The Blessing of Higher Interest Rates
Rising interest rates have decimated stock and bond portfolios so far in 2022 (through June 10). The 10-year Treasury yield has gone up from 1.5% to 3.0%. The S&P 500 has dropped in value by 15.3%. The U.S. Aggregate Bond Index has declined 12.6%.
If you are nearing or already in retirement, you may be alarmed by the fact that the value of your retirement nest egg has fallen. But in fact, you should probably be rejoicing. That is because higher interest rates mean that the present value of your future retirement spending needs has gone down. Although the value of your retirement portfolio has declined, your portfolio now probably does a better job of covering your expected retirement spending than was the case at the start of 2022. In the parlance of pension fund management, your “funding ratio” (assets/liabilities) has gone up.
Your IRA is a Pension Plan for One
In the old days of the defined benefit pension plan, when you retired you were usually given a pension that would pay you a fixed amount each month for the rest of your life. No more. Now most people must manage their own pension plan with 401ks and IRAs, which along with taxable savings (and Social Security benefits) has to cover their spending needs over the course of their retirement.
Now the onus is on you to save enough to meet your needs in retirement, and to invest your savings wisely. Many people do not feel that they have enough training, experience, or time to do this on their own, so they often hire an advisor to help them once they get close to retirement.
There are many similarities between managing your own retirement savings and managing a corporate pension plan. Even though there may be only one beneficiary of your personal pension plan (or two in the case of a married couple), many of the same principles of managing a pension plan apply.
Perhaps the most important principle that retirement investors should borrow from the corporate pension world is “asset-liability management.” Not only do you need to be sure that you have a sufficient amount of assets, but you also need to invest it in such a way that the risks of your investments will more-or-less mirror the risks of your liabilities, the future payouts from the pension plan. Your liabilities are the spending needs that you will have in retirement. The assets are the stocks, bonds, and other investments in your IRA and other accounts that you will use to pay for those spending needs.
In some respects, the risks of your personal pension plan are more difficult to manage than those of a pension plan. For example, a company pension plan has a simple fixed monthly obligation for each employee. You have to be able to cover all of your spending needs, no matter how varied or unexpected they may be. A major health crisis may arise, for example. Large, unexpected spending needs might be called “event risk,” and this is one of the risks you need to manage. Consequently, your cushion of assets over liabilities needs to be larger.
Also, a company pension plan has many participants, so although the life expectancy of any one participant is not known, the plan sponsor (or the insurance company to which they transfer the risk of making the payments) can use actuarial assumptions to closely estimate how long the average participant will live. You cannot diversify your life expectancy. You only live once, as the saying goes. And you don’t know how long that will be. You have “longevity risk.” This is another risk that requires a larger cushion of assets over liabilities. Some specific strategies, such as delaying Social Security benefits until age 70, buying an annuity (a cheap, simple fixed annuity, not an expensive variable annuity), and investing in assets with high long-term returns (like stocks), can help manage this risk.
Most company pension plans pay out a fixed amount each month to plan participants. Rarely do they have cost-of-living adjustments. But your personal pension plan has to anticipate future inflation and be able to cover escalating costs. Your liabilities have a lot of inflation risk. You need to invest with this risk in mind, and include a healthy allocation to investments that will help hedge this risk.
Payments made by pension plans take place over a long time period. To accurately compare these future payments to present assets, the future payments are discounted at an appropriate interest rate.
The reason this makes sense is quite straightforward. If you have a $100,000 payment to make in five years, you could invest now in some bond or bond fund so that you will have the $100,000 in five years. But the amount that you need to invest now is less than $100,000. The actual amount to invest will be determined by the rate of interest of the fixed-income investment you choose. That is why future payments are discounted by current interest rates.
A stream of future payments will be discounted using not just one interest rate, but an entire “yield curve” of interest rates at maturities that correspond to when the payment must be made. Corporate pension plans are required to use discount rates from the AA-rated corporate bond yield curve. Generally, payments made in a particular year are discounted using the AA-rated corporate yield for bonds maturing in that year using the entire AA-rated corporate bond yield curve.
