In our years of experience serving pre-retirees and retirees, we’ve seen a lot of bad retirement plans brought into our office for review. What constitutes a bad plan in our opinion? Well, a lot of things, one of them being the overuse of “bonds”—a term used synonymously with bond funds—in the retirement portfolio.
“Bonds” are not automatically “safe” investments for retirement, and here’s why.
“Bonds” aka Bond Funds
Because the term “bonds” is often used interchangeably with “bond funds,” let’s start off with some definitions. According to Investopedia:
“A bond fund is simply a mutual fund that invests solely in bonds…Bond funds are attractive investment options as they are usually easier for investors to participate in than purchasing the individual bond instruments that make up the bond portfolio. By investing in a bond fund, an investor need only pay the annual expense ratio that covers marketing, administrative and professional management fees, compared with purchasing multiple bonds separately and dealing with the transaction costs associated with each… An investor who invests in a bond fund is putting his money into a pool managed by a portfolio manager.
“Most bond funds are comprised of a certain type of bond, such as corporate or government bonds, and are further defined by time period to maturity, such as short-term, intermediate-term, and long-term. Some bond funds comprise of only one type…Still, other bond funds have a mix of the different types of bonds in order to create multi-asset class options.
“The types of bond funds available include: US government bond funds, municipal bond funds, corporate bond funds, mortgage-backed securities (MBS) funds, high-yield bond funds, emerging market bond funds, and global bond funds…Typically, a bond fund manager buys and sells according to market conditions and rarely holds bonds until maturity.”
In other words, bond funds are traded on the market, and the market prices on bonds change daily, just like any other publicly-traded security.
The Relationship Between Interest Rates and Bond Yields: It’s Complicated
The problem with low interest rates is that any investment that’s sold as safe doesn’t return you much at all. The good old days of getting 5% on a five-year CD and 7% on a 10-year Treasury during retirement are gone.
But here’s the other thing, it’s also true that when interest rates rise, bond prices fall.
Where have interest rates been for the last 10 years? They’re already low—at historic lows. Over the last 100 years, the 10-year Treasury yield has only hit 2% twice. Once was in 1940 and the second time was recently, in the last 18 months, when interest rates actually went below 2%.
On May 2, 2018, the 10-year Treasury yield was up to 2.944%. And although the Federal Reserve on the same day decided not to raise interest rates, it is expected to raise them again in June. The Fed has also said that it expects to make multiple interest rate hikes in 2019 and 2020, which will likely lead to lower bond prices and bond yields increasing even further.
In this economic environment, bond funds can hardly be considered “safe.”
Bonds in the Asset Allocation Pie Chart
We’ve talked many times about the problem with the asset allocation pie chart. Basically, it’s a financial pie chart containing two components: stocks and bonds. A stock/bond pie chart is totally fine when you’re in your 20s, 30s, and 40s—you can be aggressive, you can focus on stocks and equities, you can diversify among large cap, mid cap, small cap, growth value, international, emerging markets, indexes, ETFs, you can own different sectors, and you have plenty of time to ride the market up and down.
The asset allocation pie chart is basically an accumulation strategy that works when you have the time horizon to “buy and hold.” After all, you’re still getting your paychecks from work, you can handle big drops in value, and market volatility is not something that really affects or bothers you.
This is not fine for retirement.
The Flawed Rule of 100: More Bonds as you Get Older
To compound the problem with bonds in the asset allocation pie chart, bankers and brokers and other non-fiduciary financial advisors begin using the Rule of 100 once you start getting older and closer to retirement.
The Rule of 100 uses your age to determine how much of your pie chart allocation goes into bonds versus stocks. So when you are 75, 75% of your portfolio will be in bonds, which already yield low rates. And because interest rates are most likely going to go up, what will happen to the biggest portion—the bond fund portion—of your retirement portfolio when they do? That’s right, it will go down. Its value will drop right when you most need your money.
In light of record-low interest rates does it make any sense to say according to the Rule of 100 you should have 75% of your money earning almost nothing—and at risk of earning less if interest rates go up? That doesn’t make sense!
