Investing for Retirement and Why Target Date Funds Don't Make Sense ... Myth vs Reality ... Bonds Aren't Safe and Sound Investments for 401(k), IRA and Pension Fund Savers and Investors

Bonds are widely believed to be safe and solid investments by the vast majority of savers and investors, both individual and institutional. Meanwhile, stocks are thought to be the far riskier choice.

But that's wrong today, and will be for the foreseeable future as well. Thus, individual and institutional investors alike should be guided accordingly.

That there's safety and wisdom investing in bonds represents the commonly and incorrectly held view by the vast majority of today's individual investors in 401(k) and IRA plans. It's also the view of most public sector pension fund trustees responsible for selecting and retaining pension fund managers.

But it's the wrong view. The plain and inescapable fact facing today's investors is that interest rates either will rise appreciably from current levels --- or they won't. That presents a lose-lose situation for investors because if long term interest rates do rise, the value of the bonds owned will fall. And if they stay the same or don't rise significantly, the interest rate paid to investors in those bonds will remain very low.

Let's look at an illustrative example. If a portfolio is invested 50/50 in stocks and bonds, the blended return of necessity will determine the total annualized rate of return. So if bonds return only 1% and stocks return 8%, the blended rate of return will be 4.5%.

But even that unexpectedly low return is before the 'expert' adviser takes his cut, which we'll guesstimate will be a low one half of 1% per year. Thus, the investor will receive 4% annually in such a situation and not the generally assumed 8% or higher rate of return.

Unfortunately, this scenario is what's facing today's investors, both individual and institutional. And if the pension fund sponsor or individual 401(k) or IRA investor is funding based on an assumed annual investment return of 8%, an actual 4%  rate of return will make an already underfunded situation even uglier and more unaffordable. In that regard, please see my previous post today titled 'Pension Promises Made and Kept in the Public Sector ... Made by Whom and Kept at Whose Expense?'

And if individuals are participating in target date fund investing in their 401(k) or IRA plans, then they will be equally at risk of suffering a huge shortfall in funds come retirement time.

Funds That Sought to Cut Risk With Bonds Are Having to Think Again is subtitled 'Target-date funds seek to avoid losses for investors nearing retirement; as rates rise, bonds aren't such a safe haven:'

"All-in-one mutual funds for people nearing retirement face tough decisions on how much risk—and which risks—to take in search of decent returns.

When the stock market tumbled in 2008, “target date” funds for people planning to retire in 2010 sustained heavy losses. Since then, sponsors of these funds, which specify a likely retirement year in their names and are widely offered in 401(k) retirement plans, have generally lightened up on stock exposure for investors approaching retirement.

But as fund managers have raised allocations to bonds, these portfolios have grown more exposed to the negative impact on bond prices of rising interest rates—a concern now that the Federal Reserve has embarked on what is expected to be a series of U.S. interest-rate increases.

“People have been lulled into a false sense of security with fixed income because it has performed so well for so long,” says Jimmy Veneruso, a vice president at investment consulting firm Callan Associates Inc. “But there is a lot of risk in the bond side of these portfolios.”

Investment losses can be particularly devastating in the years shortly before and after people retire, because they may have little time to recover before they start pulling money out of their accounts to live on.

Target-date funds for investors in or near retirement are more exposed to bonds than they have been in years. On average, such portfolios hold 42% of their assets in stocks, down from 50% in 2007, according to investment researcher Morningstar Inc. As these portfolios have reduced their stock-market exposure, they have raised their allocations to bonds from 38% to 47%, on average, Morningstar says.

Much of that bond exposure is in funds that track or compare themselves with the Barclays U.S. Aggregate bond index of U.S. investment-grade bonds. Since 2008, that index has tilted more heavily toward bonds with longer maturities, raising its sensitivity to interest-rate movements and its exposure to losses when interest rates rise, says Mr. Veneruso.

As interest rates rise, investors flock to new bonds with higher yields, causing the prices of existing bonds to fall. Bonds with longer maturities generally lose the most because investors are locked in to their lower rates for longer.

According to a measure known as “duration”—which gauges the approximate change in the price of a bond or bond fund after a move in interest rates—the bond portions of target-date funds for people in or near retirement are likely to lose 4.8% for every one-percentage-point increase in interest rates, said Jeff Holt, an analyst who follows target-date funds at Morningstar. In 2008, the figure for comparable funds was 4.4%, Mr. Holt says.

For people in or near retirement, bond losses inside target-date funds may be hard to tolerate unless stocks rise by more than enough to compensate. “Investors who are in or near retirement need stability from their bonds,” says Jeff Coons, president of Manning & Napier Advisors LLC, a Fairport, N.Y., firm that manages target-date funds. “Rising interest rates create headwinds of negative returns for a very large portion of target-date portfolios, which is going to create real challenges for these participants in achieving their goals.”

To minimize the potential impact of rising interest rates, many target-date funds have reduced the durations of their bond portfolios for older investors. In doing that, some fund companies have sacrificed some current income, while others have introduced or accentuated other risks.

American Funds 2015 Target Date Retirement Fund now holds 9% of its assets in the Intermediate Bond Fund of America. That fund, with a duration that indicates a loss of just 2.8% for every one-percentage-point increase in rates, is far less exposed to rising interest rates than the company’s Bond Fund of America, with a duration that indicates a 5.25% loss.

“For those close to retirement, we are using bond funds with shorter durations to more closely manage risk,” says Wesley Phoa, portfolio manager at Capital Group, which oversees the American Funds.

The downside: The yield on the intermediate fund is lower—0.68% as of Nov. 30, compared with 1.51% for the longer-duration fund."

Summing Up

For both individual and institutional investors seeking adequate long term returns on their savings and investments, bonds represent a very risky way to invest in the developing low but slowly rising interest rate environment.

Blue chip dividend paying stocks are by far the better choice.

And I've been beating this drum that stocks are safer and better investments than bonds for the past several years.

So today I'm just trying to sound the alarm --- once again.

In other words, the conventional wisdom about bonds being safe and profitable long term investments is wrong, as usual.

Thanks. Bob.