The protracted low-interest rate environment is taking its toll on defined contribution plan participants, particularly conservative investors
approaching retirement age, said Zac Burns, CFA, Vice President of Investments at Pension Corporation of America and Chairman of Alliance Benefits Group’s Investment Committee.
“About five years ago, money market funds yielded over 4%. Now, on average, they pay .01%,” Burns said. “So, in 2007, you needed about $2,500 to earn $100 in interest. Today, to earn $100 in interest you need $1 million.”
When inflation is factored in, conservative savers are actually losing purchasing power on a daily basis. In fact, recent studies have shown that the likelihood that an investor’s portfolio will run out of money increases significantly in a protracted low-interest rate environment.
Burns said that some workers were now pushing back their retirement in order to save more while they wait for interest rates to rise. Others, he noted, were taking on more risk than they may be comfortable with. Older workers may now have more bonds in their portfolios than they would have had five or 10 years ago. And, because bonds are generally paying less, investors are opting for riskier bonds as well as putting a greater percentage of their assets in stock.
“So far, savers are not experiencing a negative impact because riskier bonds are doing well and the stock market has been going up,” Burns said.
Should the tide turn, these investors could face losses. Even if such a scenario doesn’t occur, Burns said he expects that as interest rates rise, bond investors across the board will start to feel a pinch.
“If you are getting 5% to 6% in interest payments on a bond, you still have a cushion if the value of the bond goes down,” Burns said. “But if you are only making 2% and then rates rise, your total return could go to zero, or you may even lose money.”
Burns pointed out that in January, interest rates went from1.75% to 2%, driving the value of some bond funds down by a quarter to a half of a percent for the month. As a result, while the economy was improving, people actually lost money on some bond funds.
In advising plan participants, Burns said the most important thing was to stress diversification – not just among stock holdings, but among bond holdings as well. Burns noted that one of the biggest mistakes investors make is to concentrate their bond holdings in just one or two bond funds.
Since bond funds react differently to changes in interest rates, investors should expose themselves to a variety of bond funds in order to take advantage of their upside while protecting against rate fluctuations, he said.
“A normal bond fund goes up when interest rates go down, but others will hold up much better or even perform well in a rising rate environment,” Burns said.
Burns said that across ABG, retirement plans were beginning to expand their bond fund offerings, with many plans adding alternative funds.
“We now recommend options in six different bond categories, not just one or two,” Burns said. These options include:
- Intermediate government bonds
- Intermediate core, the most common class of bond funds
- Inflation-protected bonds
- High-yield bonds
- Foreign bonds
- Multi-sector bonds, a catch-all class of bond funds
Now, he said, the challenge was to educate both plan sponsors and plan participants about the importance of diversifying among bond funds.
“We don’t have a blanket recommendation on the number of bond funds any given plan includes,” Burns said. “But we do feel it is important that every plan at least consider the options, particularly in light of the extraordinary circumstances facing plan participants today.”
For more information about the importance of diversifying bond portfolios, please speak with your ABG representative.
