I mentioned in my last post that I’ve been getting a lot of questions lately about bonds. There seems to be a pervasive fear (fueled by the media) that because rates are at historic lows and the Fed is winding down their quantitative easing, that bonds are a ticking time bomb. Is that true? If so, what should you do about it? Your answer might keep your retirement plans on track…or completely derail them.
Why all the fuss? What happens to bonds when rates rise?
When interest rates rise, the price of bonds falls. To understand why, imagine that you had a 10-year government bond that paid 2.5% interest per year. If rates on the 10-year rose to 3.5%, why would anyone want your bond when they could buy a new one with the better rate? Answer: They wouldn’t. If you wanted to sell, you would need to lower the price on your bond to attract a buyer. The opposite would be true if rates fell. Your bond would have a higher rate than newly issued bonds, so people would be willing to pay a premium for it.
Do rising rates affect all bonds the same?
No. Some bonds are more sensitive to changes in interest rates than others. This sensitivity is measured by something called duration. The higher the duration, the more sensitive the bond is to changes in rates. For example, if a bond (or bond fund) has a duration of 10, it will typically fall 10% in value if rates rise by 1% (or rise 10% if rates fall 1%). If a bond only has a duration of 3, it will fall by 3% if rates rise by 1% (or rise by 3% if rates fall by 1%).
Are interest rates the only thing that affect a bonds price?
No. In addition to interest rate risk, bond prices are affected by credit risk, which is the risk that the borrower won’t be able to repay what they borrowed. Credit risk is why many bonds went down in value in 2008 even though interest rates were falling. As rates fell, you would have expected the price of bonds to rise, but that relationship was sometimes overpowered by the perception that many borrowers (e.g. Greece, Bear Stearns, General Electric, homeowners) were not going to be able to pay back what they had borrowed.
Rates are at historic lows. Should I avoid bonds altogether?
No. Let me give you three very good reasons why you probably shouldn’t shun bonds. First, you could be wrong about the direction of rates. There was a spike in rates at the end of last year and pretty much every media outlet, bond fund manager, and investor assumed that the inevitable climb in rates had come. What actually happened? Rates have been falling ever since. Ten year treasuries started the year at 3.04% and ended last week at 2.34%. Most analysts and commentators were calling for rates on the 10-year to be somewhere around 3.50% by now. None of us has perfect foresight, which is why it makes sense to have a mix of stocks and bonds rather than putting all your eggs in one basket.
Second, you shouldn’t try to minimize risk by taking on more risk. What do I mean? The fear of rising rates has caused many people to sell their bonds and move that money into stocks. That’s a bit like trying to reduce your risk of being injured in a car accident by selling your car and buying a motorcycle. Motorcycle accidents are both more common and more severe. Similarly, the downside risk of stocks and bonds are generally very different. A very bad year in a bond fund is a negative 3 or 4 percent. A very bad year in a stock fund is a negative 30 or 40 percent. Don’t try to avoid risk by jumping out of the frying pan into the fire.
Third, rising rates don’t mean automatic doom for bonds. Between 2004 and 2006 the Fed increased interest rates 17 times by a total of 4.25%. If ever there were a time when you’d expect bonds to get hammered, that was it. But if you peruse the returns of a broad spectrum of bond funds from that period, you’ll notice that many of them actually made money (see chart below).
|Government Bond (VFIJX)||4.21%||3.42%||4.43%|
|Municipal Bond (THMIX)||3.52%||2.71%||4.00%|
|High Yield Bond (BHYIX)||12.21%||3.91%||11.67%|
|Corporate Bond (PBDPX)||5.91%||2.43%||4.07%|
|Global Bond (TGBAX)||14.93%||-2.84%||13.72%|
The Fed is winding down their third round of quantitative easing. Isn’t that bad for bonds?
Maybe. When demand for something drops, so does the price. But keep in mind that one of the biggest beneficiaries of QE has been the stock market. It rallied in a big way each time the Fed engaged in quantitative easing and then sold off when that quantitative easing ended. The S&P 500 fell 9% after QE1 and 11.7% after QE2. So what will happen when QE3 (aka Operation Twist) ends? Who knows? But if past is prologue, it might have a bigger impact on stocks than it does on bonds.
