Journal of Financial Planning; June 2014
Participants: David Blanchett, CFP®, CFA; Brent Burns; Larry Frank, CFP®; and Dave Yeske, Ph.D., CFP®
David Blanchett, CFP®, CFA, is head of retirement research at Morningstar Investment Management. He also serves on Morningstar’s asset allocation committee. His research has been widely published in industry journals, including the Journal of Financial Planning.
Brent Burns is president and co-founder of Asset Dedication, a San Francisco-based money management firm known for its bond portfolios where individual bonds are used to match cash flow needs, particularly for those in retirement.
Larry Frank, CFP®, is a registered investment adviser and author in Roseville, California. He has an MBA from the University of South Dakota and undergraduate degree in physics from the University of Minnesota. He has published several research papers in the Journal of Financial Planning.
Dave Yeske, Ph.D., CFP®, is managing director at Yeske Buie, with offices in San Francisco and Vienna, Virginia, providing an integrated service that includes upfront and ongoing financial planning, along with the management of client assets for a single asset-based fee. The firm currently manages more than half a billion in client assets.
Michael E. Kitces, CFP®, CLU®, ChFC®, RHU, REBC, is a partner and the director of research for Pinnacle Advisory Group, a private wealth management firm in Columbia, Maryland, that oversees approximately $1.3 billion of client assets. He is the publisher of the e-newsletter The Kitces Report and the financial planning industry blog Nerd’s Eye View through his website www.kitces.com. He also serves as practitioner editor of the Journal. Follow him on Twitter at @MichaelKitces.
Across the country, financial planners and their clients are having conversations about interest rates. Some clients—and planners—are worried about a rising-rate environment and what it could mean to portfolios and retirement income. Others are wondering if they should be worried at all. The Journal recently sat down with some of the leading minds in the profession—including planners, researchers, and portfolio managers—to gain some perspective on the questions: Should we be worried about rising interest rates, and if so, what are some tools to employ?
Kitces: Let’s start with what’s likely on everyone’s minds already. How concerned should advisers be about the potential for rising interest rates?
Burns: I think that rising rates get a lot of media attention when you see little blips here and there. We’ve done a lot of research around this, obviously because bonds are at the center of what we do, and we’ve looked at: What are these impacts of rising rates on withdrawal rates? What are the impacts of rising rates on total return? And the thing about a rising-rate environment is that it’s not actually going to be all that newsworthy. So, unlike the stock market, when interest rates rise—and we saw that in May and June of 2013—maybe you’d see a bond fund lose 5 percent, depending on its duration. You never see that big, dramatic, downward move like you would in the stock market.
Because of the way that bonds work, so long as you have coupon bonds in the portfolio, it has this little ATM machine that keeps ticking out cash flows and adding to the return, so even if the price goes down, you’ve got coupons coming in that help make things better, and so it’s never particularly dramatic.
A lot of folks have looked at the market since 1981. So interest rates peaked in 1981, and they’ve basically been falling ever since. But what a lot of folks don’t know is that if you go back much further and start at 1950, rates were about where they are now—they rose for about 30 years, and then they fell for about 30 years. When you look at what happened in that long-term, rising-rate environment, it reveals the difference between individual bonds and bond funds, and I think that’s the part that’s important, particularly when it comes to modeling retirement outcomes and Monte Carlo and things like that, because it’s a very different environment, particularly from a total return perspective. As interest rates are rising and you’ve got bond funds that are turning over inside their portfolio and the rates rise, they’re recognizing these losses, whereas individual bonds, you hold them to maturity—you get the yield to maturity, and that’s your worst-case scenario.
What you see over that period of rising rates is this malaise where total returns [on bonds] lag the coupons of the underlying bonds, and so, in a bond fund structure you’ve got an asset that’s returning less than the cash flow it’s generating, because the principal keeps taking a hit, and the impact of that, particularly on those in retirement or those who are getting close to retirement where they need that cash flow predictability in their portfolio, is that it’s going to be less predictable.
