How Much Foreign Currency Exposure Do Retirees Need?

Retirees are often on the hunt for income, and foreign stocks and bonds tantalize by offering yields that are often higher than comparable payouts available on the home front. For example,

Yet securities denominated in foreign currencies can add an element of uncertainty to a portfolio, and most pre-retirees and retirees are looking for more certainty, not less. When foreign currencies gain in value relative to the dollar, investors who own foreign-currency-denominated stocks and bonds win. That has been the case for the past few years. But the opposite can also occur: If foreign currencies slide relative to the dollar, investors would have been better keeping all of their assets in dollar-denominated securities. That was the case from early 2014 through early 2017: The dollar soared, prompting a spate of launches of foreign-stock exchange-traded funds that hedge their equity allocations into the dollar.

Because there are a huge number of variables affecting foreign currency moves--from interest rates to geopolitical considerations to trade and economic growth--it's impossible to predict whether foreign currencies will move for or against you over your specific time horizon. That argues against trying to get too clever in terms of timing your foreign-currency exposures, as Karen Wallace discussed here.

So we've taken tactical foreign-currency bets off the table; they're a bad idea. But how should retirees go about deciding how much foreign-currency exposure they want on a long-term, strategic basis? There are a few schools of thought.

The wild card of foreign-currency fluctuations has led some asset allocation experts to argue that investors should downplay foreign-currency-denominated holdings as retirement approaches, or to hedge out the currency exposures using futures. After all, when you start spending your portfolio in retirement, you're mostly likely going to do that spending in dollars, not foreign currencies. If your foreign-currency-denominated holdings have slipped in value and you need to pull the money out of the investment to pay your property taxes or purchase groceries, the foreign-currency downturn will affect the purchasing power of the withdrawal.

At the other extreme, some investors believe that diversification is a plus, and that applies to asset classes, investment styles, geographies, and currencies. Moreover, owning foreign stocks and bonds but hedging out the foreign-currency exposure has the potential to increase the portfolio's costs, as discussed here. Though those costs have come down substantially with the advent of currency-hedged exchange-traded funds, investors who own foreign stocks and bonds in an unhedged form can avoid those currency-hedging costs altogether.

Rather than opting for any of those extremes--fully avoiding foreign-currency-denominated securities or maintaining an entirely unhedged foreign-stock and bond portfolio--retirees can also find a happy middle ground. As with the bucket approach to retirement portfolio management, here's another case where anticipated spending time horizon for a given portion of your retirement assets can help inform your approach to currency exposures. For shorter spending horizons, currency fluctuations are unwelcome, but for longer time horizons they can provide a diversification benefit.

Let Spending Plans Guide the Way With spending horizon in mind, you can determine how much risk you're willing to take with that component of your portfolio. For assets that you expect to tap in the next year or two to meet living expenses (Bucket 1 in my bucket framework), you don't want any variability in your balance at all because that would have a direct impact on your spending. Thus, it's important to keep that money in cash, and foreign currency exposure would necessarily be off the table.

Ditto for the next five to eight years' worth of expenditures (say, Bucket 2 in my Bucket Portfolio framework): The answer to the "how much risk?" question is some, not too much. You want to focus on those investments that have a high probability of a positive return over an eight- to 10-year time horizon. Equities have been fairly reliably positive over rolling 10-year increments, but over shorter time periods they've been too erratic. That calls for going light on stocks of all types, foreign and U.S., hedged or unhedged, for spending horizons of less than 10 years. After all, one of the worst things you can do for the sustainability of your retirement portfolio is to tap securities after they've already dropped; that leaves less in place to recover.

But what about the bond sleeve of that component of the portfolio? While diversifying into non-U.S. bonds isn't unreasonable, venturing into nondollar-denominated bonds introduces a level of volatility that's, well, not very bondlike. Morningstar doesn't have separate categories for unhedged and hedged foreign bond funds, but a look at a pair of international bond funds, one hedged the other unhedged, illustrates the point. The standard deviation of PIMCO Global Bond (USD Unhedged) PIGLX is twice that of the Bloomberg Barclays Aggregate Index and nearly twice that of

Emerging-markets bond funds that focus on local-currency-denominated bonds are more volatile still. The 10-year standard deviation of

Fluctuations Matter Less Over Longer Time Periods That doesn't mean retirees should avoid nondollar-denominated bond holdings at all, but they're not a must-have, especially for risk-averse investors. And no matter what, their volatility suggests that investors should limit their position sizes and have a nice long holding period for them. In several of my model bucket portfolios, I've included nondollar-denominated foreign-bond exposure in small increments, but I've reserved it for Bucket 3, which assumes a 10-year horizon until spend-down commences. If currency movements break the wrong way over a shorter time horizon, the retiree has time to recover, and the diversification could provide a modest benefit at the portfolio level.

What about foreign stocks? Here the answer about how to approach foreign-currency exposure isn't as clear-cut. Of course, retirees should make sure they have a sufficiently long time horizon to spend-down before they hold stocks of any type--foreign or U.S., hedged or unhedged. But stocks will be volatile for a number of reasons, and currency-related fluctuations will be just one of them.

Ultimately, the decision about whether to obtain hedged versus unhedged exposure is a personal one, boiling down to the investor's risk preferences as well as whether there are any extra costs associated with the hedged product. As Morningstar director of global ETF research Ben Johnson discusses

, unhedged currency exposure has been a source of volatility for foreign-stock funds, but hedging it out has the potential to reduce returns, too. Risk-tolerant retirees could reasonably maintain unhedged foreign-stock exposure, while those more attuned to volatility can obtain foreign-stock exposure via one of the many low-cost dollar-hedged ETFs that have come to market in recent years.