News
News
The bond market has enjoyed over two decades of general prosperity. Since 1981, interest rates on long-term bonds have trended downward from 15% to 5%.(1) Investors have swarmed to stable-return investments since the bear market in stocks began in 2000. As a result, bond managers have trounced stock managers by an average five percentage points per year. A three-year bond winning streak is a rare event in market history, having last occurred from 1939 to 1941.(2)
The winds could be shifting soon. Interest rates are at a 40-year low. The Iraq War is essentially won. The economy is poised for a turnaround. The government is now running a budget deficit. These and other indicators point to a higher demand for credit, rising interest rates and falling bond returns in the near future.
Holding a fixed income component in your portfolio is a prudent strategy. If properly selected, bonds can enhance diversification and provide a steady interest payment stream that may reduce overall volatility while boosting total return. But many investors are herding to fixed income for less credible reasons. They are fleeing the bear market in stocks and are assuming that the bond market boom will continue.
Economic forces are working against continuing bond gains. Bond managers are warning of a current oversupply and rising volatility within the fixed income class. They also claim that investors are fueling a bond market bubble with a reckless abandon resembling the stock mania of the late-1990s.(3) We know how that story ended—and it’s worth avoiding.
Historically, interest rates climb when the economy enters a rebound. Rising business and consumer activity raises the demand for money and credit. The bond market views economic revival as indicative of higher inflation, which creates worries over the erosion of principal. And at some point, the Federal Reserve will raise interest rates to prevent the economy from overheating.
Now consider how changing interest rates affect bond values. There’s an inverse relationship between current interest rates and bond market prices. When interest rates fall, the value of an existing bond rises because investors are willing to pay more to obtain the older, higher rate. When rates increase, bond values fall since investors can get the new, higher rate from a new bond. The bond’s resulting price drop in the secondary market is necessary to make its current yield competitive with a new issue of comparable quality.
Bond price movement depends on several defining attributes, including maturity, duration, coupon rate and credit quality. These are explained in the adjacent column, Rate Sensitivity Factors. Interest rate changes affect some bonds more drastically than other debt. For instance, bonds with a lower coupon rate, a longer maturity and higher credit rating tend to be more interest sensitive. On the other end of the spectrum, high-yield bonds—or junk bonds—are the least rate sensitive due to their high coupon rate, typically shorter maturity, low credit rating and dependence on economic performance.(4)
Forecasting an economic rebound is a hard task. But rising rates will inevitably follow a strong and sustained upswing. With this in mind, you should consider how a new business cycle could affect the fixed income component of your wealth.
This begins with a review of interest rate exposure in your portfolio. Have declining stock values changed the balance of your equity/bond mix? Are you holding longer-term bonds that are showing sizable price gains? If so, you might sell a portion and use the proceeds to resupply your stock allocation and acquire bonds of shorter durations. Also examine the quantity and credit quality of bonds with an eye on diversification. If you are holding individual bonds, consider a laddering strategy to spread out maturities. If you can afford the extra risk, you might consider moving down the credit spectrum for higher yield.
Risk tolerance and time horizon should frame the decisions regarding asset allocation, income structure and bond diversification. Modern Portfolio Theory views the fixed income asset group as a tool for reducing volatility. Bond performance matters. But a portfolio’s total return should be the final measure of success. This keeps investors focused on the right things.
(1) “That’s All, Folks”, Forbes, 20 Jan. 2003, p 106. (2) ”The Coupon Clipper”, Worth, March 2003, p 49. (3) “A Little Late to the Party”, Fortune, 20 Jan. 2003, pp 176-78. (4) High-yield bonds carry substantial risk of default, however, since they have the lowest credit rating. Investors should limit their exposure to these securities and diversify extensively to reduce the effects of a high default rate.
Most baby boomers are watching their retirement hopes evaporate with each passing year. If the stock market doesn’t rebound soon, you can expect to hear a quickening drumbeat from the public policy arena. Some pundits are now warning that a “retirement crisis” awaits the aging American worker.(1)
Indeed, some pundits are blaming the lagging stock market, the pension system, demographics and other factors for robbing workers of the retirement they deserve. While it’s true that average household wealth has fallen with the multitrillion-dollar stock market slide, the low-water mark exposes the real source of the funding crisis: Most workers haven’t taken the essential steps to build retirement security for themselves.
