There's no question that the current investing environment is challenging for those -managing retirement portfolios. Stocks are hitting record highs but still producing weak dividends. Annuities are tied down to dismal rates with no relief in sight. And bonds, the traditional foundation of the retirement portfolio, are mired in low prices with interest rates primed to rise.
The Federal Reserve has indicated on several occasions that it plans to scale back its quantitative-easing program in the near future. If or when the Fed begins to taper bond purchases, interest rates will rise and prices will adjust swiftly to the changes.
HOW TO PROTECT CLIENTS
Those holding bonds, especially long-term Treasuries, might see a significant drop in the value of their holdings. How can advisers protect their clients in such a situation?
In theory, a well-diversified portfolio will mitigate risk from any one particular area. This protection can be particularly important during a crisis scenario, where it might be undesirable to hold a basket of securities that act and react similarly. In the case of rising interest rates, investing too heavily in bonds and annuities (which also are subject to interest rate risk) could be dangerous for an investor. Rather, retirement portfolios should strive for stability through diversification and noncorrelation.
A portfolio constructed of noncorrelated assets such as equities, fixed income and commodities or alternatives likely will react to changes in the market more favorably over time. To augment these holdings, a cash alternative such as a money market fund could add further balance and diversification.
Advisers should be careful when diversifying their portfolios, however. Not only have fixed-income securities been affected by rising interest rates, equities (particularly those with high yields), real estate investment trusts and other securities also have been underperforming in response to Federal Reserve actions.
Managers should be careful when investing in these instruments. Creating diversification isn't about simply collecting securities of different asset classes; it's also about addressing the composition of each asset class. Advisers should look to diversify the holdings of each of their asset classes.
For example, because of the risk of rising interest rates, advisers may want to consider decreasing the duration of fixed-income securities within that asset class. There are 5-year, 3-year, 1-year or even shorter-duration bonds available that can be used to create valuable diversification within a portfolio. It also might be wise to consider choosing floating-rate bonds over fixed-rate bonds, since rising interest rates will have less of an effect on the former.
Some speculate that market prices, to a large degree, already have adjusted for rising interest rates. Chances are, then, that retiree portfolios already have taken the hit. In fact, if retirees can keep a level head about dropping bond prices, they may see a benefit from rising rates.
HIGHER INCOME STREAM
While rising interest rates may create challenges for younger investors, such as those looking to take out a mortgage, rising rates eventually will benefit retirees in one important way: Higher interest rates mean a steadier income stream. The higher the interest rate, the higher the yield will be on Treasuries and other bonds. Retirees who have needed larger portfolios to maintain their lifestyle may soon find it easier to create the income they need.
The actions of the Federal Reserve surely will have a far-reaching effect on the national and global investing environment. Retirees, a group with very specific financial needs, may be particularly vulnerable to rising interest rates if unprepared for change. But this is also a great opportunity for retirees to benefit from the Fed's actions. That's why it is especially important for advisers to recognize the threats and opportunities of rising interest rates and to prepare their clients' portfolios for the coming changes.
Mike West is senior partner and chief executive of BPV Capital Management LLC.