5.5% interest rates may call for a rewrite of your retirement strategy

In just a few short years, the low inflation, low interest rate financial system has been turned upside down.

Thanks to lockdowns, supply chain disruptions, and a massive dose of pandemic stimulus, we've witnessed the highest inflation since the '70s breakout.

In response, the Fed has fired up one of the most aggressive interest rate hikes in history—and at 5.5%, its job isn't quite finished.

But despite today's market being a world away from the pre-pandemic days, many investors are still clutching their decades-old retirement strategies.

Read on to learn why experts believe now might be time to reconsider the stock-centric retirement playbook that ruled the past decade.

60/40 takes a hit

At the core of conventional portfolio management is the 60/40 portfolio.

It’s the long-held belief that for most people, most of the time, their portfolio should be allocated 60% toward stocks and 40% toward bonds.

Historically, this allocation formula has proven to provide attractive risk-adjusted returns.

Looking back at risk and return between 1977 and 2022, we find that a 100% stock portfolio returned an average of 9.4% annually, while a 60/40 portfolio returned an average of 8.3%.

But, a 100% stock allocation had a standard deviation (a measure of risk) of 16.1%, while the 60/40 target was substantially lower at 10.7%.

In other words, the 60/40 portfolio was 33% less risky.

The 60/40 target offers investors reasonable exposure to the riskier equities market while diversifying with significant investment in uncorrelated fixed income or bonds.

Unfortunately, the “uncorrelated” assumption broke in 2022. Last year, the 60/40 allocation lost almost 17% when stocks and bonds fell simultaneously.

For some, this represented the death of the 60/40 portfolio. For others, 2022 was an anomaly within a unique and rare market environment.

One thing’s for sure: the current environment has evolved in the short period since 2022. While 60/40 fell out of favor last year, it’s attempting a comeback.

Bonds are king again

In today’s environment, bonds—or fixed income—look increasingly attractive.

For example, the bond market’s benchmark 10-year U.S. Treasury note yielded 1.5% in early 2022. But by late August 2023, the same note was yielding 4.35%, or nearly three times the yield from the prior year.

While 4.35% may not seem like an impressive return, it is when placed in the context of risk. No other security on the planet is considered safer than U.S.-backed bonds. So it’s not simply a 4.35% return.

It’s a (nearly) guaranteed 4.35% return.

For this reason, the 10-year Treasury note is often considered the “risk-free” rate. It’s regarded as the minimum return any asset should deliver.

The “real” risk-free rate is simply the inflation-adjusted version. The U.S. 10-year TIPS (Treasury Inflation-Protected Securities) is commonly used as a proxy for the real risk-free rate.

At present, the 10-year TIPS is yielding nearly 2%. Put differently, today you can lock down almost 2% of inflation-adjusted risk-free annual returns for the next ten years.

Not bad.

Relative value

The risk-free rate is typically deducted from the expected performance when assessing an asset. The difference is called the risk premium. It’s the premium an investor hypothetically undertakes for taking on the risk of holding the security, like a stock.

At present, the S&P 500 has an earnings yield of nearly 4%. Subtracting the 2% real risk-free rate gives the broad stock market a risk premium of just 2%.

In other words, you’re only earning an additional 2% for taking on the risk of investing in more volatile equities compared to the guaranteed government bond returns. In fact, equity risk premiums are now at their lowest level in two decades.

Time to increase bond exposure?

Today’s conditions increasingly support a higher allocation to bonds in your portfolio. This is especially true for individuals in or approaching retirement.

For them, increasing exposure to a more consistent and predictable source of income may be prudent.

And it’s not just high yields that support a greater bond investment. As noted above, stocks, for their part, are looking increasingly overvalued.

Bill Gross, the “Bond King,” believes stocks are too expensive relative to risk-free assets and company earnings. Not only that, Gross says the equities market has yet to feel the full force of the Fed’s aggressive tightening campaign.

Wall Street legend Warren Buffet paints a similar picture. When the “Buffett Indicator,” a valuation metric calculated by dividing the Wilshire 5000 index by the annual US GDP, is over 100%, the index is considered overvalued.

Currently, the index sits deep in overvalued territory at 177%.

Choppy waters

The current economic landscape is nothing short of tumultuous.

Pandemic-induced disruptions coupled with severe government intervention have produced a unique financial environment.

While stocks still play a vital role in most portfolios, the current market is increasingly favoring higher allocations to fixed income as a beacon of stability with an attractive income stream.

If you’re uncertain how to proceed, consider talking with a financial professional to see if additional bond exposure makes sense for your retirement playbook.