The period of interest rates from 1950 to 1981 on the 10-year Treasury index, total return on that was 2.2 percent, whereas if you go from 1981 to 2013, it’s about 10.9 percent, so a huge difference in total return over those two periods, even though they’re roughly the same length, because of the structure of a rising rate within a bond fund. So it’s really that malaise I think is what people ought to be concerned about. It’s not a dramatic thing, but it’s a component. The bigger the role that fixed income plays in asset allocation, the bigger the impact of that drag.
Frank: If you’re using shorter-term bonds, the investor is able to more frequently roll over the principal at the new, higher rate. From a total return perspective, the role of short-term bonds is more of a shock absorber to the overall portfolio volatility. And if you use the short-term bonds exclusively throughout whatever environment, you get more of that shock absorber effect and are able to manage the volatility of the portfolio more from dissimilar price movement. Short-term bond characteristics are less similar to stock characteristics. Long-term bond characteristics are more similar to stock characteristics, so by having short-term bonds, the dissimilarity in the portfolio is what you can target from a total return perspective.
Yeske: Even with intermediate-term bonds, if you have time on your side, the impact of a given change in interest rates isn’t necessarily catastrophic.
The thing I worry about is the spending client. We have a rebalancing approach where, under certain circumstances, we’re going to spend down the bonds if there’s a cyclical downturn in the stock market. With those spending clients, if the bond price takes a hit and we have to liquidate it because they’re spending from bonds, they’re not going to recover from that. They’re not going to benefit from the higher reinvestment rate. They’re not going to benefit from the fact that the bond would mature at par, so that tends to lead us to that very short end of the [bond] spectrum when interest rates are low like they are now and we’re worried about rising rates.
Kitces: We’ve mentioned at least three different roles that bonds can play. There’s bonds as a shock absorber. There’s bonds as something that gives you return in your portfolio. There’s bonds as cash flows, particularly for retirement. Should our treatment of bonds vary depending on how we’re thinking about them or what role we’re assigning to them?
Burns: Bonds do all of those things. They generate returns, and they dampen volatility, and they generate cash flows, so you could get that triple duty, I suppose. But the thing that they’re best at, is when the markets turn down, and liquidity goes away, if you’ve timed out bonds to match your cash flow needs (at least with individual bonds), then the liquidity is delivered when you need it, even if there’s nothing else in your portfolio that you could sell.
Oftentimes, stocks and bonds are not going down at the same time, but if you look at, say the 1969 scenario, then both stocks and bonds are down, and if you’re doing a systematic withdrawal, where are you going to take it from? I guess the one that lost less?
The thing that bonds are best at—individual bonds are what I’m talking about here—is that unlike any other security, they tell you exactly how much they’re going to pay you and when they’re going to pay you. You can take advantage of that mathematically just by timing things out to match up your needs.
Blanchett: I would say yes as well. When we build portfolios for clients, we have different target asset allocations for someone who is in accumulation and someone who is in retirement.
Kitces: I’m intrigued by this. Should we be viewing the role and the risk of bonds very differently between accumulator clients and retiring clients?
Yeske: We use exactly the same instrument to get our bond exposure for pre-retirement, post-retirement, or for accumulation and decumulation, if you prefer those labels. The allocation to that asset changes; it gets bigger post-retirement. We want that bridge to be bigger, but in both cases, we’re looking forward to it being a relatively stable reserve.
When stocks are rising relative to bonds, we’re shaving the stock allocations back and adding to the bond allocation, and with stocks falling relative to bonds, we’re not doing the reverse [for our retired clients]. We’re preserving that bridge to meet spending needs.
Back in February and March of 2009, for our pre-retirement clients, we were selling bonds like crazy and buying stocks. We look for stability in both instances so that depending on the interest rate environment, we can adjust our average maturity or a duration accordingly. Right now, we’re using one fund (we’ve had as many as three), and the duration is 0.9. As Brent pointed out, there are times when stocks and bonds can both go down. Well, we don’t want that to be happening. We want that stable reserve so we have a pool from which to rebalance into the stocks during a time of falling stock prices.
Kitces: What are some tools and solutions for advisers if they are concerned about rising rates?
