Bond Risks in Retirement
We frequently talk about sequence of return risk for a retiree’s portfolio. For many people, that risk is associated with equities only; however, bonds carry market risks as well.
Unfortunately, many Americans have looked toward bonds as a safe vehicle since the financial crisis. Since that time, interest rates have generally been falling, making bonds an upward trend in prices. Bonds can fit into many portfolios, but we need to consider the risks in today’s economic environment. Three things to consider:
- Interest rates are at near all-time lows. When interest rates rise, bond prices decline – rates and bond prices move in opposite directions. Many planners have increased durations in their portfolios to provide more yield to their clients. However, the additional duration poses additional interest rate risk. For example, a five-year bond will have a 4.6 percent decline in value for a 1 percent increase in interest rates. The changes in bond prices are steeper the longer the duration. A 10-year duration bond would have an 8.7 percent drop in value due to the same 1 percent rise in interest rate. Given where we are on all segments of the yield curve, it’s likely to see rate increases over the next three to five years. This potentially creates sequencing risk on what many investors believe to be safety.
- Coupon rates continue to be low. I would argue that they are artificially low due to the financial crisis and the struggling economy. Regardless, it takes more than two times the capital to generate the same income than it did pre-financial crisis. For example, you could find a 5 percent coupon in 2009-10. It would only take $400,000 of capital to generate $20,000 of income. Today, it would take $815,000 to re-create the $20,000 of annual income. Notwithstanding a reversal of current monetary policy, these rates are likely to rise but very slowly. So, retirees don’t benefit from waiting.
- Bonds can certainly be sold quickly in today’s markets. By definition, that makes the instrument highly liquid. However, in reality, bonds may be sold at a substantial loss as described above. Depending on performance, bonds can be illiquid due to market conditions, and you can’t dictate when an emergency requires liquidation of capital for specific purposes.
So, how do annuities stack up to the risks of bond portfolios?
- Regardless of fixed or indexed, annuities provide no downside market risks. While fixed annuities may limit the growth potential, they protect the downside, making them more appropriate than ever to position into the portfolio.
- Income generation can be just as healthy using income riders versus relying on the coupon rate of the bond. In today’s market place, the client can easily find 4.5-5.0 percent distribution rates on capital. This means you would only need $400,000-$445,000 in order to generate the same $20,000.
- While most annuities have surrender charges due to their market protection and general account status, most products provide liquidity each year up to a certain percentage and for critical illnesses. In many cases, the surrender charge can be less than the loss of a bond value change, especially for longer durations.
A bond portfolio provides diversity opposite an equity asset. And, bonds can be extremely useful as a part of the asset allocation strategy to maximize the efficient frontier. A mix of bonds and equities lessens the volatility while increasing the return. However, we need to consider alternatives to bonds in the current rate and economic conditions. There is as much risk in bonds as there is in the equity market in the current climate.
Look at your bond holdings. If those clients are getting ready to turn those bonds into income, you might consider the advantages of annuities. The rules change when you turn accumulation into income. When the rules change, you need to change your strategy.
About the Author
Mike McGlothlin is a tireless advocate for the retirement planning industry. As executive vice president of retirement at Ash Brokerage, he heads a team providing income planning solutions focused on longevity and efficiency. He’s also a thought leader who provides guidance and assistance for advisors and broker-dealers navigating marketplace and regulatory changes. You can find a collection of his blog posts in his book, “Above the Clouds … Winning Strategies from 30,000 Feet.”