When financially planning for retirement, you’ve likely been encouraged to espouse conservatism and risk aversion. Common beliefs related to portfolio management suggest that as individuals get older and their investment horizons shorten, they should reduce the risk embedded in their portfolio. The stock market can exhibit erratic price fluctuations that may or may not be related to business fundamentals or the broader macroeconomic environment, so many financial advisors, fearful of impacting clients’ capital at the time in their lives when they most need those resources, recommend clients shift their exposure from more volatile equity allocations toward more stable and supposedly reliable bond investments. There is a trade-off – individuals can reduce their portfolio risk for greater stability, but typically that means rotating portfolio assets from equity investments into bonds with lower expected return. Despite conventional wisdom, the BBH investment team believes that it’s unnecessary to make such a tradeoff. Retirement planning can – and should – embrace equity investing.
Lessons from the 1929 Stock Market Crash
The widely held belief in low-risk portfolios near and during retirement has roots in the stock market crash of 1929, which ushered in the Great Depression. During the roaring 1920s, the U.S. stock market underwent a spectacular expansion, more than quadrupling in value. Investors bought stocks with borrowed money, and the rapid expansion only lent itself to further speculation. More money blindly flowed into the market, which further propped up equity prices and resulted in a massive bubble in the equity markets. On October 29, 1929, also known as “Black Tuesday,” the bubble burst, and stock prices came tumbling down. Prices spiraled toward rock bottom until June 1932, when they hit a low of $84, down 80% from a high of $432 in July 1929. It was not until 1959 – almost 30 years later – that stock prices reached previous peaks.
People who had piled their retirement and savings accounts into the equity market were left with very little to show for it. Many investors developed a sense of great skepticism toward the financial markets, and specifically toward equities.
At the same time, 10-year Treasury bonds maintained their value as the underlying borrower – the U.S. government – remained solvent and capable of paying its outstanding debt and interest payments. Investors in government debt who were not swept up in the speculation and enthusiasm surrounding the equity markets did not experience any capital impairment. Whether they were savvy enough to forecast a growing bubble in equity prices or were simply drawn to the attractive credit quality and security offered by U.S. government debt investments, these investors avoided the big losses many equity investors experienced while also earning interest income from their debt investments. The difference in investor experience across these two security types – equities and 10-year Treasury bonds – could not have been more extreme. Surprisingly, the crash was not enough to keep investors away from speculative investing. The U.S. equity market has seen many bubbles that eventually burst, including two recent examples: the dot-com bubble of 2000 and the great financial crisis of 2008 and 2009. As a result, investors nearing retirement, who do not have the luxury of time to weather potential equity market downturns, still prefer to rotate into more stable bond investments.
Challenging Conventional Wisdom
As noted, the convention of reducing equity market exposure in favor of stable bond investments when nearing retirement is widely maintained across the industry. Traditionally, fixed income has played three roles in a portfolio: (1) a source of liquidity, (2) a store of value and (3) a provider of income. In a normal interest rate environment, an investor can obtain all three of these benefits, but today only liquidity can be ensured.
We recommend a different approach given our clients’ long-term investment horizons, the current interest rate environment and our conservative approach to equity investing. We recommend that our clients remain exposed, to a greater degree, to equities that fit our strict investment criteria. We only invest client capital in quality businesses when they are “on sale” - meaning the market provides an acceptable discount to BBH’s (or our qualified third-party managers’) intrinsic value estimate. By following this discipline, we believe that our clients’ capital will be protected in down markets and compounded at a higher rate of return than the broader market over the long term.
Below are the factors that support our recommendation of maintaining exposure to equity markets for all clients, no matter how close they are to retirement.
1. Long-term, multigenerational investment horizons allow you to invest through volatility.
Many of our clients are able and willing to gift assets to charitable endeavors or rising generations. As such, we believe that our clients should view a portion of their assets as multigenerational with investment horizons that extend beyond their lifetimes. Having a long-term perspective allows equity investors to capitalize on attractive valuations when stock prices are weak and markets inefficient.
While investors with shorter investment horizons often prefer to reduce the perceived risk in their portfolio by paring back equity exposure and thus reducing their expected return, the opposite is true for clients with multidecade or multigenerational time horizons. These long-term investors have the luxury of investing through volatility, which allows them to take on more risk and target a greater expected return.
“Investors must be cognizant of not just after-tax and after-fee returns, but also after-inflation returns.”
2. Low interest rate environments can make fixed income investing less attractive.
Since the early 1980s, 10-year Treasury bond rates have been on a steady march down from a high of nearly 14% in 1981 to below 2% in 2016.
Retirees and upcoming retirees considering transitioning most of their portfolio into bonds should keep in mind the impact low rates can have on portfolios with fixed income exposure, including:
- Reducing the absolute yield of a portfolio
- Producing negative real rates of return (after inflation)
- Introducing the risk of capital impairment
Reduction of Absolute Yield
Let’s begin with the reduction of yield in a client’s portfolio. Consider two investors – one investing in 1981 and the other investing today; both portfolios have $10 million and are completely invested in 10-year Treasury bonds. Due to the respective rates during each time period, the 1981 investor’s annual interest income is seven times greater than today’s theoretical investor.