So what should I be doing?
That depends. If you have a well thought out asset allocation that is appropriate for your circumstances, you probably don’t need to do anything. My concern, however, is that many people are not in that boat. Anytime a particular investment theme gets as much press as interest rates are getting now, it causes people to make changes that may not be appropriate (see also 1999, 2007 and 2008). So take a look at your investments and see if your allocation is appropriate given your goals, risk tolerance and time to retirement. If you’re not sure, schedule a meeting with a trusted adviser. No one knows what direction markets will take, but a good asset allocation can help you prosper when times are good and stay on track when things get bad.
Have a great week and touch base if I can help.
Last week we got a taste of something that we haven’t experienced in awhile: Volatility. A wave of anxiety swept through the markets, pushing the Dow into negative territory for the year and handing the S&P 500 its worst week in two years.
What is causing the selling? There are plenty of headlines to choose from. Argentina is close to (another) default. Israel and Hamas are fighting in Gaza. Tensions in Ukraine have continued to worsen. The economy in Europe is sluggish. Banking issues are percolating again in Portugal. And above all of these, it seems, is the fear that the Fed will soon reverse course and begin to raise interest rates.
I have no idea if this is the beginning of a broader selloff or just a temporary breather before markets quickly resume their march higher. One thing I do know, however, is that markets have had five years of uninterrupted gains. Anytime that happens, it’s easy to become complacent with your investment portfolio and that complacency can be a very dangerous thing when you’re close to (or in) retirement.
With that in mind, let’s pretend that the recent volatility is a canary in the coalmine, warning us of a major pullback. What can you do to protect your nest egg?
As I said earlier, after 5 years of gains it’s easy to become complacent and just assume that the path of least resistance is higher. If history is any guide, however, we’re long overdue for a correction. How would your portfolio fare if the markets dropped 10%? How about 20%? Or what if we have a repeat of 2008 and they dropped nearly 40%. Would that affect your plans for retirement? If so, some changes may be in order.
Stock and bond markets rarely move in lockstep. Sometimes stocks outperform. Sometimes bonds. One consequence of this is that, left untouched, your portfolio will gradually get out of balance. The longer this imbalance is allowed to persist, the worse it gets. Take a look at the percentage of your portfolio that you have allocated to stocks and bonds. If the relative outperformance in stocks has resulted in that balance being skewed toward stocks, you should consider rebalancing back to your intended allocation.
Of course rebalancing will just get you back to your prior allocation. It’s probably worth asking if that prior allocation is still appropriate for your current circumstances. You’re five years closer to retirement than you were in 2008. A major downturn now might actually derail your plans rather than just causing a bit of anxiety. Rather than rebalancing to a prior allocation, it might be more appropriate to change your allocation altogether. If you’re really close to retirement, you might also consider setting aside a year or two of your expenses in cash so that you can minimize any potential sequence risk (the risk that you will experience negative returns early in retirement).
Those are just a few proactive ways to deal with the inevitable volatility that is part and parcel of our financial markets. For other ideas on how to keep your plans on track you can read this: Anxious? Focus on what you can control.
Next up: I’ve been getting a lot of questions about bonds lately. What if the Fed starts raising rates? How much of my portfolio should be allocated to bonds? What types of bonds are most impacted by rising rates? I’ll dig into those questions and more in my next post.
Have a great week.
Just like it’s a good idea to get a health checkup every year, it’s a good idea to get a financial checkup as well. Doing so can help you detect problems early (while they’re still treatable) and will also help you gauge your progress and make sure you’re on track for a healthy retirement.
To help, I put together this Financial Checkup Checklist with areas that you should be reviewing. Go through it and then touch base with me if you have any questions or there’s anything I can help you with. Have a great week!
If you work with a financial adviser, it’s a good idea to get together at least annually to review your accounts. As we get ready to transition into a new year and as our government grapples with the issues surrounding the “Fiscal Cliff,” now may be a good time to call your adviser and schedule that meeting. Below are seven questions you can ask to make sure that your retirement planning stays on track.