Your Funding Ratio
The ratio of a pension’s assets to its liabilities is called the “funding ratio.” A funding ratio above 1.0 implies that the pension is able to fund all of its liabilities. The same is true of your personal pension funding ratio.
One of the most striking insights of asset-liability management is that when interest rates go up, as they have so far in 2022, funding ratios often go up even thought asset values have gone down. The reason is that when discount rates go up, the present value of future liabilities goes down. If the present value of the liabilities falls by more than the value of the assets, the funding ratio goes up.
The graph below provides a real-world example of the impact of changes in the discount rate on the present value of the string of payments. In this case, the payments are $100,000 each year for 30 years, which is the retirement duration for many retirees. On December 31, 2021, the yield-to-maturity of an A-rated 10-year corporate bond index was 2.5%. As of today (June 10, 2022), that rate has risen to 4.5%. At 2.5%, the present value of 30 years of $100,000 payments was $2.09 million. However, at 4.5%, the revised present value of that payment stream is $1.63 million. That is a 22% drop!
Have your retirement assets fallen by 22% since the beginning of the year? Probably not. Consequently, the funding ratio of your retirement assets compared to liabilities has probably increased, perhaps by a lot, depending upon how much interest rate risk you have in your portfolio. If you have less interest rate risk in your portfolio, the value of your assets has probably declined less, and your funding ratio is that much higher.
Interest Rate Risk
The sensitivity of a fixed-income asset to changes in interest rates is a straightforward mathematical calculation called “modified duration” (heretofore referred to simply as “duration”). Duration can also be calculated for liabilities. You can think of the stream of future payments you will make to yourself in retirement as a “negative bond.” In the example depicted above, a 2% increase in the discount rate caused a 22% decrease in value, which implies a duration of 11.0 for a payment stream of $100,000 per year for 30 years.
If the assets used to fund that payment stream have a duration of less than 11, then the funding ratio since the beginning of the year has gone up. Chances are, most funding ratios have gone up this year, since the duration of the overall bond market, as measured by the iShares Core U.S. Aggregate Bond ETF (AGG), is 6.5. Also, most retirement portfolios have a least some amount of cash, which has a duration of zero.
On the other hand, most retirement portfolios also have a lot invested in stocks. The duration of the stock market is uncertain. Various methodologies have been put forward over the years to estimate the duration of the stock market. The resulting estimates have varied widely, from as low as 2.5 to as high as 20. In my opinion, the soundest approach is that of Liebowitz et. al., based on the relative volatilities of stocks and bonds, their correlation, and the duration of the bond index. Using the Leibowitz formula, I estimate that duration of stocks is about 10. If this is close to accurate, a portfolio comprised of almost any combination of stocks, bonds, and cash would have a duration of less than 11.0, and would have seen its funding ratio increase this year, despite the decline in asset values.
“Immunizing” Your Interest Rate Risk
Keeping a short duration has been good for asset value preservation thus far in 2022. However, if interest rates had gone the other way, instead of an increase in the funding ratio, there would have been a decrease. This is why some pension fund managers seek to match the duration of their assets with the duration of their liabilities, a process known as “immunization.”
The simplest and cheapest method of immunization is “duration matching.” This is simply a matter of maintaining the same duration in the asset portfolio as the duration of the liability stream. Of course, the same asset duration may be obtained with a “bullet” approach (at its most extreme, holding only one bond), a “barbell approach” (holding a balance of very short-duration and very long-duration bonds), or a broadly diversified approach of holding a wide array of bond maturities and durations. (I am ignoring stocks for the moment because of their uncertain duration, but stocks have very high durations and play a very important role in nearly all retirement portfolios of increasing long-term returns and hedging inflation risk.)