In this context, it becomes clear why past retirees made this seemingly reasonable tradeoff, capping their portfolio upside for attractive interest income and more stability and security. However, the story is different today, as current interest rates do not offer attractive interest income relative to potential returns in equity markets.
Negative Real Rates
With interest rates below 2%, investors must be concerned with their “real return,” or their return after inflation. The Federal Reserve states that its long-term inflation target is 2%. By investing in a 10-year Treasury bond today with an interest rate of 1.78%, clients will experience real (after-inflation) losses assuming the Fed’s long-term inflation target is achieved.
Said another way, at realization, the purchasing power of these investors’ invested capital will shrink because expected inflation will outstrip the expected bond return. If our clients were to invest capital in a 10-year Treasury bond today, they would receive less in the future on an inflation-adjusted basis.
Risk of Capital Impairment
Today’s interest rates are at historical lows, and as such, are expected to increase. As bond prices have an inverse relationship with interest rates, they will decrease alongside rising rates. This is a positive for investors with limited exposure to bonds who would like to increase their exposure and capture higher interest rates. However, for investors with exposure to bonds today, a rate increase will likely result in the price reduction of their current holdings and impair their real capital.
Imagine you purchased a widget factory for $10,000, and it produces 1,000 widgets a month. Someone then builds the same factory at the same cost but produces 1,200 widgets monthly. Nothing has changed at your factory, but its resale value has decreased relative to the second widget factory. The same is true for a bond. If an investor can invest in a high-yielding bond with the same credit profile as a lower-yielding bond, then the relative value of the lower-yielding bond has decreased.
Investors must be cognizant of not just after-tax and after-fee returns, but also after-inflation returns. Low rates offer low returns and possibly negative real returns, while rising rates introduce the risk of capital impairment. As a result, we believe that the current interest rate environment introduces material risks to bondholders and would not recommend investors overweight long-duration bonds in their portfolios.
We realize that successfully investing through retirement can be challenging and understand an individual’s natural risk aversion given the equity market’s volatility and history of speculative investing. However, BBH strongly believes that a prudent asset allocation process must take into consideration the likely investment timeframe, the opportunity cost to investing in high-quality credit, the tax implications and a portfolio’s expected total return. As such, we believe a disciplined approach to equity investing will benefit our clients throughout their investment horizon.
A Total Return Approach to Investing in Retirement
Retirees are often advised to live off interest income and dividends and avoid redeeming principal. It is a belief that dates back to the 1929 stock market crash when corporate bonds, which have greater credit risk than government bonds, were caught up in the negative sentiment of capital markets and experienced price declines. Investors who did not sell their corporate bonds were generally paid out in full with the accompanying interest payments. Those who sold out of fear or necessity locked in substantial losses for their portfolio. Thus an orientation toward generating sufficient income in retirement from interest became the new convention.
Our philosophy shies away from solely focusing on income in favor of a total return approach. We believe that capital gains in equity-oriented portfolios fund spending just as well as interest income. Therefore, we attempt to maximize our clients’ potential returns and not worry about whether capital gain, interest or both will provide the necessary income to fund their lifestyles.
To illustrate this point, let’s compare a theoretical $1 million portfolio of 10-year Treasury bonds to a $1 million balanced portfolio with ample equity exposure. In this example, we assume a 2% rate of return for the portfolio of 10-year Treasury bonds and a 5% rate of return for the balanced portfolio.
After 10 years with both investors spending $40,000 a year, the bond portfolio is worth $781,006, while the balanced portfolio is worth $1,125,780 – a 44% greater value than the bond portfolio. It should be noted that this is an illustrative example. An equity-biased portfolio will not produce consistent 5% returns.
Why is there such a meaningful divergence in portfolio values? The bond portfolio’s expected return is not sufficient to meet the client’s spending requirements and, as a consequence, requires the redemption of principal. Each year, the principal value of the portfolio declines, which decreases the annual income, requiring more principal to be redeemed and resulting in lower annual income for the following year. This cycle continues each year, diluting the portfolio’s value.
The opposite is true for the balanced portfolio. The expected return is in excess of the spending requirement, so the marginal gain is reinvested in the portfolio and allowed to compound for the remainder of the investment horizon, resulting in meaningful capital appreciation compared with the bond portfolio’s capital depreciation.
This example illustrates the outperformance of a total return approach while understating the after-tax benefits as this example represents pre-tax return. Long-term capital gains have a preferential tax treatment compared with ordinary income and short-term gains. While a client’s tax rate will be specific to his or her circumstances, long-term gains at the federal level are generally taxed at 23.8%, and ordinary income and short-term gains are taxed 43.4%. As long-term investors, the overwhelming majority of realized gains in our clients’ portfolios are long-term capital gains. An almost 20% lower tax rate for long-term capital gains provides great benefits to clients’ after-tax and after-fee returns.
An investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration may not reflect these factors.
This hypothetical illustration does not predict or project the performance of an investment or investment strategy. The return and principal value of an investment in stocks fluctuates with changes in market conditions. Government bonds are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value.
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