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How Dangerous Is Common Retirement Advice?


  • Things are much different than they were 10 or 20 years ago but everyone seems to follow the same retirement investing advice.
  • As retirees are in need of more security they are now forced into more risk as bonds have become riskier than stocks while also giving a lower yield.
  • If you’re looking for security, cash may be your best bet.

Introduction

You’ve likely heard the advice that as you get closer to retirement you should move toward having a bigger chunk of your portfolio in bonds rather than stocks. Most retirement funds are structured in that way. Vanguard Target Retirement Funds allocate 90% of assets in equities and 10% in bonds if you are going to retire between 2058 and 2062, thus 45 years from now. For those with 20 years until retirement, the division is 80/20. The ratio is 75/25 for those with 15 years, 65/35 for those with 10, 60/40 for those with only 5 years, and 50/50 for those of retirement age. For those in retirement, the division is 64% in bonds and 36% in equities if you’re younger than age 73, and 70% in bonds and 30% in equities if you’re older than 73. You can see this represented in figure 1 below.

figure 1 vanguard asset allocation
Figure 1: Vanguard Target Retirement Fund asset allocation per age group. Source: Vanguard.

The example above follows the standard and traditional retirement advice issued by the majority of financial institutions and retirement specialists. In this article we are going to analyze if that advice still holds up in the current financial environment, what the risks related to it are, and finally, what can be done differently.

Don’t forget that it is a given in the financial world that if an advisor gives the wrong advice but the advice is the same as what the majority does, there will be no negative implications for the advisor’s career if and when things turn for the worse. On the other hand, if you point out risks but nothing happens, your financial career is in jeopardy. Think of the movie The Big Short and the guys shorting A rated credit institutions.

What Has Changed In The Last Two Decades? Bonds.

The common advice outlined above comes from an environment that was significantly different than the one we have today. The first major difference is that yields have gone down and bond prices have gone up in the last 20 years.

figure 2 bond yields
Figure 2: Thirty-year treasury yield. Source: FRED.

The current yield on 30-year treasuries is 2.24%, which is a record low. What is significant is that yields have been declining since 1981 and before that yields had only been increasing.

The declining yields trend pushed bond prices upwards. The net asset value of the iShares 20+ Year Treasury Bond ETF (TLT) has gone from $103 at the end of 2013 to the current price of $140. This means that if yields go back to the levels they were at the end of 2013, of around 4%, the value of 20+ bonds will decline by 29%. It would take more than 10 years for the increase in yields to cover for the decline in value. So, by being long bonds, you are risking a loss of 30% for a yield of 2.24%.

Yes, bond prices can go higher if the U.S. becomes like Japan or Europe where negative interest rates are the new normal, but with the FED contemplating interest rate increases and an employment rate of 4.9%, which is half of Europe’s rate, we could say that the chances are more in favor of higher yields.

The retirement strategy that was formed a long time ago didn’t have to account for global negative interest rates, treasuries yields below 2.5% and the fact that bond yields could jump up or decline 50% in a matter of a year.

figure 3 volatility
Figure 3: Thirty-year treasury yield volatility in the last 5 years. Source: FRED.

What Has Changed In The Last Two Decades? Stocks.

Stocks are in the same asset bubble as bonds. Low bond yields push investors to seek better yields elsewhere. The S&P 500 has a PE ratio of 25.23 which implies a yield from stocks of 3.96% which is, the same as with bonds, the highest level ever reached if we exclude the 2000 tech bubble and the depressed earnings in 2009.

figure 4 s&P 500 multipl
Figure 4: S&P 500 PE ratio. Source: Multpl.

The Shiller PE ratio, which takes into account 10-year earnings averages in order to eliminate cyclical influences, is even worse and at 27.08.

figure 5 shiller
Figure 5: Shiller PE ratio. Source: Multpl.

To put it simply, if bond yields go to 4% and we attach the historical stock premium of 2.29% for stocks, the expected yield from stocks would be 6.29%. With current earnings, it would imply a PE ratio of 15.97 and an S&P 500 value of 1,380, or a decline of 37% from current values. This means that for the current S&P 500 earnings yield of 3.96%, you are risking 37% of your stocks portfolio if the FED reaches its 2% inflation target.

Conclusion

Given the risk versus reward outlined above for both bonds and stocks, one clearly has to be prudent with their savings, especially for those close to retirement. Many retirees watched their retirement savings get cut in half during the last financial crisis and unfortunately it looks like many will go down the same road again because they follow the same old rules without questioning them.

Low yields force investors to hold a greater percentage of their savings in assets that produce some form of yield in order to reach a satisfying retirement income, but if you look at risk as a function of price and not volatility you see that those assets become more and more risky as their prices go up and yield goes down. As we described in our article about Carl Icahn, smart investors continue to warn us about the long-term negative effects of low interest rates as they threaten to bankrupt pension funds and retirement incomes. Those low interest rates force people to save more as they will need more money to retire safely.

The main point of this article is to make investors think and to show them the risks they are running by just following the old investment dogmas in a different world. If you are close to retirement, assess your future needs, assess the risks you are currently exposed to and create a portfolio that you can sleep well with no matter what happens.

An asset that is pretty safe but that no financial advisor will ever recommend because you do not get any commission on it, is cash. Something to think about in this new world.

There is one additional strategy, which happens to be one of our favorites, where the bulk of your retirement savings sits safely in cash, yet still allows you to earn high double digit yields on your capital. Click here to learn more.

 

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