For a while, Brandon and I have been discussing the coming 401k bond blood bath for people who are retiring and have been planning for years to shift their asset allocation to a much more conservative posture. Remember when the conventional wisdom was that during your retirement years you would shift the weighting of your investment portfolio to income producing assets…think bonds.
Well, for those of my grandparents generation and older, that worked pretty well as we had a great many years of relatively high interest rates.
You mean there was a time before “Helicopter Ben”?
Yeah, there was actually a time that you could expect to take your life savings, plow it into treasuries, savings bonds, municipal bonds and a few corporates and live quite comfortably collecting your interest payments.
Hard to believe there was ever such a time.
My big concern now is for the baby boomers, their all facing protracted retirement periods (if you view retirement in the traditional sense of beginning at 65). And a great majority of them will run out of money if they plan to live a traditional retirement–you know…traveling, playing golf, etc.
Now, I’m not completely naïve.
I also understand that the “retirement” paradigm has shifted or at least is in the process of doing so. Mainly, because a great many folks are being forced to shift their old view of the retirement landscape.
But that’s a greater topic, for another day.
What I’m immediately concerned with in this post that of investor behavior over the last several years and how it could negatively impact their financial future.
The S&P 500 is hovering near its all time high of 1565 and while that’s certainly a great thing considering that means it has rebounded over 100% of its value since the market bottom in 2009, people are still leaving equity investments like it's 2009 and plowing their retirement dollars into fixed income investments (bonds).
A recent article in Investment News said that, “investors yanked $300 billion more from actively managed U.S. equity stock funds than they put in over the three-year period through July 31. While the net $140 billion that investors dumped in to passively managed funds (index funds) and ETFs over that period offset those withdrawals, it still leaves a net $160 billion on the sidelines”
So, if people are still running from stocks, where is the money going?
Well, bond funds actually grew over the same three period ending July 31 of this year. They grew by $734 billion to be exact!
Why does this matter?
Think about this and you'll understand.
In the last couple of weeks, the Fed has said that they intend to keep rates at or near zero at least until mid 2015. This is not a good thing if you are invested in bonds or CD's.
Our concern is that this flight to “perceived safety” that many investors have chosen by running into bond funds will not end well. Most of the people making this transition are only thinking of bonds as they knew them as children—buy the bond, collect the interest and when the bond matures, you collect your principal.
But when you invest in a bond mutual fund it doesn't work out this neatly.
Yeah, the dividend rate on your fund may increase with a rise in rates but your net asset value (NAV) also known as, your principal investment will be walking out the back door. Think about it this way, you currently own a fund that has a 3% dividend rate. Interest rates rise and now you're really excited because the dividend rate on your fund has increased to 5%. But if you look closer you may notice that your investment has decreased by 10% in its net asset value.
That's not a good thing. And now you're caught up in a really sophisticated shell game…guess who wins?
Yeah, not you.
Remember, that all the data points I’ve given you thus far are being reported by Morningstar which means that they are tracking fund data i.e. mutual funds and ETFs (exchange traded funds). And when you invest in a bond mutual fund or ETF, you aren't buying a bond. You're buying a basket of bonds with varying maturity dates and coupon rates. So, that means the fund managers are constantly having buy new bonds and that every bond in their portfolio will decrease in value as interest rates start to rise.
Which tells me that a vast majority of this money is held in 401k plans by far the largest pool of fund money in the universe.
You have to consider the relationship that bond values have to interest rates. Basically, the correlation is inversely related, that is that when interest rates rise, the value of bonds you hold in your portfolio decreases. I always learned to think of it as a see saw.
Okay, if you understand that basic analogy then think about this, the same article I quoted earlier also reported that
“The Barclays Aggregate Bond Index, the most widely used proxy for U.S. investment-grade bonds, has an average duration of between four and five years. A rate rise of just 1% would cause it to lose 5% of its principal.”
I’m willing to bet this is not what most people understand about the bond funds they hold in their retirement accounts and they will be greatly surprised when rates finally do begin to move back up.
Now, we’re not suggesting that people complete shun the use of bonds in favor of stocks. No we believe that people should consider alternative strategies that will hedge the risks of inflation, longevity and tax policy.
If you’d like to learn more, contact us, we’re always happy to help.
Brantley is a practicing life insurance agent and has been for nearly 18 years. After years of trying to sell like his sales managers wanted him to, he discovered that people want to buy life insurance if you actually explain the benefits.