't justify the added risk.

"One great risk for retirees is not taking enough risk and running out of money," said Christopher Krell, a certified financial planner at Cassaday & Co. in McLean, Va.

Duration and cash

Krell recommends that retirees diversify their portfolios among all four asset classes—stocks, bonds, real estate and other "tangible assets" and cash—and then further diversify within each asset class.

"Retirees need to be prudently invested in all four asset classes so they can have a rate of return that meets or exceeds inflationary risks," he said. "The goal is to find the least-risky way to achieve their financial objectives."

To get a sense as to how rising rates might impact their portfolios, investors should familiarize themselves with the concept of duration. Duration is a numerical expression of the interest-rate sensitivity of a bond or portfolio of bonds. Shorter-term bonds generally have shorter durations and thus are less sensitive to rate fluctuations.

"As interest rates rise, a cash position will put retirees in a better place in terms of getting better yield." -Lazetta Braxton, chief executive officer of Financial Fountains

In a rising-rate environment, advisors also stress the importance of setting aside a certain amount of cash, anywhere from six months' to three years' worth of living expenses, depending on a retiree's overall sources of income.

Cash reserves allow retirees to cover unforeseen expenses without having to sell bonds or other types of investments at inopportune times. Retirees with large cash reserves can also put some of that money to work in the bond market as rates climb.

Read MoreThe ABCs of bonds

"As interest rates rise, a cash position will put retirees in a better place in terms of getting better yield," said certified financial planner Lazetta Braxton, chief executive officer of Financial Fountains.

"You may not earn a lot from a large cash position," she added. "But it will help to protect your portfolio so you can enter into the withdrawal phase when the market is a bit more attractive."

Game-changers making retirees nervous
Tempted by the run-up in the stock market and turned off by the recent long stretch of low rates, many retirees have scaled back their holdings of safe, low-yielding government bonds and ramped up their exposure to riskier asset classes in search of higher returns.

Although advisors disagree about the wisdom of such moves, they certainly understand why many older Americans are nervous about whether their savings and investments will keep pace with inflation or, worse, whether they will run out of money during retirement.

Thanks in large part to medical advances, today's retirees are likely to live longer than their parents and grandparents did. According to the Society of Actuaries, at age 65 men can expect to live for another 21.6 years and women for another 23.8 years.

While longer life expectancy is certainly a good thing, today's retirees are also more exposed to the vagaries of the financial markets than their predecessors. Over the last several decades, many employers have eliminated defined-benefit retirement plans in favor of less-costly defined-contribution plans.

In 1980 the vast majority of private-sector workers with pension plans had defined-benefit plans, according to Kevin Cahill, a research economist at the Sloan Center on Aging & Work at Boston College. Defined-benefit plans are funded and run by employers and provide beneficiaries with a guaranteed stream of income. Defined-contribution plans—the most common of which are 401(k) and 403(b) plans—are funded by employees, although employers often provide matching contributions. Under these plans, employees choose from a menu of investment options, and returns aren't guaranteed.

"The issue with 401(k)s is that the individual is in charge of investing and spending down their assets, said Cahill. "They assume the investment risk and the longevity risk, which is the risk of outliving your assets."

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