Instead, many baby boom investors placed a dangerous bet on rising stock values in the late 90s. Their swelling account statements obscured a pitifully low savings rate and excessive living standard. Many investors relied on unrelenting double-digit returns to help them make up for lost time and avoid the consequences of past financial neglect.
The oldest boomers will reach traditional retirement age in 2012. That’s less than a decade from now. Some are hoping that a revitalized stock market can replenish their lost wealth. This requires them to load up on risk amidst volatile markets and economic uncertainty. Other people have abandoned stocks for the promise of more stable returns in fixed income instruments. But this decision will have devastating effects over time since these assets may lack growth potential and can experience declining market value when interest rates begin rising.
And now for worse news. The retirement funding task is growing more difficult and complex as the largest generation in history ages. Let’s examine some of the prevailing forces working against financial security:
• A longer retirement. A century ago, men started working young and retired due to failing health, which typically struck during their 50s. After 35 years or more of labor, they declined rapidly, usually spending only a handful of years as non-producers before dying. Today, the blessings of long life and material abundance have changed life cycle dynamics, which affects most aspects of the economy—from labor markets to asset values. The target retirement age now is the early 60s—and new retirees face even odds of living into their 90s. People start work later, toil fewer years and retire younger.(2) Retirement is not a last resort, but a second career spanning two or three decades. Success means building a larger asset base in less time.
• Vague goals, no plan. How much accumulated wealth is necessary to fund two or three decades of leisure? Amazingly, few people have checked the math. For all but the wealthiest, funding a middle or upper-middle class retirement takes honest self-analysis, long-term perspective, boldness and discipline.
The “average” American worker views retirement security as a dream, not a task. This could explain why most baby boomers lack a detailed wealth building plan, don’t save enough and, ultimately, will look to government for help. Despite all the information, expertise and resources available in today’s financial market, most people are not doing a competent job building retirement wealth, if they are making any attempt at all.
• Shifting pension burden. The company pension is generally considered the largest contributor to retirement security. But today, companies are less generous with their employee retirement programs. In most cases, they are shifting the burden of saving and investing to employees.
Many firms are replacing their traditional defined benefit plan with the newer defined contribution structure, such as the 401(k) savings plan. The newer arrangement enables a company to avoid the high cost of administration, the risk of investing pension assets and the liability of paying future retirees.(3)
Over the last 25 years, participation in the 401(k) has grown from 18% to 46% of the U.S. workforce. But these programs are feeling the strain as companies reduce employee compensation to endure recessionary times. Many companies have slashed or eliminated their matching contributions while cutting other benefits that can help employees save more.(4)
About 22% of the workforce still participates in defined benefit pensions. But some of the largest programs are currently underfunded. So, even retirees who are banking on a fat monthly pension check may find their benefits scaled back.(5)
The American corporation is ceding its role as the guardian of employee retirement security. Workers must assume responsibility for saving and investing—and assume the related risks.
• Poor investment management. The self-directed 401(k) plan has become the primary tool for tax-assisted retirement investing. But the average worker has shown a lack of knowledge, skill and discipline to manage this wealth building opportunity. Consider a few common mistakes made in 401(k) accounts:
> Low participation or contributions: Many employees opt out of their company-sponsored 401(k) or don’t contribute a significant amount over the years.
> Poor asset allocation: Account owners may acquire too much company stock, hold assets in cash, take too much or too little portfolio risk, switch investments often, choose investments without regard to compatibility, goals or diversification, and incur high expenses.
> Lack of commitment: Many workers don’t keep their tax-deferred money working for them. They either borrow from their account, which freezes the employer’s matching funds, or don’t roll-over their account balance when they change jobs—a decision which incurs early withdrawal penalties and income taxes while foregoing future tax-deferred growth.(6)
All of these actions produce disappointing account performance. Studies show that, on average, 401(k) plans as a group fail to match the broad market or a balanced stock/bond index, and experience lower returns than company-managed pensions.(7)
Here’s another compelling investment lesson from a survey of company plans: Higher income employees tend to earn higher returns on their self-directed 401(k) accounts. The primary reason is that higher-paid employees devote a higher percentage of their account to stocks.(8) Perhaps this is due to a more sophisticated understanding of investment principles. If so, knowledge proves itself.