Duration measures the impact of a change in interest rates at a particular point on the yield curve. In the case of multiple assets or liabilities, the value-weighted average duration is generally used to measure interest rate risk. However, in that case, the duration would only be accurate in the event of a “parallel” shift in interest rates across the entire yield curve. That almost never happens.
Consequently, when seeking to immunize the funding ratio of a portfolio to changes in interest rates, most pension fund managers pay close attention to the shape of the liability yield curve and seek to more-or-less mimic it with their assets. When the assets intended to fund liabilities behave differently than those liabilities, it is called a “mismatch.”
Bond Ladders are Extreme Immunization
Of course, it is possible to buy specific bonds that will mature at precisely the times that cash flows need to be paid out. This is “cash-flow matching.” Since in most cases the payments occur at regular intervals, this technique is commonly known as a “bond ladder.” Most investors do not attempt to construct their own bond ladder portfolios, since individual bonds tend to be illiquid, with wide bid-ask spreads, and because the lot size for bond transactions tends to be quite large. One approach is to hire a fixed-income manager to construct and maintain a bond ladder, and the management fees for this service are modest. (I mostly see quotes in the .50% range.) In recent years, ETFs from both iShares iBonds and Invesco BulletShares have made it easy and inexpensive to construct a simple laddered portfolio out to about 10 years, with expense ratios of only .07% for Treasury bond funds and .10% for corporate bond funds.
The attraction of bond ladders is partly psychological. An investor can know “for sure” that the first x years (usually up to 10) of expected retirement expenses are completely and safely “covered” by a bond ladder. Part of the pitch given by ladder proponents is that interest rate risk can therefore be ignored, since the intention is to hold the positions to maturity. It is as though by ignoring interest rate risk, the investor can make it go away.
This is irrational behavior. A laddered bond portfolio with a duration of 5.0 has the same interest rate risk as a bond fund with duration of 5.0. Willfully ignoring the risk does not make it go away. If interest rates go up during the holding period, the value of the bonds will go down, whether or not they are sold. In the same way, if the stock market goes down, a stock portfolio loses money even if none of the stocks are sold. Selling does not “lock in” the loss. The loss was already there.
The appeal of a bond ladder is closely related to the appeal of putting assets into various “risk buckets.” Typically, there is a “safe” bucket for near-term and/or emergency spending and a more aggressive bucket for long-term investment purposes. Sometimes there are three buckets, or even more.
The desire to segregate assets into various “buckets” is known as “mental accounting.” Behavioral economists have observed that investors who separate their assets into “safe” and “speculative” portfolios derive psychological comfort from doing so. The bigger the “safe” bucket, the better they feel. In their minds, short-term negative returns from riskier investments can be more easily tolerated knowing that they have a lot tucked away in safe investments. In more extreme cases, only “extra money” that they can “afford to lose” will be allocated to long-term, “speculative” investments.
The problems with mental accounting include:
- Overestimating the safety of the “safe” category (e.g., ignoring inflation risk)
- Over-allocating to low-return investments (e.g., cash equivalents)
- Failing to take full advantage of asset class diversification at the overall portfolio level
- Restricting portfolio allocation flexibility to respond to changes in circumstances
- Ignoring tax efficiencies in asset placement among taxable, tax-deferred, and tax-exempt accounts
Perhaps the most important fallacy of mental accounting is that it ignores the fact that money is fungible. For example, cash from a maturing bond ladder rung spends exactly the same as cash from stock dividends, bond interest payments, or the proceeds from selling a stock or bond. Spending can be funded from anywhere in the portfolio. It spends the same whether it is from the “safe” bucket or the “speculative” bucket. What matters are the risks and returns of the overall portfolio.