Burns: We know that we’re at relatively historic lows, so the only logical direction to move is up. The question is, when? I think the real challenge for bond investors is not being caught in the catch-22. The reason I say it’s a catch-22 is, if interest rates rise and you have any duration on your bond fund, the more duration you have, the bigger the decline in the price. So if you’re worried about that, you shorten your duration, which means that you shorten the maturities. If you look at the 30-day SEC yield on your fund, it’s going to be very low. The catch-22 is that if you stay short and interest rates stay low for a prolonged period of time, which we’ve seen in Japan and lots of other places, and you weren’t able to take on duration, your opportunity cost starts to look pretty big.
Let’s say you’ve got a spending need that’s out five years, but you’re funding that with a bond fund that’s got a 0.9 duration. That means you’re much shorter than you would need to be if you owned an individual bond that went out further where you would make more. However, if you took a bond fund that had a five-year duration and then interest rates did rise, then it would take a much greater hit than the fund with the 0.9 duration, and then you wouldn’t have enough money because you lost principal.
Some of it is timing sensitive, but when you have that combination of sequence risk and the unknown of when rates will rise, the real trade-off is: Am I willing to lock up an interest rate that is this low for whatever period of time is necessary to wait? And if I’m willing to do that, how fast would rates need to rise in order for some other investment to be worth waiting for?
We’ve got some really great data on interest rates going back to 1800. They don’t rise as fast as you’d think they would. Most of the time when we see rates rise, they’re only rising somewhere around 25 basis points [in short movements].
It’s a real challenge for the bond fund investor, because there’s a lot of opportunity costs; a lot of potential returns that you give up because you’re worried about the potential rising rates, but you don’t know when they’re coming.
Kitces: David [Blanchett], when you look at this from the research perspective, how should we be thinking about the trade-off between: the good news is, bonds don’t lose 40 percent in a market crash; the bad news is, they don’t yield enough to give you much retirement income?
Blanchett: If you go back long term, bonds have yielded 5.5 to 6 percent per year on average. Today’s is about 3 percent. The problem is—whether you buy a bond mutual fund or an individual bond—you’re effectively buying certainty. If you buy a bond at 3 percent, you’re only going to earn 3 percent for the duration that you hold the bond. That could have a significant impact on the success of a retirement strategy, because if that person were to retire, that’s effectively 2 percent less over the first 10 years, so it can have a potential negative impact on the long-term success of retirees today, because they just can’t earn the same returns they could have earned historically, on average.
Burns: I think a lot of folks don’t recognize that many of the retirement software packages that are running Monte Carlo analyses don’t have data sets with the rising-rate environment in them, because a lot of them go back to the ’70s, which is not far enough to capture much of that rising-rate environment or the flat-rate environment that existed before that. The Monte Carlo overstates the total return that bonds in general would deliver, so they are led to believe that we’ve got a 10.9 percent combined long-term total return, and that’s not likely the case going forward; it’s certainly not the case given where we’re starting from.
I think what David mentioned is right. You buy certainty. You’re locking in 3 percent, and that means you’re having to lean much more heavily on your equities. As soon as your withdrawal rate is above the yield curve, you know that bonds are actually hurting your ability to meet your cash flow needs, although they do provide stability. But what they’re contributing from a return perspective, they don’t have enough juice in them to get you where you want to go.
Kitces: Larry, you’ve done some recent work around annuitization. Does annuitization give us some alternative to navigating bonds if we’re trying to manage low yields and the risk of rising rates? How does the value of mortality credit factor in? Or, do we get into the problem of annuitization of people having to worry about locking in low yields?
Frank: More of the latter. The longer period of time that you’re exposed to that fixed income, you get into that fixed income dilemma where the long-term purchasing power deteriorates, and so annuitization in the current environment with current rates was [according to my recent research] more appropriate for older retirees who manage their assets until they’re older and then annuitize, where there is a shorter period of time with that exposure to the inflation effect, and also a shorter period that gives them a higher withdrawal rate because of their ages, etc. Once rates start rising on paper, then there’s a methodology to continue to re-evaluate your own data, or to break even with annuitization. (See “Lifetime Expected Income Breakeven Comparison between SPIAs and Managed Portfolios” in the April 2014 issue of the Journal.)
