Among the lessons we’ve learned from the recent financial crisis is that traditional asset class diversification is not always a free lunch. Another lesson, corresponding with the close of what was essentially a lost decade for major stock indexes: Equities aren’t always long-term winners.
For retirees depending on income from their investments, this education is particularly painful, going to the very heart of their ability to maintain their lifestyle. While a decline in equities may, at times in the past, have been offset by a rise in bonds, having the two assets fall fast and hard in tandem during the crisis was rough for even well-diversified retirees.
School, unfortunately, is still in session, as we head into a period which may well see lower economic growth, increased savings, more government intervention – all topped off with the eventual return of inflationary threats.
This New Normal will challenge all investors and may heighten the traditional risks that retirees face, whether from volatile markets, outliving their portfolios, or simply not having enough savings. Here’s where inflation — long under-addressed by the retirement industry – starts to look particularly virulent.
Many investors have traditionally relied on stocks and bonds to see them through retirement, based on the widely held – yet often incorrect – assumption that equities are a suitable inflation hedge. It is true that equities might perform well over many time periods, even in the New Normal. However, the volatility of equity returns could represent a substantial deviation from purchasing power when equities do not perform well versus inflation, such as the 10-year period that ended December 31, 2009, or during periods of extremely high inflation like the 1970’s.
For today’s retirees it’s not unusual to live 20, 30, or even 40 years into retirement, complicating their ability to manage risk and deliver returns that maintain their purchasing power. Even if an investor believes that equity exposures may help keep up with inflation, such a strategy elevates the risk of irreparable portfolio damage in the face of extreme, unforeseen market events. Retirees should be spending their time enjoying their lives, not worrying about the risks of having their portfolios ravaged by market crises, of inflation cutting into their purchasing power, or both.
While financial service providers have been aggressively developing retirement income products to meet retirees’ needs, traction has been limited. In recent years, managed payout funds had proliferated and grown in popularity, yet their image has been tarnished by the damage they sustained in the financial crisis due to heavy equity allocations. Insurers, meanwhile, have expanded their menu of annuities – including some that hedge for inflation – yet many retirement investors remain wary of these investments. Annuities offer a fixed rate of return, backed by the claims paying ability of the insurer, but they often have high management costs and steep penalties for withdrawals.
The need for food, healthcare and housing never ends, and portfolios aimed at providing in-retirement income should have elements that cover these costs every month, regardless of equity-market performance or whether inflation is steadily raising the costs of buying these essentials. There is little tolerance for risk in these areas.
Fortunately, there is a compelling solution designed precisely to preserve purchasing power, typically with substantially less volatility than stocks: Treasury Inflation Protected Securities, or TIPS.
TIPS offer an explicit inflation hedge. They are issued by the U.S. government, which guarantees their timely payment of interest and return of principal at maturity. Their face value is adjusted in step with changes in the rate of inflation as measured by the Consumer Price Index for All Urban Consumers (CPI-U), with interest paid on the adjusted amount. At maturity, a TIPS investor receives the original principal plus the sum of all the inflation adjustments since the bond was issued. The result is a 100% connection to inflation, guaranteed by Uncle Sam.
Whether a retiree is drawing down savings over time or living off of interest payments and dividends – and few can – we believe the explicit inflation hedge that TIPS provide can help protect purchasing power over an extended period, while their high quality and government guarantee can offer some reassurance for risk-conscious retirees.
There are risks to TIPS, but we believe many of these can be addressed by a well-designed investment process. The value of a TIPS investment can decline if real (inflation-adjusted) interest rates rise. In the event of a deflationary cycle, which is a sustained fall in prices, the U.S. government guarantees repayment of principal; at maturity, investors receive the greater of the inflation-adjusted principal or the initial par amount. Interest payments on TIPS would decrease in a deflationary environment because interest payments are always based on the inflation-adjusted principal amount, which could potentially be lower than the face value of the bond.
Also, investing in TIPS clearly isn’t without its challenges, particularly for retirement investors who wish to receive a high frequency of payments (preferably monthly) to replace employment income. Most retirees require monthly income to pay for their “must haves,” while TIPS interest payments are twice-yearly. Moreover, there are substantial gaps in TIPS issuance that make for an irregular schedule of maturities – up to four year gaps in some cases.
The challenge is as stark as the pain many investors have felt: Traditional approaches to building a retirement portfolio often depend on a risky asset class that does not explicitly track inflation – or ignores inflation altogether. Investors need a better way. We think TIPS, properly managed, are up to the challenge.
© 2010 PIMCO, Inc. All rights reserved.
Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your PIMCO representative. Please read them carefully before you invest or send money.
Past performance is not a guarantee or a reliable indicator of future results. PIMCO does not offer insurance guaranteed products or related products that combine both securities and insurance features. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Inflation-indexed bonds issued by the U.S. Government, also known as TIPS, are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Repayment upon maturity of the original principal as adjusted for inflation is guaranteed by the U.S. Government. Neither the current market value of inflation-indexed bonds nor the value of shares of a fund that invests in inflation-indexed bonds is guaranteed, and either or both may fluctuate.The funds may use derivatives for hedging purposes which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The Funds are non-diversified, which means that they may concentrate their assets in a smaller number of issuers than a diversified fund.
During periods of rising inflation the amount of the monthly distribution is expected to increase and during periods of deflation the amount of the monthly distribution is expected to decrease. The monthly distribution amount may be adjusted during the term of a Fund to better enable the Fund to provide regular monthly distributions through the final maturity date. These distributions are not guaranteed.
The value of most bond funds and fixed income securities are impacted by changes in interest rates. Bonds and bond funds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise.
The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC. ©2010, PIMCO.
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