The same as before, even in a low-to-zero interest rate environment (except …)
Some recent pieces in different countries have been brought to my attention by readers, who themselves have expressed multiple views. Not a surprise, because these are tough issues. So I thought I’d express my own views, and see what you think. The title of this post, and the blurb, tell you all you’re interested in, if you’re in a hurry. For the more patient, I’ll expand on “the same as before” (which is not obvious), and my reasoning.
Since I see fixed income as having two potential roles, I’ll trace a bit of history to explain them.
By the way, this post is addressed to individuals in the decumulation or drawdown phase, not to pension fund managers. But most investment principles for individuals were developed by applying pension fund principles to the limited case of individuals: what would a fund do, if it was down to its final member? So the history I trace will relate to pension funds.
(I have subjected my wife to this angle for many years. She tells me that if she hears again that she and I should consider ourselves the last two members of a collective defined contribution plan, she will not be responsible for the consequences.)
I’ll try to do this in 6 logical steps.
All of which sounds simple. Simple, but not easy. In fact I found it very difficult. It took me a long time before I was able to filter and organize my thinking into the 6 steps here.
And that’s before it suddenly occurred to me that I’m taking a narrow view here. There’s a valid way to react that’s different from the one in those 6 steps. So I’ve added a seventh step.
Warning: This is a much more advanced piece on investing than my usual stuff. But I hope you’ll be able to follow the logic, even if not all the details. And for the investment geeks, I’ll try to be as complete as possible by telling you all the things I’m ignoring. But I’ll do that in footnotes, to keep the flow as smooth as possible.
(1) We need growth assets: At the two extremes, if you have so much money that you don’t need growth, or so little that even a lot of growth won’t get you to your target, then none of this applies to you. So I’m only addressing those who absolutely need future asset growth. They either don’t have quite enough to lock in their desired spending for their longevity horizon, or they’re only slightly above the necessary amount. Either way, future growth is an imperative for them. And so we start with growth-seeking assets as the base of the portfolio. The simplest approach is to buy a stock index fund, in the form of a mutual fund or an ETF. This traditionally used to be a local-country index fund, but these days it’s more likely to be a global one. In the old days this needed to be a simple index fund, but these days it’s also possible to get an index fund devoted to ESG characteristics.
(2) But they bring problems: We know, however, that while growth is highly likely over the long term, it is not guaranteed – that’s what William Bernstein calls “deep risk.” And its uncertainty leads to short-term price volatility, which is bad when we’re forced to interact with the market at an adverse time – what Bernstein calls “shallow risk.” Deep risk is unavoidable. Shallow risk is either avoidable or capable of being acceptably mitigated, and that’s where fixed income comes in.
(3) Pension funds and volatility: Once upon a time there used to be defined benefit (DB) pension plans flourishing on this earth. (Yes, I’m joking. I know this rare creature is not yet extinct.) The contributions required to finance the promised benefits are necessarily unknown, because they depend heavily on future investment returns. The practice used to be to update the estimated required contributions every three years. This meant that three-year market volatility got reflected in contribution volatility. To reduce the contribution volatility to what was considered acceptable by the plan’s guarantor, the practice arose of diluting the growth exposure with 40% of fixed income assets, like bonds and mortgages. These had the effect of providing some investment return, though less than that expected from the stocks, while reducing the portfolio’s overall volatility and therefore the contribution volatility.
That 60/40 allocation become the default approach for many, many years.
In fact it got to be a joke: “No matter what the investment question is, the answer is always 60/40.” And a clever and witty friend of mine told me that when he drove to his local airport, he always drove up to the 6th floor of the parking garage so that he could occupy spot D40 on that floor. Why? Because then he could ask himself, on his return days later, “Where did I leave the car?” And the answer was always “6D40.”
(4) Pension funds discover a new need: This 60/40 policy worked fine when new contributions exceeded benefit payments, because there was no forced need to sell assets: the benefits could be paid from the new contributions. Some plans are still in this “going concern” open position, or at any rate their investment income and maturities, when added to contributions, are sufficient to meet benefit payments. But if a DB plan closed to new entrants and then to future service, regular contributions for the current year’s service became smaller and then vanished, and asset sales became necessary to pay benefits. And any forced asset sale right after a market decline locked in a permanent loss. So funds now had a new need: make sure there’s enough cash to pay the benefits, at least for a few years. And that led in turn to a realignment of the fixed income assets, to structure them in such a way that their combined interest and maturity payments matched the benefit cash flows required. This became known as “liability-driven investing” (LDI for short), and fixed income now took on a maturity structure matched to the liability cash flow, rather than just accommodating the idea that a fixed income index fund would do the volatility-reducing job.
As closed DB plans matured, the fixed income content tended to become much larger than 40% of the portfolio, and the average maturity tended to shrink as the cash flow needs in the next few (or several) years got matched.
(5) Reflections on what’s different today: All of that is history that’s well known to older people like me. But in my early days, fixed income at least promised a relatively high stream of interest payments. Today those interest payments are very low, in fact edging closer and closer to zero, sometimes even negative when considered in real (after-inflation) terms. What difference does that make? My answer: None. That’s just tough. You still need to reduce stock volatility, you still need to match benefit cash flows. The two needs haven’t changed. All that has happened (yes, I know that’s a casual way to express it) is that the reward expected in the old days from interest payments has essentially gone., Too bad, but life has simply become more expensive. (I’ve likened reduced bond yields to a tax on investors.) And there isn’t an adequate substitute for fixed income. You can consider high-dividend stocks, but (a) they don’t reduce the volatility problem and (b) the dividends make only a small dent in the cash flow needed to pay benefits. So they don’t solve either of the two essential problems.
