[Dongeul Dongeul] 401K, Caught Between Rising Bond Yields... Are US Millionaires' Pension Accounts a Thing of the Past?

Bond Yields Surge Leading to Asset Reduction
Asset Management Returns Hit Bottom
Retirees Withdraw Pensions to Invest in Stocks
Experts Recommend Maintaining Funds

Unlike Korea, many elderly people in the United States enjoy a prosperous life even after retirement. This is thanks to the retirement pension '401K,' which has delivered an average annual return of over 10% for the past decade. With 401K serving as a significant financial pillar, American retirees can enjoy a leisurely life in vacation spots during their old age. It is said that there are about 350,000 so-called pension millionaires in the U.S. who hold balances exceeding one million dollars in their retirement accounts.

However, recent changes in U.S. bond yields have caused notable shifts in the returns of 401K plans. After recording a loss of about 15% last year, 401K is showing unsatisfactory performance this year as well. Today, we will explore the reasons why the once thriving 401K has been posting poor results.

[Image source=Bloomberg]

401K: Bonds Defend When Stocks Fall... Optimal Returns by Mitigating Losses

401K is a pension product similar to Korea’s Defined Contribution (DC) retirement pension. The core concept is that employees and employers contribute a fixed amount monthly to a retirement account within certain limits, enjoying tax deduction benefits, and the employee manages the funds directly to generate returns. However, since the enactment of the Pension Protection Act in 2006, a default option was implemented, whereby if employees do not express separate intentions, the employer manages the retirement funds according to a pre-established method.

Employers typically offer a Target Date Fund (TDF) as the default option, which adjusts the ratio of stocks and bonds according to the employee’s expected retirement date. Under the default option, retirement funds of employees who do not express separate intentions are automatically managed through the asset management company (trustee) selected by the employer using the designated product.

TDFs automatically allocate assets according to the lifecycle by reducing the proportion of risky assets like stocks and increasing safer assets like bonds as the investor’s retirement date approaches. The portfolio’s allocation between stocks and bonds varies accordingly. Asset managers generally assume the retirement age to be 65 when employees do not specify otherwise and construct the TDF portfolio based on that assumption.

TDFs have achieved optimal returns by combining the high profitability of stocks with the stability of bonds. Also, since stock and bond prices typically move inversely, losses in one asset class are offset by gains in the other, minimizing overall asset losses.

Rising Bond Yields Lead to Asset Value Decline... Returns Limited to 7% This Year

However, last year, simultaneous declines in U.S. bond prices and stocks triggered alarm bells for returns. The 10-year U.S. Treasury yield surged to 4.21% in 2022, causing bond prices to fall. At the same time, the S&P 500 index dropped by 19%. As a result, a portfolio evenly split 50/50 between stocks and bonds recorded a 15.5% loss.

[Image source=Getty Images Bank]

The upward trend in bond yields continued into this year, affecting the slowdown in returns. Although the S&P 500 rebounded by 17.56% this year, the 10-year Treasury yield surpassed 5% last month, reaching its highest level in 16 years and accelerating the decline in bond prices. Despite the S&P 500’s rebound, assets invested in bonds sharply decreased, resulting in the 50/50 portfolio achieving only a 7.9% return from the beginning of the year through the end of last month. A portfolio investing 60% in stocks and 40% in 10-year Treasury bonds recorded a 17% loss last year, marking the worst performance since 1937. This portfolio’s return this year was 6.7%, significantly underperforming the S&P 500 during the same period.

Workers managing their pensions through TDF funds found themselves in a difficult position. Typically, TDFs reduce the proportion of risky assets like stocks and increase safer assets like bonds as retirement approaches. It is estimated that workers nearing retirement experienced even greater losses.

Consequently, workers began withdrawing money from their stock accounts and 401K plans to invest in other products. According to Vanguard, 11% of investors managing assets through 401K withdrew funds last year to invest in other products. Investments have mainly flowed into newly issued Treasury bonds. Since Treasury yields recently exceeded 4%, investing there can yield higher interest income than existing bonds.

Experts Recommend Maintaining Funds... Need to Retain Bonds to Mitigate Losses

However, experts warn that increasing stock allocations in 401K accounts or withdrawing assets to invest in newly issued bonds may not yield significant profits. In fact, investors who managed assets through TDFs over the past decade recorded an average annual loss of 0.46%. In contrast, investors who diversified across stocks, municipal bonds, and various funds experienced an annual loss of 1.7%.

[Image source=Getty Images]

Moreover, experts advise against selling bonds held through existing TDF funds. Since it is impossible to predict whether the current high-interest, high-inflation environment will persist, it is important to have mechanisms in place to offset losses if stocks decline. Because individuals find it difficult to time the market correctly, experts repeatedly emphasize that in the current market, it is best to do nothing and keep funds invested in the fund.

However, retirees may find it difficult to watch their asset values shrink quietly. In the current situation of rapidly rising Treasury yields, investors are likely to remain confused about whether staying put is the best way to protect their assets or if they should seek new investment opportunities.