Protect your 401(k) from rising interest rates with this plan

Now that the Federal Reserve, the central bank of the U.S., has raised interest rates a quarter of a percentage point, you may be wondering: What does this mean for my retirement account?

In the short term, as the stock and bond markets react to the increase, even a diversified retirement account may lose value, but that's no reason to sell your investments in a panic.

While a Fed rate increase can at times drive down stock prices, and almost inevitably pushes down bond prices, investors who maintain focus on their long-term goals can ride out those dips.

Still, now is a good time to make sure your retirement savings plan is on track.

"With equities, it's hard to know what effect rising rates are going to have," says David Blanchett, head of retirement research for Morningstar Investment Management. "When we think rising rates, the most obvious and immediate focus should be on … your fixed-income portfolio."

Here's a five-step plan to ensure your retirement account can handle rising rates.

1. Remember why you have bonds. Even if your investments have lost some value, keep in mind you've got bonds in your portfolio to act as a balance against stock market volatility. Bonds may fall, but they generally don't fall as far as stocks. And they usually, though not always, move in opposite directions: When stock prices are rising, bond prices tend to fall, and vice versa.

And before you think about exiting bonds because you expect rates to keep rising, note that it's as difficult to predict how fast rates will rise as it is to predict the next market crash.

Instead of trying to time the bond market, focus on what you can control. One step is to make sure your investment holdings are diversified. It can take as few as three to five mutual funds to make a perfectly well-diversified retirement account.

2. Realize that higher rates aren't all bad news. Generally, bond prices drop when interest rates rise because existing bonds' coupon — the interest they promise to pay while you hold the bond — is lower than the coupons offered by bonds issued under the new, higher rates.

Say you buy a $1,000 bond that promises to pay 1 percent a year. Then, interest rates rise. As a result, new $1,000 bonds promise a 2 percent payout. If you want to sell your bond, you'll need to sell it for less than its face value to be able to compete against the new higher-paying bonds.

If you hold the bond until maturity, you'll get paid its coupon rate and recover your principal when the bond matures, assuming the issuer doesn't default. But in retirement accounts, most of us are investing in bond mutual funds, rather than individual bonds. In bond funds, the manager is likely buying and selling bonds on the secondary market. That's where price fluctuations matter — and how your bonds can lose value.

But long-term investors have less to worry about.

3. Revisit the risks of cash. As interest rates rise, savings and money market accounts start to look more appealing. What you're not seeing is inflation's big bite.

"You get into cash initially because something scary is happening. You feel great for a while, but then you run into inflation," says Brett Horowitz, a wealth manager in Coral Gables, Fla. Cash is "a horrible long-term investment. It's not going to help anyone achieve their goals if they need to earn a return on their money."

4. Check your bond holdings. Some bonds are riskier than others. In a rising-rate environment, bonds with long maturities are likely to drop the most in price. If you have a high proportion of long-term bonds — bonds with terms 10 years or longer — it might be worth shifting out of those, Blanchett says.

The name of your bond fund should indicate average maturity, but if it doesn't, read the fund's description. Horowitz says his company avoids bonds with maturities over 10 years.

Log in to your retirement account provider's website and click on each investment. Look for the expense ratio — that's an annual fee expressed as a percentage of your investment — and make sure it's less than about 0.5 percent.