Strategies to Protect Your Retirement (Fidelity)

Grow and protect retirement principal

Two strategies for cautious investors to help balance growth with protection of principal.

• FIDELITY VIEWPOINTS 
• – 08/25/2015

 

Fear of loss is a powerful motivator, as the recent market selloff reminded us. But fear like greed is a dangerous sentiment for investors. In the wake of the financial crisis, many clung to the seeming safety of cash, only to miss out on a six-year bull rally. Beware of letting nervousness over the current volatility derail your long-term investment plan

“Money and investing are very emotional things,” says Tim Gannon, vice president of product management at Fidelity Investments Life Insurance Company. “Many people tend to approach investing the way they approach other personal and emotional parts of their lives—they try to protect themselves from potential loss.”

Excessive fear of loss—which behavioral economists call loss aversion—causes many investors to act counterproductively. For example, many investors who fled the markets during the worst of the 2008—2009 bear market still haven’t fully reinvested,3 so they missed most of the current six-year bull market. “There is a segment of the investor population that would like to hold stocks, and who need that growth potential, but are too afraid to take that step,” explains Tom Ewanich, vice president and actuary at Fidelity Investments Life Insurance Company. “They are afraid of the consequences of losing their money in a down market.”

It’s natural to want to protect yourself from loss. That said, most investors need exposure to certain asset classes, like stocks, for investment growth. A diversified portfolio of different asset classes—stocks, bonds, cash—is a time-tested approach to providing growth potential while managing volatility. But given the combination of volatility in both the stock and bond markets, some investors have instead opted for the sidelines to protect their investments. Fortunately, you don’t have to treat growth and protection as mutually exclusive. Certain strategies can help you benefit from market gains, while protecting you on the downside.

The fiction of market timing

Equities are volatile by nature. During the 10 years ending December 31, 2014, the S&P 500 lost 1% or more in about one out of every seven trading days.4 Avoiding the down days would be a great strategy. Trouble is, it’s highly unlikely. No one ever has successfully and consistently predicted stock market returns. In fact, the strategy of jumping in and out of the market, known as market timing, is one of the main reasons the average equity investor underperformed the S&P 500 by 4.2 percentage points per year over the past 20 years.5 Investors trying to time the market typically sell after their investments have lost money, and buy only after stocks have recovered—selling low and buying high.

Avoiding stocks altogether has major drawbacks, too. Stocks provide the potential growth nearly every long-term investor needs to stay ahead of inflation. With life expectancies on the rise, most retirement-focused investors have longer time horizons than they think—even after they enter retirement.

Cautious investors with long-term saving goals—those who will not need to access a portion of their assets for five to 10 years—may benefit from strategies that allow them to protect principal while exposing some of their assets to the stock market’s growth potential. If you fit that description, consider the following strategies: the anchor strategy or the protected accumulation strategy.

Anchor strategy

An anchor strategy involves dividing your portfolio into two parts, a conservative anchor and more growth-oriented investments. The anchor portion of your portfolio uses investments that offer a small return, such as certificates of deposit (CDs) or single-premium deferred annuities (SPDAs). These assets have a set lifespan, and the amount you invest is designed to grow back with interest on your original principal. This portion of your portfolio acts as your anchor, while your remaining assets are invested in more volatile, growth-oriented securities such as stock mutual funds or ETFs.

A true anchor strategy protects your entire starting principal. For example, say you have $100,000 in assets and a five-year investment period. You could invest $90,000 in a five-year CD yielding 2.25%. When that CD matures it will be worth $100,591—more or less your original principal—leaving you free to invest the remaining $10,000 in stocks without risking any of your principal. “The anchor strategy can remove the negative outcomes cautious investors fear,” Ewanich says. “Even if the markets fall, your anchor makes sure you at least have what you started out with. Keep in mind, though, that inflation can erode the purchasing power of your original investment over time and that this strategy generates taxes each year in a taxable account.”

Gannon points out, “Interest rates are so low today that you will either need to commit more to the anchor portion of your plan or go with longer-duration products to get a higher yield.” In higher interest rate environments, the anchor strategy might become a more attractive option.

Protected accumulation strategy

Principal protection with growth potential

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This hypothetical is for illustrative purposes only and is not intended to predict or project-investment results. Your results will vary.