Still Using the Discredited 4% Rule for Retirement: Just Say No
But to make matters worse, there’s more. There’s the 4% Rule, which was debunked and abandoned by its creator William Bengen in 2009—after the great recession of 2008 when many retirees lost everything—when he said it “did not work in a low-interest rate environment.” He called it “dangerous.”
Yet bankers and brokers and other types of non-fiduciary advisors are still using the 4% Rule! Despite the fact that it was responsible for so many retirees losing their life savings and having to go back to work in 2008! In our opinion, the 4% Rule has destroyed more people’s retirements than any other piece of financial advice ever.
For those that don’t know what the 4% Rule is, it works like this. The rule says that if stocks have averaged around 8-1/2% for the last 100 years (true) and bonds have averaged around 4-1/2% for the last 37 years (also true) then you can be “really conservative” and just draw 4% from your accumulated assets for the rest of your life and you should be fine (FALSE).
The problem is that the 4% Rule only works if you have a forever-up market cycle. But that’s not reality. If you get into a flat market cycle, or a market drop, the 4% Rule actually destroys your retirement because of something called “sequence of returns risk,” which works something like compound interest—in reverse.
Here’s an example based on math—and based on historic returns.
It’s January 1, 2000 and you just retired with $4 million in stocks and bonds (great!) Oops, the tech bubble burst and you just lost 50%. But you had to take 4% out each year, so you actually lost more. Your portfolio was down by 62% going into 2003. Luckily, from 2003 to 2007, the markets doubled, but you didn’t reap the full benefit because you had to draw 4% out each of those years. Then all of a sudden it’s 2008, and uh oh, you take the 37% hit plus your 4% draw. You’re done, you sell the house, go back to work, move in with the kids or whatever you have to do. You can’t stay retired.
A Retirement Distribution Plan Designed by a Retirement Fiduciary
Our clients didn’t skip a beat in 2008 because as a retirement fiduciary, our retirement plans are designed using math-based distribution planning. People often come in to see us having been told that they needed $2 to $4 million accumulated in order to retire based on the 4% Rule, but we run the numbers and they need much less.
We mathematically calculate and show you on a spreadsheet how much money you can draw for the rest of your life (up to age 100), net of tax, and exactly where your retirement income could be coming from. We use an incremental approach, and laddered guaranteed products which you can read about in other articles right here on our website.
Bond Fund Danger Zone
We especially want to warn people about municipal bonds and foreign bonds, which are subject to credit risk.
Municipal bonds are often touted as great investments for retirement because the interest is exempt from income taxes. But here’s the thing, many municipalities are running in the red. We haven’t used them since 2008, because since then, 49 out of 50 states have taken on pension obligations that they cannot possibly pay back. (The one exception is North Dakota, flush because of fracking.)
We believe there will be more bankruptcies, more Chapter 11s to come—New York, New Jersey, Illinois—many states are having issues.
If you own any municipal bonds, check your statement, because they should be trading around 109 to 112 depending on their maturity. If you have any trading below par—below 100—we hope you sell it. Your banker or broker won’t tell you this, because they are not fiduciaries. They will defend their sale, and tell you to keep them.
(We see the same thing happening with government bonds, like Puerto Rico, which is broke. Those bonds—which were sold as SAFE by the way—are now trading at 20 cents on the dollar.)
[I think Puerto Rico is a U.S. Commonwealth and unincorporated territory of the U.S., and technically not a foreign government. Brian is likely talking about Puerto Rico’s General Obligation bonds which are a type of municipal bond that have the same tax-free interest benefits as other munis.]
Get a Second Opinion from a Retirement Fiduciary
If you have at least $300,000 in investable assets and you’re concerned about your “safe” money for retirement (or just bond funds in general), we encourage you to come in and get a second opinion about your retirement plan. We’ll review your portfolio, especially your bonds.
Decker Retirement Planning Inc. is a registered investment advisor in the state of Washington. Our investment advisors may not transact business in states unless appropriately registered or excluded or exempted from such registration. We are registered as an investment advisor in WA, ID, UT, CA, NV and TX. We can provide investment advisory services in these states and other states where we are exempted from registration.