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A Year-End Portfolio Check for Retirees

Adam Zoll
Christine Benz

Adam Zoll: For Morningstar, I am Adam Zoll, and welcome to our Retirement Radar year-end review. Here, joining me as always is Christine Benz. She is 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 an issue that was of concern this year for lots of retirees, which is the bond market. The bond market this year experienced probably more volatility than we're used to. Can you talk about why that was?

Benz: [There was] a lot of concern over the Fed's tapering and when that would begin--so when the Fed would pull back on this bond-buying program, which has pushed down on interest rates for the past couple of years, [there was] a lot of concern about that. And then, more broadly, I would say, it was just sort of a risk-on sort of year. Investors were very attracted to equity investments. We saw very strong performance from the equity markets, and so fixed-income investments just didn't perform, as well.

Zoll: Now, were there particular areas of fixed income that were hit harder by this trend than others?

Benz: Absolutely. As you might expect, any sort of investment with a lot of interest-rate sensitivity embedded into it performed particularly poorly. Long-duration Treasuries, of course, bringing up the rear for 2013. Treasury Inflation-Protected Securities also performed pretty badly. There was kind of a double-whammy here. Inflation was generally at bay, so investors didn't have a strong appetite for these securities, and also most TIPS tend to be pretty interest-rate-sensitive. Those were the categories that were the hardest-hit.

On the plus side, we did see very strong performance from a couple of the more credit-sensitive categories. High-yield bonds and bond funds performed very well as you might expect in a risk-on sort of year. And then also bank loan investments generated very strong numbers during the year. Both of those were leading the pack really at the expense of everything else.

I also forgot to mention municipal bonds performed very, very poorly. They were down in the list of laggards. And there you had interest-rate worries weighing on munis as well as some of the concerns over municipalities' finances; that, too, weighed on muni bonds. Most [muni-bond] funds will end the year in the red slightly, but a loss just the same.

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Zoll: Now that we've seen the Fed actually announce that it is starting its tapering of its bond-buying program, moving into the new year what should people who are invested in bonds expect with regard to interest rates?

Benz: I think that it's still probably a good idea to avoid taking a lot of interest-rate sensitivity. You probably don't want to go out and buy any sort of long-duration bond portfolio. But I think a helpful thing to do is really to think about your holding period for your bond investments.

Certainly, if you have money that you expect to spend within the next year or two, I would keep that very, very short, or in fact keep it in cash because you're just not getting paid to take a lot of interest-rate risk at this time. But if you have, say, a time horizon of five or seven years for a portion of your fixed-income portfolio, I think there it probably is reasonable to keep that portion of the portfolio in intermediate-term bonds. Maybe some sort of a diversified portfolio that includes Treasuries, as well as, high-quality corporates. It's probably not a great market environment in my view to be taking a lot of credit risk given the very strong performance we've seen credit-sensitive bonds turn in over the past year.

Zoll: Some welcome news this year for retirees and for everyone is that the rate of inflation remained low. That's of particular interest to lots of retirees who are living off of fixed income. Can you talk about why the inflation rate remains low and what it means for retirees?

Benz: A couple of key categories where we saw slowing rates of inflation, and energy was a big one. Also particularly of interest for retirees is that we have seen the rate of health-care costs slow pretty precipitously. In fact, the recent inflation rate from 2010 through the present, the annual inflation rate was just 1.3% in health-care costs. That's a big downward trend relative to what we had gotten used to, given that health-care expenditures are a big portion of many retirees' baskets of goods that they purchased, this is really good news.

Zoll: Should retirees and people saving for retirement not worry so much about hedging for inflation given what this trend has been?

Benz: I think the key thing to keep in mind is that you want to add to your inflation-fighting investments at a time when people aren't that worried about inflation and therefore prices might be slightly more attractive.

There are a couple of key categories that retired investors often look to when adding inflation protection to their portfolios. Treasury Inflation-Protected Securities are a big one. I don't think that most investors probably want to be to investing in long-duration TIPS at this point. But I think a good short duration TIPS fund makes a lot of sense. I like Vanguard's fund and also perhaps some sort of a commodities investment as another very small slice of the portfolio might also make sense.

But I do think you want to be a contrarian when thinking about adding this dedicated inflation protection to your portfolio. Right now with no one worried about inflation, it might be a good time to do that.

Zoll: That makes a lot of sense. Another dose of good news this year came with regard to 401(k) balances, and we saw the stock market up big, up close to 30% so far this year. Is that the reason that people maybe are smiling now when they open their 401(k) notices?

Benz: It's a big reason for sure, but Fidelity, which does annual reporting on participant 401(k) balances, also said that participants were kicking up their contributions a little bit in part because some people were getting salary increases. The average 401(k) balance in a Fidelity 401(k) plan was $84,300. And it was an even higher balance for people who have been socking it away for a while--so about $220,000 in average balance for people who have been investing in the 401(k) plan for 10 years or more. So, that's encouraging news.

Zoll: It seems like with the market up and 401(k) balances as high as they are, investors might be prone to falling into some behavioral traps as the market's riding high. How would you recommend that they guard against that?

Benz: That's right. I think when you do have the kind of market environment that we've had where it's been very strong performance from the equity market, sometimes investors feel that wealth effect. And I think the problem spot is that some investors might think, "Well, my balance is looking pretty plump right now. Maybe I can pull back on my savings rate a little bit or maybe even tap that balance, take a loan or something like that to fund some other goals."

So I think that investors want to be careful on that front.

Another tendency that we sometimes see, not just with 401(k) investors but all investors, is a tendency to do a little bit of performance chasing, which is looking at whatever has been very hot in the portfolio in the recent past, adding to that, and stripping away from what hasn't performed as well.

I think investors can take a couple of steps to guard against those behavioral traps. One is to simply institute a rebalancing program in the portfolio. A lot of 401(k) plans now actually have automatic rebalancing that you can just turn on, check a box, and the company will strip back on whatever has performed well and will add to the underperformers. I think that that's a good thing to do if you're not comfortable doing that rebalancing yourself.

Another thing I think that people should take a look at is investing in just the target-date fund within the 401(k) plan. Our data on investor outcomes within target-date funds is very encouraging. It shows that investors are generally pretty placid. They stick with the funds through a variety of market conditions, and that helps them generate better outcomes than people who are managing portfolios of individual holdings.

I think for people who aren’t comfortable doing asset allocation or getting that asset allocation more conservative as they get closer to retirement, I think the target-date fund--provided it's a good plan with very low costs--I think that that can be a really good way to go.

Zoll: It sounds like to summarize, heading into 2014, your advice would be to not get carried away with some of these trends we've seen, continue with bonds and your fixed-income portfolio if you need that, still think about an inflation hedge even though right now inflation is not a major concern, and also don’t get carried away with equities even though the market's been at an all-time high?

Benz: That's exactly right. It's kind of a contrarian thing to do. I think a lot of us are feeling like, "Why not continue to plow money into equities?"

But it's actually a pretty good time, I think, to strip back.

Zoll: Christine, thank you for sharing your thoughts with us today and throughout the year about retirement issues.

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

Zoll: For Morningstar, I'm Adam Zoll. Thank you and happy holidays.