Blanchett: When talking about annuities, I think it’s always important to note that Social Security is the best annuity around today, because it’s not priced upon interest rates.
Kitces: Good point. So what about this broad category of stuff we call “alternative investments?” Are alternatives a good or an appropriate place to look to deal with low yields and fear of rising rates, or do we create more problems than we solve?
Frank: If you use an index fund, like
the S&P 500, there’s already a pretty high percentage of those index companies that are commodity exposed [so outright commodities funds may not be necessary]. When you start getting into alternatives, you also have to start looking closely at the expenses of managing those funds.
Burns: I think there are some interesting alternatives that are not part of the income piece, but are part of a more diversified and stable total return that could be interesting, but bonds are unique. Bonds mature when they tell you they’re going to, and they deliver that coupon. All the other alternatives have risks that are inherent to them.
I think things like lottery receivables and life settlements, which are kind of distasteful maybe, but what the asset is based on, it’s got no correlation to anything, and it does have a relatively predictable maturity schedule, but it’s much too slippery to rely upon for a paycheck. For somebody who’s an accumulator, they’re okay. They provide some stability, they’ve got some extra juice in them, but they’re kind of in between bonds and stocks, and maybe they bring some interesting returns through the low correlation, but I don’t think that they’re alternatives to bonds.
Kitces: David [Blanchett], from a research perspective, is it better to add in more alternatives in lieu of the stocks, or in lieu of the bonds? What do you see around alternatives and sustainable retirement income?
Blanchett: I think it’s based upon your assumptions. If you add an asset class that reduces the risk and it increases the return of your portfolio, it improves the outcome. For me, it’s a question of: What do you think is going to happen with whatever alternative that you’re modeling? Then that will affect the simulations accordingly.
We use some commodities in our allocations, and some real estate, but we’re still very much equities and bonds.
Yeske: Are we using alternatives [as a substitute for bonds]? The answer is no. We do have real estate securities in there. But we’re not fans of investing in commodities as an asset class. We fall into the camp of believing that commodities really don’t have intrinsic value. They only have value in use.
This is a gross simplification, but if you look at the stock market, every publicly traded company out there is the producer of a commodity or a consumer of a commodity or several, and so if you want to access the commodity price cycles, it’s much more nuanced, we think, to do so via the stock market, because if you lump commodities together the way they’re often lumped together, you’ve got an asset class that has no economic rational. The only underlying economic driver is a common sensitivity to inflation.
When prices in any given commodity rise or spike, I think historically you find that almost invariably it’s because of a bottle neck, and historically, I think you also often find that in general, human beings are pretty damned ingenious at getting around bottle necks, and so who wants to be betting against human ingenuity? Not me.
Kitces: Let’s shift tracks a bit. How are you communicating to clients who have fears of rising rates?
Frank: It’s explaining clearly the strategy that the adviser is using, and how it addresses rising rates both on the interest rate side and on the inflation side, which is that loss of purchasing power. They tend to go hand in hand, but sometimes there is a little disconnect. Right now it’s more expected inflation; it’s not actual inflation, so it’s looking at what is actually happening with the client’s own expenses specifically, and ignoring the news about national averages and all the worries that the media has, and explaining how you address that with the strategy that you have in place, whatever school of thought you come from.
Yeske: In terms of client communication, I think we’ve been ahead of the curve in addressing the risks of a rising interest rate environment and taking action accordingly. We’ve done a series of cascading changes over the last year or year and a half, and as we’ve done that, we’ve continuously communicated with clients what we were doing and why we were doing it. From the clients who had maybe heard about a bond bubble or who understood the risks of rising interest rates, we’d get a response along the lines of, “Thank you, glad you’re doing that.”
