It’s been rightfully said that today’s investors, likely many of your clients and particularly those of the pre-retirement sort, are both ‘scarred’ and ‘skeptical.’ They’re scarred from the $12.8 trillion of net worth they lost in 2008 and skeptical of their chances of ever getting it back. As if that weren’t enough, now we can add ‘scared’ to the mix. Why? Because just as some 76 million Americans move into the retirement corridor, not only are the pleasant tailwinds of recent decades fading, a financial storm is taking shape. Investors who expected to rely on fixed income as a significant portion of their retirement portfolio allocation will have to make preparations.
Where You Start Matters
When it comes to investing, particularly for retirement, the starting point matters, and there’s no denying this generation of pre-retirees suffered a major setback. By most accounts, Americans lost some 20% of their collective wealth as a result of the financial crisis—the largest loss of wealth since World War II, by the way—and to date have recovered less than half the amount. The ‘wealth effect’ of the 1990s, i.e., rising equities and rising home values, was essentially wiped out. It’s been slow to come back, and by all appearance, the path to recovery is only going to get more difficult.
At this hour, virtually every economic risk factor we follow points to continued volatility. On a global basis, our good friends in Europe are struggling mightily with a sovereign debt crisis, while our less well-known acquaintances in China and the emerging markets are battling their own economic slowdowns. Here at home, our own economy labors under $16 trillion of debt, declining corporate earnings, and the possibility of a double-dip recession if we fall off the ‘Fiscal Cliff.’ There’s also the small matter of a presidential election. At the least, it’s a confluence of factors that complicates the investment picture for any American, and it’s hardly the least of our worries.
Despite, or maybe because of, the difficulties of this current environment, investors nearing retirement are, as conventional wisdom would dictate, moving to fixed income in a meaningful way. Recent asset flow data from the Investment Company Institute show that, with only a handful of exceptions, net mutual fund bond flows have consistently trumped equity fund flows on a monthly basis over the last five years. Unfortunately enough, these folks are re-allocating their retirement portfolios at or near the bottom of a 30-year secular decline in interest rates.
Since yield is predictive of future returns, and since there is little room for interest rates to fall from here, there is a bleak outlook for returns. Duration risk is exceptionally high as well, as evidenced by the August 31, 2012 modified Duration of the 30-year Treasury at 20.1 years at 2.7% yield. With a yield this low, just a 1% rise in yield would result in a 20% price decline. Simply put, investors entering retirement are facing an extraordinary risk from rising interest rates on the back of several years of global stimulus.