Are there any actions I need to take before the end of the year? Most of the questions below can wait until next year, but for obvious reasons, you need an answer to this one before December 31. With changes expected to both dividend and capital gains taxes in 2013, review your holdings and ask your adviser what actions, if any, you should be taking before yearend. Also, if you are 70 ½ or older you will likely need to make a Required Minimum Distribution (RMD) from your retirement accounts before the end of the year.
How did my investments perform relative to their peers? It is difficult to gauge performance by returns alone. If your stock mutual fund drops 20 percent does that mean that it’s bad? Not if similar funds dropped 40 percent. When monitoring performance, it’s important to have either a benchmark or peer group that you’re measuring against. Your adviser should be able to review your holdings and see if the managers you’ve hired are earning their fee. If so, great. If not, changes may be in order.
Is my asset allocation still appropriate? Your portfolio is likely made up of a variety of different asset classes such as U.S. stocks, foreign stocks, small cap stocks, government bonds, corporate bonds and municipal bonds. How much you have in each area is referred to as your asset allocation. The balance will vary based on a number of factors such as your age, risk tolerance, goals and outlook for the global economy. As your circumstances change and as market movements alter your allocation, it is important to meet with your adviser and rebalance your holdings to get them back in line.
Is the amount of risk I’m taking still appropriate? Investing too aggressively can result in significant losses to your portfolio. Investing too conservatively can mean that your investments don’t keep pace with inflation. Either of those outcomes will reduce the purchasing power of your money in retirement. Work with your adviser to make sure that the amount of risk you’re taking is still appropriate for your circumstances.
Am I saving enough? There are a number of assumptions that go into calculating how much you need to save in order to retire. Even small errors in those assumptions can have drastic changes in the predicted outcome. Rather than making a plan and then waiting 20 years to see if it works, it’s important to make small adjustments along the way. With each new year, you have new information relating to things like investment returns, savings rates and taxes. It’s important to evaluate that new information and ask your adviser “Based on these new realities, am I still on track to reach my retirement goals.” If the answer is no, talk through any needed changes.
Is my withdrawal rate sustainable? Of course, this question is only appropriate if you’re already retired and drawing income from your portfolio. Running out of money is a major fear for many retirees. To avoid that problem, it is important to have a sustainable withdrawal rate. A suitable rate depends on a number of factors including investment returns, inflation, longevity and even luck. A popular rule of thumb is to limit withdrawal rates to 4 percent, but everyone’s circumstances are different, so work closely with your adviser to make sure your income lasts.
Do you recommend any other changes? A good adviser is realistic and honest. Rather than telling you what you want to hear, he or she is paid to give you straightforward advice that will help you accomplish your goals. Not only that, but a good adviser should be able to look at your total financial picture and offer comprehensive advice. Take advantage of that knowledge and experience and ask what, if any, other changes are necessary.
The annual review is an important element to the client-adviser relationship. It is an ideal time to evaluate performance and make necessary adjustments to help you reach your retirement goals. Pick up the phone and schedule a meeting today so you can start the New Year off right.
I originally published this article at www.fpanet.org.
If you spend a good portion of your day in a building like an office or a school, chances are good that you’ve participated in a fire drill. Those faux escapes give everyone a chance to practice evacuating the building and give those in charge an opportunity to identify and fix any potential problems.
If retirement is on your horizon, it would probably make sense to do something similar. Call it your “Retirement Fire Drill.” After all, sometimes you get to choose when you retire, sometimes (through illness or layoffs) you don’t. It’s good to be prepared.
So let’s sound the alarm and pretend that today is the day that you’re transitioning into the next phase of life. How will the planning you’ve done so far hold up in the real world? Below are 5 areas to test.
Is your budget going to work?