As far as inflation, interestingly, when the Fed was first taking heroic actions back in late 2008 and beyond, there was a lot more talk in the press about how inflationary that could be, and therefore, it was on our clients’ minds that we might be building a fire that would consume us somewhere down the road. Those issues and concerns among clients seemed to have faded away in the face of persistent slow growth and a global environment that’s constantly shifting a little bit more toward deflation than inflation. That may be a future conversation, but right now, that one seems to have receded into the background.
We’re all having lots of conversations because of the low interest rate environment, both on cash investments and bonds. What I find myself saying more and more is that we’re living in a particular environment in which safe equals something pretty damn close to zero, and that environment will not persist forever, but that is the environment now, and trying to overcome it will too often lead us down a dangerous path.
Sometimes I just have to tell clients to sit back and breathe and accept the fact that extraordinary measures taken by the Federal Reserve and other central banks have left us in a situation where safe equals zero or near zero, and again, it won’t be that way forever, but we may just have to live with that for a while.
Kitces: When it comes to owning bonds, clients can often go in three directions. They don’t want to own bonds, they’d rather own cash. They don’t want to own bonds, they’d rather own stocks, especially when stocks are going up. Or, they don’t want to own bonds, they want to own some alternative that would have better returns than bonds. What do you say to clients who want to abandon bonds in one direction or the other?
Burns: What we do is we price it for them. We get a lot of push back that those rates are awfully low, and they ask, “Why would I want to buy bonds with that kind of yield right now?” Of course, our answer to that is: What else are you going to do with your money? If you’re going to bury it in a Mason jar in the backyard, then the bonds will yield better. If you’re going to put it in cash, that’s about the same as putting it in the Mason jar. If you’re going to wait for rates to rise, how fast do they have to rise in order for your strategy to pay off? And if you’re going to wait, where are you going to wait? If you’re going to wait in a bond fund, and then rates rise, if you’ve got any duration, you may have taken a hit.
Sometimes [rates] move very quickly, but most of the time, they don’t move quickly enough for people to not—certainly within a 10-year window—just go ahead and buy the individual bond now.
When clients look at things like, maybe instead of using bonds for my paycheck, I’ll use dividends because those are really consistent, there’s a risk—they are consistent, until they aren’t. Look at 2008, that’s a great example. Bonds are not in your portfolio for when things are going well, right? When things are going well, we all wish we had all stocks. But when things are going poorly, do you have a part of your portfolio you can lean on that’s truly the buttress that holds that thing up so you have the fortitude to ride through that market?
You’re also buying time. So if we’re building a portfolio that’s got income for years one, two, three, four, and five, I now have five years of income that’s set aside and taken off the table, so I have some time to ride through that market.
Frank: I agree with the concept, and then the application is having that shorter-term distribution reservoir that can address that. And that may have some individual bonds, shorter-term bond funds, and cash. The whole purpose is to bridge them through that cycle. You can design that bridge to be as many years as desired.
Kitces: How should we weave this together with delaying Social Security, or the rest of the plan, or the entire retirement income strategy?
Frank: If you want to look at Social Security, and if you have a couple, then you’ve got the capability of doing some of those maximization strategies and looking at the portfolio, and maybe buying some years to bridge the spending pattern until Social Security is higher. You could do that with single people as well. It all has to be looked at from the larger picture, including pensions, and then evaluating when an immediate annuity might fit in the picture, depending on their payout rate.
Burns: Particularly because we’re a liability-driven shop, I’ll say, “Absolutely [there’s value to coordinating these].” I think there is tremendous value in making sure that people optimize their Social Security. David [Blanchett], I know you’ve got your “Alpha, Beta, and Now ... Gamma” work that you’ve done where you’ve looked at some of the various pieces, whether it’s asset location, Social Security timing, liability matching, how all of those things are adding value independently from what the investments are doing. And the value is tremendous. I think it’s really important to build the portfolio around what the final spending needs are.
At Asset Dedication, we always hinge on, “What are the spending needs?” That’s what drives the way we build portfolios. I think that it’s really important to figure out what you’re going to own, and why you’re going to own it, and more importantly, when you’re going to own it. When is this asset going to be used to spend? Is it 20 years from now, or is it five years from now? Depending on what the needs are, that’s what’s going to determine what I’m going to own and why I’m going to own it.
