How the Fed Has Warped the 401k

Michael Thompson authored an op-ed in The Wall Street Journal on another potential negative consequence of quantitative easing:

Seven years of near-zero interest rates has created a serious problem for retirees and those nearing retirement. When interest rates finally start to rise, the rest of the investment marketplace—and the Federal Reserve—will feel the pain.

In place of the Treasurys and investment-grade corporate bonds that had been the hallmark of retirement investment strategy for decades, current retirees, and those soon to retire, have resorted to investing in equities and high-yield corporate bonds to generate the returns they need to avoid outliving their nest eggs.

A recent report from Fidelity Investments found that 11% of its 401(k) account holders aged 50-54 had a staggering 100% of their retirement assets invested in stocks. All told, 18% of the firm’s retirement account holders in that age bracket had a stock allocation at least 10 percentage points or higher than recommended. That figure increased to 27% among people ages 55-59. But with 10-year U.S. Treasury yields averaging 2.3% over the past five years, retirement-age investors have had few alternatives.

However, once the Federal Reserve finally starts raising rates, investors will begin reallocating their portfolios into more age-appropriate risk profiles. The large-scale unwinding of those “risk on” allocations will result in the inability of the Fed to dictate the shape of the yield curve.

The investment committee at my firm estimates that roughly $1.3 trillion in retiree assets are currently misallocated into equities based on the historic 16-year average price-to-earnings ratio for the S&P 500. This has resulted in stock price inflation that has kept equity valuations aloft even as quarterly corporate earnings results have begun to show signs of weakness.

As these misallocated investments stream back into the fixed-income markets once the Fed starts raising rates, the supply-demand imbalance will drive up prices and push down yields faster than the Fed can raise them. Essentially, every time the Fed introduces any additional yield into the marketplace, it will be immediately swallowed up by retiree (or near-retiree) investors who need to de-risk their portfolios.

This puts the Fed—and the Bank of England and Bank of Japan, which are both in a similar situation—in the unenviable position of having the yield curve flatten even as they continue to raise rates.

Meanwhile, a steady exodus from equities and corporate bonds will cause valuations to fall more in line with fundamentals, which have not supported the high valuations we’ve seen over the past several years.

In all, my firm anticipates that the overnight federal-funds rate will need to reach about 3% before this supply-demand imbalance is normalized. That could take several years.

This is another unintended consequence of the Fed’s quantitative easing. For retirement-age investors, it will be critical to seize the opportunity of increasing interest yields to de-risk their portfolios. But for equity and corporate credit investors, the result might very well be a prolonged period of subpar returns. For central bankers, it will be a hard lesson in how much easier it is to add monetary accommodation than it is to remove it.

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