You have made a retirement budget haven’t you? If not, download our free retirement budget worksheet. What will your sources of income be once your paycheck stops? Do you have a realistic estimate of how much that income will be? How about expenses? Some people say you can live on about 70 percent of your preretirement income, but is that realistic for you? There’s only one way to find out. Practice living for a few months on the income and expenses that you’ve projected. Then reexamine your budget and see if anything needs to change. If it didn’t work for a 2 month trial, it probably won’t work for a 20 year retirement. Take what you learned and make adjustments as necessary.
Is your asset allocation going to work?
If you retired today, how would your investments fare if we had another downturn like 2008? Are you invested too aggressively? Or how about if we got into a period like the late 1970s and early 1980s when inflation increased by double digits each year. Are you invested too conservatively for your retirement income to keep pace? Shocks to your portfolio early in retirement greatly increase your chances of running out of money. You can minimize that risk by having your asset allocation correct and by setting aside a year or so of retirement income in cash so you can draw from that, rather than your investments, in the event of a downturn.
Is your health care going to work?
You won’t be eligible for Medicare until 65. Are you planning on retiring before that? If so, how are you planning to bridge the gap? Even if you wait until 65, do you have enough set aside to pay for the premiums and co-pays required under Medicare? Have you budgeted in the cost of a Medicare supplement policy? Are there any health care issues (e.g. dental work, operations) that you should take care of now, before transitioning into retirement? And what about long term care? What if you or your spouse became disabled or needed ongoing professional care? Do you have a plan to pay for that care that doesn’t include spending down all of your assets and leaving the healthy person in a financial bind?
Is your income strategy going to work?
If you and your spouse are 65, there’s a 72 percent chance that one of you will live to age 85. There’s a 45 percent chance that one of you will live to age 90. Will your income last that long? Are you taking a sustainable amount from your investments each year or are you in danger of running out of money because you’re taking too much? Will part or your income (such as a pension or Social Security) disappear when you or your spouse dies? Can the surviving spouse live on the remainder? Rework your budget to factor in one or more of those income shocks and then think about how you would respond.
Is your estate plan going to work?
If you plan on moving to a different state, have you checked with your attorney to see if your will and estate plan documents will be valid in the new state? What if you became disabled or incapacitated? Do you have powers of attorney that specify who takes charge? If that person is your spouse, what happens if he or she dies before you? Does your will reflect your current wishes? Do you have the correct beneficiaries listed on accounts and insurance policies? Are your documents organized and easily accessible? Do everything you can to have your affairs in order.
How did you do? If you encountered a few problems, don’t worry. One of the great things about a drill is that it’s just practice. Take the information you learned from the fire drill and tweak your plans to give yourself a better outcome. That way you’ll be ready when the real alarm bell sounds.
I originally published this article at www.fpanet.org.
(Note: This is Part 2 in a three part series that I did for the Omaha World Herald on retirement planning for different life stages. I’m re-posting it here for all of you who don’t live in snowy, freezing Omaha!)
Forty-five is an interesting age. It’s like the Junior High of aging. Too old to fit in with the kids at the Kanye West concert, but too young for the senior discount crowd at Denny’s. Exactly halfway between 25 and 65, it’s like a weigh station between the carefree and exciting days of your 20s and what will hopefully be the carefree and exciting days of retirement.
With 20 years to go, it’s a good time to reflect on the planning you’ve done so far and see if you are on the right track. If not, you’ve still got time to do something about it, but the clock is ticking. Here are 20 ways to make sure you’ll have enough in 20 years.
1. Actually figure out what you need. Too many people retire based on their birthday instead of their bank account. Knowing how much you’ll need will help you save with purpose and intention. A good rule of thumb is to shoot for a nest egg that is 25 times larger than the amount you want to take from it each year.
2. Get out of debt. No one in the history of the universe has gotten rich spending money they don’t have on things they don’t need. You won’t be the first to crack the code.
3. Perform budget triage. Most budgets don’t bleed to death from a gaping wound, but rather a thousand little cuts. Wasting $20 per day for 20 years will shave about $334,000 from your nest egg (assuming an 8 percent annual return).
