40 years of declining interest rates have created the perception that bonds are not only safe—they always increase in value. In some countries, interest on government bonds plunged below zero. In the U.S., the Federal Reserve manipulated interest rates under its ZIRP—Zero Interest Rate Policy.
But that’s all changed as the world moves to control inflationary pressures that have been exacerbated by the costs of fighting COVID. In normal (unmanipulated times) bonds yield 2% above the rate of inflation, so 7% when inflation is 5%.
Bonds are risky again
Total Risk in Target Date Funds
Until now equity exposure in TDFs has been a reasonably good measure of their risk, and the framework for contrasting glidepaths. In previous articles I’ve argued that equity exposure in most TDFs is too high near retirement for a variety of reasons, especially the fact that glidepaths do not follow the economic theory that they claim to follow. It’s a fraud.
Actual practice is hugely different from financially engineered academically based glide paths as shown in the following:
The triangle shown in the picture is the cost of protection when markets do not fall and the benefit when they do fall. It’s the classic cost-benefit tradeoff. The 13 years ending in 2021 came with an opportunity cost for protection—safe TDFs lost the performance horse race. Over the past decade, the opportunity cost of safety at the target date has been about 3.1% per year, placing safe TDF near-dated performance at the bottom of peer groups.
But that’s changing now, although most believe the Fed will pivot and revert back to ZIRP, restoring the risk-free view of long-term bonds. The next decade will not be a repeat of the past decade because ZIRP really needs to end. As Vitaliy Katsenelson observes in this article:
“Over the last decade, risks were compressed by low interest rates, but they have not escaped the system; they are just trapped inside it, waiting to come out in unexpected places.”
The Fed has a dilemma summarized in the following. A pivot at this stage will fuel inflation fires. But allowing interest rates to increase will create unaffordable interest expense that uses up 75% of tax receipts.
The Oligopoly vs. Financial Engineering
The return to some normalcy in bond yields restores the risk in bonds and creates a new reality for TDFs. They are now as risky for young people as they are for the old, unless you choose a financially engineered glidepath.
Most don’t know about financially engineered glidepaths because they have not looked beyond the TDF oligopoly that has emerged as described in the following.
The financially engineered group includes the Federal Thrift Savings Plan (TSP), the office professional’s union OPEIU, the SMART Target Date Fund Index and some personalized target date accounts. They actually exist.
Conclusion
The prospect that interest rates might actually increase exposes most TDFs to an interesting dilemma. Their risk is about the same for all ages.
There is no risk management. Accordingly, near-dated funds will perform about the same as long-dated. Most importantly, older participants are not protected.
Now you know.
SEE ALSO:
• 3 Shocking Facts You Should Know About Target Date Funds
• Theory vs. Practice in Target Date Fund Glidepaths