The protected accumulation strategy takes advantage of principal protection features—commonly referred to as guaranteed minimum accumulation benefit (GMAB) riders—on variable annuities. Your assets are invested in a portfolio that typically has a larger equity position than the 10% stake outlined in the anchor strategy above. For a fee, the GMAB rider guarantees that at the end of the annuity’s investment period—typically 10 years—you’ll have at least the same asset value you started with. The main benefit over the anchor strategy is that more of your assets are likely to be exposed to growth. Based on current market conditions, you might have equity stocks represent 10--15% of your anchor strategy, compared with the GMAB holding 60% or more in equities. “The GMAB doesn’t guarantee growth but it provides a way for you to expose more of your assets to real growth potential,” Gannon says. Recognize that a similar investment portfolio held outside the annuity would have higher returns in up markets without the cost of the guarantee, though you would sacrifice the protection (see chart below).

Another potential benefit is that most GMAB riders let you reset the level of principal protection each year if your investments have grown in value. If you do lock in a higher balance, the investment period resets and your balance is guaranteed for another 10 years. It is possible that your fee may increase if you elect this option and annuity features will vary by the issuing company.

For example, say you originally invested $100,000 in a variable annuity with a GMAB rider. After the first year, the annuity’s underlying investments grew to a value of $105,000. Locking in that new balance guaranteed that you would have at least $105,000, regardless of how the markets performed after a new 10-year period. If the underlying investments lost value in that first year, you could be comforted by the knowledge that your original $100,000 was guaranteed.

Making a choice

Determining which strategy may make more sense for you will depend on a number of factors, including your investing goal, fees on your investments, your time horizon, and your tolerance for risk. First consider if you might be better off investing in a diversified portfolio, because either of these strategies (anchor or protected accumulation) may limit your upside growth potential—and the diversified portfolio may offer a greater long-term benefit. But for those who are just not comfortable exposing their investments to stocks without some kind of loss protection, one of these approaches might be worth considering.

You also need to consider when you will need access to these assets, because both strategies might penalize early withdrawals. For instance, redeeming a CD before it matures typically means forfeiting some or all of the interest earned, while variable annuities may levy a surrender charge representing a percentage of the account value. So if your goal is less than 10 years away, the protected accumulation strategy is not a good fit. “You want to make sure you invest only the money you need for that specific goal,” Ewanich says.

The anchor strategy is generally considered the more conservative of the two strategies, as it has less potential for growth than the protected accumulation strategy. That said, investors who are more comfortable with some volatility in their portfolio could adapt the anchor strategy by protecting only a portion of their principal. That approach would free up more assets for growth in the equity portion of the strategy in exchange for a lesser degree of principal protection.

Also consider the cost of each plan. You can assemble a very low-cost combination of CDs and stock funds. However, the protected accumulation strategy can carry fees of more than 2.5% annually, which will lessen the potential return on your investments. While both strategies are designed to protect principal, that principal will lose purchasing power over the applicable investment horizon.

The decision may well come down to your investor personality. With your principal protected from loss, would you gain the confidence to invest more aggressively than you are today? The protected accumulation strategy requires little action from you aside from your initial investment and an annual decision whether to lock in any growth. The anchor strategy requires that you invest the assets that are left over after establishing your anchor. Those may or may not be decisions you’re interested in making. “All these factors hit on the same point,” Gannon says. “What kind of investor are you? What are you going to be most comfortable with? And, most importantly, what will let you sleep better at night?”

 1. S&P Dow Jones Indices; three-year average annual return through April 2, 2015.

2. Strategic Insight Simfund Federal Reserve Bank.

3. The New York Times, May 2012.

4. S&P Dow Jones Indices.

5. DALBAR2014.

Should You Sell Your Bonds Now? (New York Times)

June 28, 2013

Taking a Cue From Bernanke a Little Too Far

By TARA SIEGEL BERNARD

Financial advisers have been fielding calls from shaken investors in recent weeks, particularly retirees, who are nervous that a bond market crash is on the horizon.

You can hardly blame them. Investors have been fleeing bonds in droves; a record $76.5 billion poured out of bond funds and exchange-traded funds during the month of June through Wednesday. That exceeds the previous record, according to TrimTabs, when $41.8 billion streamed out of the funds in October 2008 and the financial crisis was in full force.

But the rush for the exits really means one thing: investors are betting that interest rates are about to begin their upward trajectory, something that’s been expected for several years now.

Their cue came from the Federal Reserve chairman, Ben Bernanke, who recently suggested that the economic recovery might allow the central bank to ease its efforts to stimulate the economy. That includes scaling back its bond-buying program beginning later this year.

So the big fear is that interest rates are poised to rise much further, driving down bond prices; the two move in opposite directions.

A Barclays index tracking a broad swath of investment-grade bonds lost 3.77 percent from the beginning of May through Thursday, according to Morningstar. United States government notes with maturities of 10 years or longer, however, lost an average of 10.8 percent over the same period.