Tax-Efficient Asset Location
Mental accounting often gets in the way of tax-efficient asset location. (Click here to see my recent article on this subject.) From a tax-minimization standpoint, it is generally optimal to spend from a taxable portfolio in the early years of retirement in order to maximize the tax-free buildup available in tax-deferred accounts such as an IRA. And from a tax-smart asset-placement standpoint, it is best to allocate stocks to taxable accounts first, because they are more tax-efficient, and to allocate bonds to tax-deferred accounts first because they are less tax-efficient. These facts usually contradict the idea of constructing a bond ladder to fund the first x years of retirement, for example, because most people should invest their taxable accounts heavily or even exclusively in stocks, leaving bonds for their IRA accounts.
Tax-efficient asset placement also usually runs counter to the idea of maintaining a large portfolio of liquid cash equivalents that can easily be drawn upon for spending purposes. As long as taxable investments are reasonably liquid, there is no reason (apart from mental accounting) for an emphasis on extreme liquidity and safety in taxable accounts. Spending needs can easily be met with automatic monthly withdrawals from a taxable account, for example. Allocation among stocks, bonds, and cash should be established for strategic reasons of risk and return at the overall portfolio level. Then, given the strategic asset allocation targets (however conservative or aggressive they may be), assets should be placed in taxable, tax-deferred (401k and IRA), and tax-free (Roth 401k and Roth IRA) accounts to minimize expected lifetime taxes.
As investors are now finding out, it can be perilous to ignore inflation. Over the course of a 30-year retirement, the value of a dollar of savings can depreciate significantly, as shown in the graph below. Even relatively mild rates of inflation, such as the Fed’s target of 2%, will materially erode the purchasing power of a retirement nest egg over time.
It is vital to protect against inflation risk in your retirement portfolio! So-called low-risk investments usually focus on short-term volatility and ignore long-term inflation risk. Since their yield is so paltry, the purchasing power of cash equivalent investments (the “lowest risk” investments) will erode at almost the rate of inflation. Nominal bond investments (including bond ladders), will not protect against inflation risk either. In fact, in periods of rising inflation, nominal bonds will tend to lose money fast, with longer-dated maturities (of higher duration) losing the greatest amounts.
I have written elsewhere about “Investing to Hedge Inflation Risk.” Based on my own research and that of others, nominal bonds, particularly long-term Treasury bonds, are the worst investments in an environment of rising inflation. The best inflation hedges include:
- Treasury Inflation-Protected Securities (TIPS), particularly short-term TIPS
- Commodity-related stocks (energy, natural resources, materials, mining, etc.)
- Stocks, including international stocks
- Real estate, including international real estate
Lowering Portfolio Risk with TIPS
Treasury Inflation-Protected Securities (TIPS) can play a significant role in protecting against inflation. And as fixed-income securities, TIPS also have a low correlation with stocks, diversifying stock market risk and lowering overall portfolio volatility. (Click here to see my recent investment article on TIPS.)
Because they are indexed to inflation, TIPS are truly the only “risk-free asset.” Treasury bonds certainly are not. Only TIPS provide a guaranteed real return (backed by the U.S. government) and preservation of purchasing power (based on the CPI Index).
Consequently, investors seeking to reduce the interest rate risk of their expected retirement liabilities should consider emphasizing TIPS rather than Treasury or corporate bonds because only TIPS will also immunize their inflation risk.
The dominant risk in most portfolios is stock market risk—which is often more than 90% of total risk in a portfolio. (Click here for my article on the relative importance of stock market vs bond market risk.) So, the role of non-stock asset classes is primarily to diversify stock market risk and thereby lower overall portfolio volatility. “Correlation” is the statistic that measures how two assets move in relation to each other. The lower the correlation, the better they diversify each other.
The mix of non-stock assets used to diversify stock market risk will have a significant influence on overall portfolio volatility. As shown above, Treasury bonds (green line) are the best for diversifying stock market risk because they have the lowest correlation to stocks. The problems with Treasurys are that 1) they have low yields (expected returns) and 2) they are terrible at protecting against inflation risk. But during a panic, they are wonderful “safe-haven” investments and tend to perform very well, so having some Treasury bonds is optimal for most investors.