4. Beware any sentence that begins with “Hey dad. Can I…” People in their teens and twenties are incapable of ending that sentence with anything that doesn’t cost you money and put a hole in your nest egg. Whatever the request, just answer with a firm “Yes, as long as I can move in with you in 20 years because I had earmarked that money for retirement.”
5. Make your saving automatic. Saving is like going to the gym or eating your vegetables. You know you should do it, but it takes discipline. Make it easy on yourself by having money automatically deducted from your checking account or paycheck each month.
6. Focus on the basics. Saving and investing doesn’t need to be complicated. You can contribute $17,000 to a 401(k) and $5,000 to an IRA each year. Start there. Maxing out your contributions for 20 years would add about $1,006,000 to your nest egg (assuming an 8 percent annual return).
7. Refinance. Interest rates are at historic lows. If you still owe money on your house, consider refinancing into a loan with the same payment, but a lower rate and shorter term. You’ll save thousands in interest and you’ll enter retirement with no mortgage.
8. Get healthy. In 1900 the three leading causes of death were influenza, diarrhea, and tuberculosis. Today they are heart disease, cancer and stroke. All three of those diseases are expensive (even with insurance) and heavily dependent on things like diet, exercise, smoking, drinking, and stress.
9. Beware midlife crisis purchases. If you’re tempted to buy a Hemi powered midlife crisis-mobile, don’t. Buy a nice used grocery getter instead and put the difference in your IRA.
10. Add up everything you’ve spent during the last 12 months on beverages (e.g. soda, red bull, alcohol, venti non-fat no foam double shot hazelnut lattes, etc.). If the number is greater than the world median annual income (about $1,700), reacquaint yourself with the benefits of water.
11. Make it personal. You’re not planning “retirement,” you’re planning “your retirement.” Once you realize that and spend some time thinking about the things you are really looking forward to, you’ll be incredibly motivated to make it happen.
12. Avoid mistakes, especially those that result in large investment losses. At 20 you had plenty of time to recover. At 45, large losses are like meteors to dinosaurs. They are extinction level events. Don’t put all your eggs in one basket (like your own company’s stock) or make questionable investments (like that can’t miss tip from your brother-in-law).
13. Meet with a trusted adviser annually. Answer three key questions at each meeting: How did my investments do this past year? Am I still on track for retirement (see number 1)? What changes do I need to make?
14. Work on your marriage. Middle age is a risky time for you and your spouse. Having a happy marriage is reason enough to put forth the effort, but if you need something more, remember this: A sure fire way to derail your retirement is to divide all your assets in half.
15. Don’t be too conservative. The markets have been crazy these last few years and a lot of people responded by moving everything to cash. That may help you sleep well, but it won’t help you grow your assets and outpace inflation. Repeat after me: Safe is risky.
16. Review your asset allocation. If instead of moving to cash, you ignored your investments through the recent market turmoil, there’s a good chance that the ups and downs threw your portfolio out of balance. Research shows that your asset allocation is responsible for 90 percent of your investment returns. Work with your adviser to rebalance to a more appropriate allocation.
17. Downsize. Once the kids are gone, reconsider the necessity of having a house big enough to have its own gravitational field. A smaller place means that you’ll be spending less on your mortgage, heating, cooling, insurance and property taxes. Invest that savings for retirement.
18. Take advantage of peak earning years. You’ll likely make a lot of money in your 40s and 50s. As the kids grow up and move on, be sure to make your peak earning years your peak savings years as well.
19. Beware of fees. A good adviser or mutual fund can add value, but pay close attention to the fees you are paying. It’s not just the fees, but the compound interest those fees would have earned had they stayed in your account. Over a 30 year period, an extra 1 percent in fees is enough to shave 25 percent off the ending value of your investments.
20. Don’t retire early. Calling it quits before your full Social Security retirement age could mean a 20 percent permanent reduction in benefits. It’s worth remembering that the number one reason people retire early is poor health (see number 8).
Unless you’re a trust fund baby or a lottery winner (and let’s be honest, they all quit reading after number 3), you’ve probably got a little work to do. But have no fear. You can do a lot in 20 years. The key, as with most things, is to start. Ready? Go.