Making a bet on interest rates is no different from trying to predict the next big drop in stocks, or jumping into the market when it appears to be poised to surge higher. These sort of emotional moves are exactly why research shows that investors’ returns tend to trail the broader market.

And it’s also why many financial advisers suggest ignoring the noise, as long as you have a smart assortment of bond funds that will provide stability when stocks inevitably tumble once again.

“It’s a futile game to base portfolio moves on interest rate guesses,” said Milo Benningfield, a financial adviser in San Francisco. “We don’t have to look any further than highly regarded Pimco manager Bill Gross, whose horrible interest rate bet against Treasuries in 2011 landed him in the bottom 15 percent of fund managers in his category that year. Investors should take a strategic approach designed around the reason they hold bonds — and then sit tight whenever hedge funds and other institutions shake the ground around them.”

The main reason longer-term investors hold bonds, of course, is to provide a steadying force. And though today’s lower yields provide less of a cushion — the 10-year Treasury is yielding about 2.5 percent — bonds still remain the best, if imperfect, foil to stocks.

“The role of bonds in a portfolio has always been to be a ballast or a diversifier to equity risk,” said Francis Kinniry, a principal in the Vanguard Investment Strategy Group. “And that is very true today. Yields are low, but this is what a bear market in bonds looks like.”

So, yes, losses are indeed more probable than they have been in recent years. From 1976 through Jan. 31, 2013, high-quality bonds yielded an average of 7.3 percent, according to a recent Vanguard , which provided a nice cushion. For instance, if you had a portfolio of 60 percent stocks and 40 percent bonds — and stocks fell by 20 percent — the overall portfolio would have lost 9.1 percent. If the market plummeted 40 percent, the entire pile of money would be worth 21 percent less.

The situation is a bit different now. Assuming a more conservative average return on bonds of 1.9 percent — a reasonable estimate based on bond yields now, according to Vanguard — the same 20 percent drop in the stock market would cause the overall portfolio to decline by about two percentage points more, or 11.2 percent. If the market plummeted by 40 percent, the portfolio would lose 23 percent.

“Investors have been conditioned by higher bond yields going into both bear markets in the last decade to believe that bonds will substantially offset stock declines,” Mr. Benningfield added.

So perhaps the loss from the bonds somehow feels worse because it’s not something investors are accustomed to. And the memories of the stock market collapse of 2008-9 are still fresh enough.

“People are using adjectives like ‘blood bath’ and ‘devastation,’ but we are talking about a negative 3 percent return,” said Mr. Kinniry, referring to the Vanguard Total Bond Market Index fund, which is down by that amount year-to-date.

Even the big bond market sell-off in 1994, which many refer to as a “massacre,” doesn’t seem quite as violent as that moniker suggests. As Mr. Kinniry points out, the same index fund lost 5.3 percent that year, after interest rates spiked by 2.83 percent. If the same sort of situation were to play out now, he said the returns would be significantly worse because bond yields are lower than they were back then. “You might lose about 8 percent,” he said, adding that losses could be deeper depending on how quickly rates rose, among other factors. But typically, “we’re talking about single-digit losses.”

Still, some advisers suggested taking a closer look at your overall allocation to stocks, particularly if you’re not well diversified, since bonds will provide less protection.

For most investors, holding bonds through low-cost index funds remains the most prudent course. People who invest in individual bonds don’t have to worry about fluctuations in their price because they can continue to hold the bond and collect their interest payments until maturity, at which point they’ll collect its face value (unless, of course, the bond issuer defaults). But you need to have a good pile of cash — some experts say $500,000, even more — to assemble a diversified portfolio of municipal and corporate bonds (though you don’t need quite as much for Treasuries, since they’re backed by the government).

You can figure out how sensitive your fund is to interest rates by looking at its duration, which essentially measures how long it will take to receive all of your money back, on average, from interest and your original investment. Generally speaking, for every percentage point that interest rates rise (or fall), a bond’s value will decline (or increase) by its duration, which is stated in years. Bond funds with shorter durations are less susceptible to interest rate risk — the faster a bond matures, the thinking goes, the more quickly you can reinvest the money at a higher interest rate.

That means a fund like the Vanguard Total Bond Market Index fund, which has a duration of 5.5 years, would decline by about 5.5 percent. But since the fund also pays investors income — it has a yield of about 1.7 percent — it would actually only post a total loss of about 3.8 percent. (Future returns would be one percentage point higher, too, thanks to the rise in rates).

But if even that feels too risky, experts say you can put some of your bond money into a diversified index fund with an even shorter duration. The trade-off, of course, is that you will earn less income. That might not matter once you remind yourself why you own bonds at all.