Corporate bonds (blue line) are not much better at protecting against inflation than Treasury bonds. And they have a much higher correlation with stocks, making them weaker diversifiers. By nature, corporate bonds combine interest rate risk and credit risk. Credit risk is highly correlated with stock market risk. The good thing about corporate bonds is that they have higher yields than Treasury bonds, particularly in the post-2008 era of Fed quantitative easing, which has artificially driven down the yields on government bonds.
Despite their government guarantee, it appears that bond market investors do not assign to TIPS (orange line) nearly the same safe-haven status as nominal Treasury bonds, since their correlation with stocks is almost as high as that of corporate bonds. Part of this may have to do with the lower level of liquidity of TIPS bonds compared to nominal Treasurys. Also, a market selloff caused by concern about an impending recession would tend to penalize TIPS relative to Treasurys because it would tend to lower the inflation expectations that drive the Treasury-TIPS yield spread. Consequently, most of the time TIPS have a higher correlation with stocks than Treasurys.
On the other hand, an “inflation scare” is likely to lower the correlation of TIPS and stocks, since TIPS would rise in price and stocks (along with all nominal bonds, Treasurys and corporates both) would fall in price. A period of rising inflationary expectations would be the ideal time to emphasize TIPS in a portfolio. We have been living through such a time in recent months.
Note that it is changes in inflationary expectations that influence the returns of TIPS, not high inflation itself. If, as some contend, we are at “peak inflation,” then inflationary expectations will deflate and TIPS will underperform straight Treasury bonds. However, it seems just as likely that inflationary expectations will continue to rise, providing a boost to TIPS. In any event, because of their unique roll among fixed-income investments in hedging inflation, TIPS should be included in most portfolios.
Summary and Conclusions
- Higher interest rates are a blessing, and not a curse, for your retirement savings.
- The discounted present value of your future spending needs has probably declined more than the value of your retirement nest egg.
- Consequently, your “funding ratio” (assets/liabilities) has gone up.
- Retirement investors should use asset-liability management, just like pension plans do.
- Managing the liabilities of your retirement is harder because of unique risks:
- Event risk – the risk of large, unexpected expenses, such as a health crisis.
- Longevity risk – the risk that you will live a lot longer than you expect.
- Inflation risk – the risk that inflation will be a lot higher than you expect.
- One important risk shared by retirement investors and pension plans is interest rate risk.
- Duration measures how much the value of a bond will change for a 1% change in interest rates.
- The payments needed to fund a 30-year retirement have a very high duration (about 11.0, higher than the overall bond market duration of 6.5).
- The stock market has a higher duration than the bond market, but it is difficult to estimate.
- My estimate of stock market duration is 10.0.
- Duration matching immunization involves matching the duration of assets to the duration of liabilities.
- Cash-flow matching immunization involves pairing the cash flows of individual assets (usually bonds) to the cash flows of particular liabilities, often a regular intervals.
- This technique, known as a bond ladder, is the most extreme form of immunization.
- Usually, bond ladders are used to fund only the first x years (x<10) of retirement spending.
- Bond ladders do not eliminate interest rate risk, but they can make investors “feel” they can safely ignore it for that segment of their portfolio.
- However, a bond ladder with a duration of 5.0 has the same level of interest rate risk as a bond fund with a duration of 5.0.
- Segregating portfolio assets into various “buckets” (for example, safe vs speculative) is a form irrational behavior known as “mental accounting.”
- Money is fungible and spends the same no matter which bucket, account, or asset it comes from.
- What investors should focus on are the various risks and long-term expected return of their overall retirement portfolio.
- Maintaining a “whole portfolio” viewpoint also enables tax-efficient asset placement.
- So-called “low-risk” investments often focus on avoiding short-term volatility and ignore long-term inflation risk.
- Treasury Inflation-Protected Securities (TIPS) are fixed-income investments that can lower both inflation risk and interest rate risk while diversifying stock market risk.
- Nearly all retirement portfolios should have a balance of bonds (including TIPS) and stocks.