This is why so-called alternative assets, such as real estate and private equity, have become so popular. Not being traded daily, they aren’t subject to the volatility of traded stocks, so they help with the volatility problem. But they definitely don’t solve the LDI problem.
So the two problems that fixed income used to happily solve still exist. That’s why I say that the role of fixed income is the same as before. What’s changed is the degree of comfort with the solution. Too bad. It’s like living in the same world as before, but with higher taxes. Your problems are the same, the solutions are largely the same, you’re just worse off than before.
However, see (7) below for another way to deal with the new conditions.
(6) What about individuals? I’ll skip over the issue of individuals in their accumulation stage (that’s easier to deal with), and will apply all of this to the more complex issue of individuals in the drawdown or decumulation stage of their financial lives. They have accumulated assets. They (almost invariably) need growth to finance their desired spending. They need cash periodically to actually spend. They’re very much like a pension fund, except of course that there isn’t anyone making added contributions if growth isn’t adequate to support their desires.
So individuals need growth, and they also need predictable cash flow for a few years, because they want to avoid the need to sell stocks right after a market decline. The ratio of the two parts may or may not be 60/40, but they will certainly reflect the lifestyle risk tolerance of the couple or person involved.
That risk, of having to sell into a market decline, is now well known. It means that, when you think of the sequence of the volatile stock returns over time, you’d rather have high returns in the early years, when your assets are at their peak, than in the later years, when your assets have been mostly spent. When Bob Collie, Matt Smith and I wrote our book in 2008, we couldn’t find a recognized name for this risk; I think it was Matt who came up with “sequential risk.” Today there’s a standard term: “sequence-of-returns risk” – not quite as elegant as Matt’s.
Anyway, what this inevitably leads to is the notion that a drawdown portfolio should consist of a base of growth-seeking assets, on top of which you place fixed income (typically bank securities like CDs) that generate the cash you need for a few years, so that if the stock market falls you’ve mitigated the “shallow risk” to the risk that, after however many years, the market still hasn’t recovered.
By the way, how many years? As I said, that depends on your risk tolerance. For my wife and me, we use five years. Why? Because historically, stock markets have recovered enough to provide at least a 0% real (after inflation) annualized return over 5-year periods – three quarters of the time. The remaining 25% of the time is our acceptable shallow risk. Others I know use 3 years, or 1 year. In the opposite direction, one particularly risk-averse friend prefers 10 years. Whatever the time period chosen, that shallow risk is mitigated but not eliminated. The dividends on the stock portion of our portfolio don’t come close to meeting our annual cash needs, though they help.
And now that our bank securities provide hardly more than zero interest (actually negative, in real terms), well, that’s just too bad for us. It doesn’t change the nature of our problem, it doesn’t change our solution, it just means we’re worse off than when interest rates were higher.
(7) But wait – there’s more: This is the aspect that occurred to me later. Clearly, the world has changed. Or at any rate, the parameters that define the problem have changed. My own reaction has been to accept the reduction in return. But there’s another valid way to react, and that’s to decide that you’re willing to accept more risk than before, in order to get your expected return back to where it used to be. In other words, you’re thinking: it’s a new world, and a new me, willing to take more risk than before. Then you’ll reduce the amount of fixed income relative to what you used to be comfortable with. At the extreme, you’d reduce it to zero; in which case, something like high-dividend stocks would be your preferred route. Expected return up again, risk (both deep risk and shallow risk) up too, but you’re willing to bear it. That’s a valid reaction too.
I think of low-to-zero interest rates as a world of higher taxation. There are no magic new solutions to the problems. We’re just worse off than before. Or, in search of a higher return, the new you can also accept higher risk.
 See, for example, https://donezra.com/51-wealth-zones-essentials-lifestyle-bequest-endowed/
 Strictly we need a return rather than growth. But I’ve used the word “growth” so extensively in the past that I’ll stick with it. Fixed income gives you a return too, of course. Typically stocks give you a higher return over the long term, with higher volatility and uncertainty.
 I’ll skip the stuff on currency risk, as it’s not relevant here. The same goes for active management – a separate issue.
 I noticed, practising in three countries, that while the US default was 60/40, it tended to be 70/30 in the UK and 50/50 in Canada. To some extent this may have reflected different fixed income yields. But the same principle applied everywhere: how much contribution volatility was acceptable?
 I won’t distinguish between nominal and price-index-linked bonds, because it’s not relevant to the general role. Nor will I go in to detail on more limited LDI that is implemented simply by matching the duration of fixed income holdings to the duration of the DB liabilities.
 It has been pointed out to me that, in a zero-interest-rate environment, you might as well use Treasury bills as long bonds: the same expected return, with the implicit option to switch to long bonds if and when the yield curve rises.
 I’m assuming (or postulating) that, with the decline in fixed income yields, the expected return from stocks has declined by the same amount: in other words, that the equity risk premium has not changed. This is consistent with the rise in the stock index that was triggered by the decline in yields and becomes the new base for future projections. With the same equity risk premium, if your risk tolerance doesn’t change, your asset allocation should also not change. Only your expected return changes – downwards.
 … even though low volatility is an artificial characteristic here – but I won’t pursue that angle.
 I won’t get into collective arrangements or life-annuity-type products. Those solutions existed under the old conditions and they still exist under the new conditions.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.