Implications Of The End Of QE On Retirement Planning
As the Federal Reserve churns towards tapering its $80 billion per month asset purchases as soon as this month, we wanted to share our thoughts on the implications that the tapering of this historic program may have on retirement planning.
There are two traditional financial planning rules of thumb when it comes to planning for retirement: 1) as people age, they should shift their securities portfolios towards a higher percentage of fixed income products i.e. a 50 year-old should have 50% in bonds, a 60 year-old should be 60% invested in bonds, etc.; and 2) a 4% withdrawal rate from retirement savings each year is the maximum that one should expect to preserve savings for the entirety of retirement. In today’s world of QE, however, Americans near retirement should re-consider whether these two axioms will hold true over the near-term.
With regard to the first rule mentioned above, financial planners usually recommend an asset allocation “sliding scale” towards fixed income as investors age due to the relatively lower risk associated with fixed income compared to equities over time. However, given the unprecedented interest rate dynamic that has been created by the Fed, what was traditionally perceived as “safe” now looks a lot riskier. This is because many individual retail investors hold fixed income through portfolios of mutual funds and ETFs rather than through individual purchases of bonds that they hold through maturity. An investor who purchases a bond mutual fund or ETF faces significant interest rate exposure depending on the overall duration of the fixed income portfolio held by the mutual fund or ETF. This is because mutual funds hold a basket of fixed income securities that are not typically held to maturity, but rather are traded and re-allocated over time while the mutual fund appreciates or depreciates in the market with investor demand. An investor who purchases an individual bond solely for income is somewhat less concerned with interest rate fluctuations especially if the bond is held until maturity.
Why the concern over interest rates? Because the Fed has been propping up fixed income securities for the last five years, which has caused short and long term interest rates to be artificially suppressed to historically low levels – far below where the market would ordinarily dictate under the present conditions. How has the Fed been doing this? Bond prices and interest rates move in opposite directions – when bonds are in high demand and become more expensive in the market, the fixed coupon payments associated with bonds represent smaller percentages of the price of the bond, therefore signifying a lower effective yield. According to the thesis behind QE: this makes the bond less attractive to investors, lowers overall interest rates in the capital markets, and is intended to deter conservative savings and stimulate capital spending in business expansion, investment in equities and other job-producing ventures. What is the danger? When the Fed begins to taper, or reduce, its massive bond buying programs, however, the fixed income markets will begin to move in the opposite direction (as indeed they already started to move after the Fed’s June policy statement that first alluded to tapering). This will cause significant capital depreciation in bond funds due to the erosion of the Fed’s support for the fixed income market and a subsequent rising interest rate environment.
This brings us to our second point: if near-retirees expect to withdraw 4% of their retirement savings each year to support their retirement while also preserving their nest egg, and 60-70% of those retirement savings are held in bond funds, what will happen when the value of those bonds funds significantly deteriorate as interest rates rise over the next decade? The answer is grim: either retirement income will be smaller if 4% is withdrawn each year or retirees will have to withdraw more than 4% to support their planned retirement lifestyle. Therefore, in order to rely on the 4% rule in retirement to support a lifestyle that may have seemed feasible only a few years ago, many retirees may need to maintain greater exposure to equities over the near term. We typically have favored a larger equities allocation for our clients than under the traditional rule and continue to favor a higher equity component under the current economic and market conditions. Unfortunately, many near-retirees are still shell-shocked from the experience of the Great Recession and resist equities. Here’s hoping that these near-retirees don’t get bounced by the Great Recession to the Great Bond Bubble bursting.