Over the last thirty years, interest rates have steadily fallen,
pumping up bond returns. Now that rates have hit rock bottom, many
investors may find themselves in the middle of an imminent storm -
the burst of the bond bubble. The potential for higher interest
rates and inflation are brewing; thus, if we experience rising
rates, bond prices have to fall. What does this mean for those who
are invested with typical asset allocations prescribed for
retirement?
Mainstream investment advice says that those who are retiring
need to dial down their equity exposure and concentrate a larger
percentage of their portfolio to "safer" or "more conservative"
investments - bonds and cash. Many people believe that bonds add
safety to a portfolio; however, the primary function of bonds in a
retirement portfolio is to produce income.
In a standard retirement portfolio, you'll likely have 60%
bonds, 30% stocks, and 10% cash (or something pretty close). Cash
is seen as a buffer in a portfolio because of its relative safety,
and the stock component is needed for portfolio growth. Bonds
generate fixed income; however, it's rarely enough to fully support
the investor.
What happens, then, is portfolio managers end up having to sell
assets to produce more income. This is perfectly acceptable, except
when it happens at a loss. Selling assets at a loss can create a
serious problem known as
reverse compounding
. Reverse compounding can damage a portfolio to the point of no
return, and unfortunately, it's only a matter of time before the
retiree
runs out of money
.
So, if interest rates begin to rise and bond prices start
dropping, what does that mean for the retired investor with his
portfolio in 60% bonds? If you're holding bonds to maturity, it
might not matter to you. But for the majority of investors, it
means bond funds become a whole lot less attractive all of a
sudden. These funds hold a "basket" of bonds with varied maturity
dates, so the portfolio can take a beating as interest rates
rise.
Start selling these at a loss because you need more income, and
well, it's obvious why this way of investing in retirement is
severely flawed. Lower bond prices will make life hard on anyone
who has to pay for retirement.
The number one job of a retirement portfolio is to produce the
cash flow necessary to fill the gap between your retirement
expenses and any guaranteed sources of income that you may have
(Social Security, pensions, etc...). Selling assets at a permanent
loss and exposing yourself to the risks of reverse compounding is
not acceptable. Take a good hard look at your portfolio and assess
whether it's designed to meet your needs and address the
challenges. If not, there is
an answer
... you just have to be willing to make the changes necessary to
position yourself for the best that your golden years have to
offer.
The intent of this article is to help expand your financial
education. Although the information included may be relevant to
your particular situation, it is not meant to be personalized
advice. When it comes to investing, insurance and financial
planning, it is important to speak to a professional and get advice
that is tailored to your unique, individual situation. All
investments involve risk including possible loss of principal.
Investment objectives, risks and other information are contained in
the Snider Investment Method Owner's Manual; read and consider them
carefully before investing. More information can be found on our
website or by calling 1-888-6SNIDER. Past performance is not
indicative of future results.