Kitces: There is this dynamic between what I frame as liability-driven investing—let’s be very specific about matching our cash flows to our spending needs—versus a more holistic, total return style approach. David [Blanchett], you’ve done research that ties to both of these, so do you see one as stronger than the other, or at the end of the day, does it not matter as long as you implement it right?
Blanchett: I think the investors who are in accumulation should focus more on total return, because their liability is 40 years out, and as the individual approaches that goal, they have to think about the characteristics of that goal when it comes to building a portfolio, which is why you have different portfolios for different investors, even if it’s the same equity targets. Even though you’re targeting, say, 50 percent stocks, you may have a different set of allocations among the equity pieces and the fixed income pieces, because that investor has a different timeframe. So I think it makes a lot of sense to have investors have portfolios that target different goals. If your goal is to fund college in five years, that may require a different portfolio than funding a retirement in 30 years.
Kitces: And so you really can have a scenario of more total return oriented in the accumulation phase, and more cash-flow matching specific as we move into retirement?
Burns: That makes sense to me as well, but I would say you don’t have to consider [liability-driven and total return investing] separately. I think that LDI is really just special-case total return where your total return is positive and it’s linked to your spending needs, but there are plenty of opportunities to take the upside. We certainly saw this when rates were falling when we were building portfolios in the late ’90s and early 2000s. It’s better to liquidate the portfolio, because if you sell the bonds at maturity, you’d actually have less than if you liquidated it now and then invested the proceeds a little differently. You still want to protect them, obviously, but you’ve got some extra money, so why not take it? I think with LDI, there’s total return to the upside—the possibility still exists there—it just caps the downside.
One thing I think is important that we didn’t get much of a chance to touch on, and this is my view—stocks and bonds, individual bonds in particular, are very different instruments, so we can look at them differently. When interest rates rise, you may see on paper that the value of this bond will go down, but that’s okay because we bought it for the cash flow characteristics, and it’s still going to deliver the cash flows when we expect them the same way as the day we bought it.
Frank: When you look at the entire lifetime of the retiree—call it 30 years or 35 years—you’re still looking at a total return, because eventually that seven- or 10-year period that you’ve got set aside for the income part using bonds or bond funds with an income component, needs to be refilled, rebalanced. You’ve got to go back to the stock part, the long-term part, for rebalancing, and that’s where the uncertainty is. What’s going to happen after you’ve gone past this income period?
The perception advisers have, in general, is that the choice is only between total return or liability matching. In truth, it is both. This is easier to see when there are two retirement portfolio [segments]: one for long-term growth, which has an allocation that matches the retiree’s risk tolerance; and the second is the near-term, defined by any length of time to bridge any coming market decline, be it three, five, or seven years, for example. Yes, these could be all in one portfolio, however it is easier to help the retiree visualize the differences by separating components so they are not in one portfolio. As money is spent year by year, the income component shrinks; the only source to refill the bridge is from long-term resources. If the long-term resources are down due to markets, then the refill can be temporarily halted. But, eventually resources spent need to be replaced. That is a dynamic process that happens during each annual review.
So, the conversation about bonds needs to fit into the context of the bigger picture, which includes stocks and other stores of wealth, to also include the short-term versus long-term differences, and how to integrate both total return and liability matching concepts. All of this is where David Blanchett’s Gamma concept comes in.
Blanchett: You know, it’s interesting, because I’ve been at Morningstar for a little over two years now, and I was at a place previously where we always had relatively low duration portfolios, always fearing the rates might rise, and it cost our clients money because rates haven’t risen enough. So obviously it’s difficult to balance this fear of rising rates because we tend to move the duration downward to protect, but I think you have to have a more balanced perspective because it’s tough to time the market, and even if you do believe that rates will rise, the question is still when?
Remember, that if you do have clients invested in a low-duration portfolio, there’s a large loss of opportunity cost there based on the fact that they’re earning particularly nothing, waiting for rates to eventually rise.