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By Christine Benz and Adam Zoll | 08-07-2013 12:00 PM

Retirees: Learn From the Recent Bond Turbulence

How investors can use the recent interest-rate-driven disruption as a stress-test for their portfolios. Plus, a new retirement income tool and some good news on prescription-drug costs.

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Adam Zoll: For Morningstar, I'm Adam Zoll, and welcome to The Retirement Radar.

Many retirees who depend on fixed-income investments got a scare recently when interest rates shot up. Here to talk about the impact and other issues of concern to retirees and near-retirees is Christine Benz, Morningstar's director of personal finance.

Christine, thanks for being here.

Christine Benz: Adam, it's great to be here.

Zoll: Let's first talk about what exactly happened. Why did interest rates go up recently and what areas of the market were affected?

Benz: Fed Chairmen Ben Bernanke made some comments that were widely construed to mean that the Fed may end the bond-buying program. [That program] has spurred interest rates to drop and bond prices to go up. So as a result, we saw long-term government bonds and bond funds fall like a rock during this period, which was really the beginning of May through very early in July. So long-term government bonds and funds got hit hard.

Treasury inflation-protected securities were also a big casualty here, and they were hit on a couple of fronts. First, the prices for the bonds dropped in part because people aren't that concerned about inflation right now. We've seen inflation really be quite mild through this period. So in addition to being quite rate sensitive, the bonds dropped because there just isn't the demand for that inflation protection.

One category that really did drop a lot that was somewhat unexpected was the emerging-markets bond group. The reason is that, in light of the fact that rates could be rising here in the U.S., people would rather have U.S. government bonds than emerging-markets bonds. They'd rather not have to take the extra risk by investing in emerging markets. So we saw emerging-markets bonds drop pretty significantly, and in particular the ones denominated in foreign currencies. There's been a mania for some of these foreign-currency denominated bond funds recently. We saw them suffer particularly large losses, in part because some key emerging-markets currencies have actually declined in value pretty significantly relative to the dollar.

Zoll: Many retirees have been wringing their hands, worried about what would happen once interest rates start to creep up. This is actually an opportunity to test your portfolio to see how sensitive it is to that.

Benz: Exactly. I had been talking for a while about the importance of conducting this interest rate sensitivity stress test, and I think that's still a worthy exercise. So, people should look for their funds' duration, which you can find on Morningstar.com or on your fund company's website. Find that figure, find the SEC yield, which you can also find on Morningstar.com or the fund company website. Subtract the SEC yield from duration, and that's about how much you could expect to see your fund lose in a one-year period in which interest rates increased by 1 percentage point. That's still a worthy exercise.

But I also think that people can look back on this very recent real-life period to take a look at what their bond funds did. So in particular you can look from early May through early July, and you can customize a time period using the charting feature that we've got on Morningstar.com. Do this on a fund-by-fund basis just to see how much your holdings lost during that period.

By the way, I would say don't limit it necessarily to your bond funds, because we also saw some equity categories suffer pretty significant losses during this two-month period as well. Categories that people look to for income--in particular real estate, utilities would be another category--those categories suffered losses in the range of 6%-7%, because investors view them as alternatives to bonds. They suffered pretty big losses during that period as well.

Zoll: Potentially a learning experience for people who have been wondering what is going to happen in a rising-rate environment?

Benz: For all us, because we all do have bonds in our portfolio. It's a good time to get in there and just see what kinds of losses we could be in for if rates rose.

I would also remind people that rising rates aren't all bad. You do get higher yields available on money market securities, on bonds eventually, that help offset some of these principal losses that we'll incur when rates are going up.

Zoll: For people still saving for retirement and looking forward to retirement, you've identified a new online tool that can help look at retirement savings in a slightly different way.

Benz: That's right. This is a new tool that BlackRock rolled out within the past couple of weeks, and it's interesting in that it helps you look at how many dollars today you would need to have for a dollar in income for the rest of your life.

You plug in your age--and this tool is available for people who are between ages 55 and 64, so, Adam, you can't use it just yet. For example, if you're a 60-year-old person and you plug in that you're looking for a dollar in income for the rest of your life [starting] when you turn age 65, you can see that right now you would need about $16 in current savings to give you that $1 in annual income for the rest of your life. For example, if you think you need $50,000 a year, you can see that you would actually need something like [$797,000] to be able to deliver that $50,000 a year in annual income. It's another tool in investors' toolkits.

This is really the thing that investors wrestle with: How much will they need for retirement. This is another thing that you can do to stress-test your assumptions, to take a look at how many dollars today you'll need to deliver that income in retirement.

Zoll: Another recent development involves retiree health-care costs. Can you tell us about that?

Benz: Health-care expenses are obviously a huge expense in many retiree households. What we're seeing is some good news on the Medicare Part D prescription drug front. We're seeing premiums actually … projected to stay in line in 2014 with where they have been for the past three years. That's good news. The average premium is around $31. It's anticipated to stay around that range.

The other thing is that the deductibles for Medicare Part D coverage are actually declining in 2014, from $325 currently down to $310.

Another thing that we've been monitoring is the ongoing closing of this "donut hole" for prescription drug coverage. This is when coverage for basic prescription drug costs leaves off and [before] catastrophic coverage kicks in. That's gradually shrinking. So the period of vulnerability for retirees is declining, and we're expecting to see the donut hole go away altogether in the year 2020. So far, as a result of the closing of the donut hole, we've seen Medicare Part D recipients experience something like $7 billion in reduced costs. So this is all positive news in what is a very expensive category for many retiree households.

Zoll: And certainly a welcome development for many people who do have a lot of out-of-pocket costs for drugs.

Benz: Absolutely.

Zoll: Thanks so much, Christine, for being with us to share your thoughts on recent developments of interest to retirees and near-retirees.

Benz: Thank you, Adam. Great to here.

Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.

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