What are the ramifications of the financial crisis for retirement investing? Let us begin by understanding the macroeconomic situation and then focus on specific investment strategies.
The financial crisis was caused in part by a huge imbalance in global trade — U.S. consumers spent until they dropped and Chinese families saved most of their earnings. Then these Chinese savings were recycled through the global financial system by buying U.S. Treasuries and mortgage-backed securities. These Chinese funds helped supply the excess liquidity that spawned the real estate bubble in the United States.
At the G-20 meeting in Pittsburgh in September, the U.S. committed to increase its personal savings rate. In fact, that rate has spiked recently as American consumers have become more concerned about their jobs. If the U.S. wants to increase personal savings on a permanent basis, Congress should enact the automatic individual retirement account. That would require every employer with more than 25 workers to offer a retirement plan with automatic payroll deductions. The employer would not have to contribute to the plan, and any worker could decide not to participate.
While the personal savings may stay high, it will be overshadowed by the rise in U.S. budget deficits — $1.4 trillion in the current fiscal year, and $1 trillion a year for the next decade. By the end of that period, the external debt of the U.S., held by both U.S. and foreign investors, will be close to $17 trillion, and the annual interest payments on this debt will be roughly the size of the current defense budget. These huge deficits have already dampened enthusiasm for the U.S. dollar, and they are likely to lead to higher interest rates once the economy revives.
These macroeconomic trends have important implications for retirement investing.
Diversification remains a central tenet of stock investing. Although all stock markets, as well as the credit markets, swooned in 2008, the foreign markets have again decoupled from the U.S. markets since March 2009. The large emerging markets, for example, have risen twice as much as the U.S. stock market. Moreover, with the uncertain future of the U.S. dollar, international investing is a prudent form of currency diversification.
Bond investing must take into account the likelihood of higher interest rates when renewed economic growth will create inflationary pressures in the U.S. One responsive strategy would be to invest in short-term bonds, but short-term rates are very low. A better strategy would be to invest in Treasury inflation-protected securities, because they pay additional interest based on the rise in the consumer price index. International diversification again can play a role by owning bonds issued by emerging market countries, whose resource-based economies may benefit from rising inflation and where debt levels did not rise as fast as in the U.S.
The financial crisis shattered the illusions surrounding lifestyle funds. Many investors nearing retirement believed they would be protected by the automatic increase in the bond portion of such funds. However, many lifestyle funds with target retirement dates of 2010 to 2020 fell sharply last year as many fund managers left equity allocations high on the theory that increasing life expectancies mean investors need more equity exposure to keep up with inflation over longer retirement periods. In fact, there are large differences among workers at age 55 or 60 as to when they expect to retire, and these differences cannot be reflected in one lifestyle fund for each age cohort.
Academic researchers have shown that, over 20 to 30 years, the chances of achieving favorable gross returns are roughly the same for lifestyle funds and asset allocation funds with a fixed ratio of stocks and bonds rebalanced each year. But the net returns were better for asset allocation funds because they generally had lower expense levels than lifestyle funds. Moreover, an array of asset allocation funds allows plan participants to choose the target risk appropriate for their working years. And when they reach age 55 or 60, they can decide whether to switch to another fund in light of their own time horizon for moving into retirement.
Timing the market is extremely difficult. Retirement investors who were uncomfortable with the level of losses in their portfolio should re-examine their risk tolerance and set their equity allocation accordingly, rather than trying to make decisions about when to close out their equity position and when to jump back in. Most who tried this tactic didn't get out in time to miss much of the recent downturn, and many who did get out failed to catch the subsequent rebound off the bottom of more than 60% in the Standard & Poor's 500.
Finally, the financial crisis drove home the dangers of borrowing to invest — buying stocks on margin or purchasing real estate with minimal down payments. Highly leveraged investors suffered double-barreled losses: Not only did the value of their holdings plummet, but also they were forced to sell assets at distressed prices to meet margin calls or mortgage payments. Financial crises are not a once-in-a-lifetime event. Over the last 25 years, we have experienced at least four major market debacles in the U.S. Therefore, it makes sense for retirement investors to keep their debt levels as low as practical.
In short, retirement investors must learn to live with a financial system less dominated by the U.S., and more punctuated with financial crises. In such a world, they should follow the principles of international diversification, prudent asset allocation and relatively low levels of borrowing.
Robert Pozen is chairman of MFS Investment Management, Boston, a senior lecturer at Harvard Business School, and author of “Too Big to Save? — How to Fix the U.S. Financial System,” scheduled to be published by John Wiley & Sons Inc. this month.