• Inadequate savings rate. The current tax code discourages savings and investment outside a 401(k), IRA or other tax-deferred retirement plan. But the lifestyle and credit decisions of the average American family reveal a propensity to defer financial responsibility to the future.
The downward-trending personal savings rate over the last few decades confirms this. From 1946 to 2000, household savings averaged 7.8%. During the 1990s, the average savings rate was 6.0%. Since 2000, it has averaged 2.9%.(9) This paltry rate looks even worse when you consider that the government has recently revised it upward and figures retirement plan contributions into the calculation.
• Failing Social Security. Despite all the talk about the impending Social Security funding disaster, Congress has done virtually nothing to shore-up the program. For now the system collects more than it pays out. But Congress spends the surplus every year—and not a single dollar of future obligation is funded.
Social Security is projected to enter deficit range around 2017, which will induce tax increases or benefit cuts as more boomers retire. If you expect federal assistance to close the gap in your retirement deficit, you should think again. The combined present value of the future deficit of Medicare and Social Security is a vast $10 trillion—the size of current annual U.S. gross domestic product (GDP).(10)
A recent study estimates that almost half of the households nearing retirement (47 to 64 age group) will earn less than half their preretirement income when they stop working—and 20% will fall below the poverty line.(11) The next generation of seniors may realize too late that financial security isn’t automatic or guaranteed. Neither is it a right.
All three building blocks of retirement—pension, Social Security and savings—are in jeopardy. The good news is that you have charge of the future. And, ultimately, you will get the level of financial independence you deserve. The time is ripe to earn it. If you are behind, take action now to save more and invest wisely. If in doubt, seek financial guidance.
(1) Two opposing philosophies comprise the retirement funding debate. One looks to free market principles, tax reform and economic growth to help workers build private retirement wealth. The other mindset emphasizes federal regulation and funding to guarantee retirement security. This “progressive” approach focuses on closing the wealth gap between higher and lower-paid workers. It endorses building a national system of mandated benefits for every American.
A few of their proposals:
• Requiring businesses to offer and supplement uniform retirement coverage for all workers.
• Funding low-income worker accounts with federal dollars.
• Creating incentives to revitalize the centralized defined benefit pension model, while phasing out the 401(k) structure.
• Transferring ownership and control of pension assets from individuals to government.
• Disallowing investment in the equity markets due to higher perceived risk and volatility.
(Source: White Papers and Issue Guides, Economic Policy Institute; www.epinet.org.)
(2) For prior generations, the ratio of working years to retirement years was about 12:1. This assumes 35 years of total work and about three years of retirement. Today, the ratio is 2:1—or two years of work to one year of retirement. (Brooks Hamilton and Scott Burns. “Reinventing Retirement Income in America”, National Center for Policy Analysis, Report No. 248, Dec. 2001. www.ncpa.org)
(3) With a traditional defined benefit pension, the company funds the plan, manages the assets and pays a fixed income to retired employees, based on a prescribed earnings and years-of-service formula. In a defined contribution plan, workers fund their own portable account (often assisted by a matching contribution from the firm) and make all investment decisions.
(4) “Saving the Retirement We’ve Earned”, Bloomberg Personal Finance, November 2002, p 47.
(5) “The No-Legged Stool”, Bloomberg Wealth Manager, Dec. 2002, p 53.
(6) “Are We Cashing Out Our Future?”, Working Group Report to the ERISA Advisory Council on Employee Welfare and Pension Benefits, 13 Nov. 1998.
(7) “Investment Returns: Defined Benefit vs. 401(k)”, Watson Wyatt Insider, Sept. 1998. (8) Hamilton and Burns, p 15.
(9) Bureau of Economic Analysis, 2003.
(10) Bloomberg Wealth Manager, Dec. 2002, p 53.
(11) “Retirement Insecurity: The Income Shortfalls Awaiting the Soon-to-Retire”, Economic Policy Institute, 2002.
