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Investment & Portfolio Strategy

September 2013

E. William Stone, CFA®, CMTManaging Director, Investment & Portfolio StrategyChief Investment Strategist

Marsella MartinoSenior Investment Strategist

Michael ZollerInvestment Strategist

pnc.comPNWI0090113

Five Threats to Your Retirement Thinking about retirement is no longer a future event for many Americans; most recognize the need for careful planning throughout their working years.While it is a positive that Americans are expected to live longer, this can add tothe already daunting challenges of funding a comfortable retirement. With thehelp of a PNC Wealth Management advisor, investors can map out a course formeeting their financial goals. This process often entails an investment objectiveof saving and of investing a portfolio designed to help meet individual cash flowneeds in retirement while preserving capital and managing risk. We have writtenseveral times about different (yet not mutually exclusive) methods of investingfor retirement (see PNC Wealth Management’s May 2013 white papers,Retirement: Total Return and Retirement: Income Floor), which provide insights on how investors may seek to achieve their stated objectives.

With the goal of investing for retirement in mind, we want to address fivethreats to retirement of which an investor should be cognizant.

n inappropriate asset allocation;n higher interest rates; n loss of purchasing power (financial repression);n rising health-care costs (private and public); andn changes in net worth.

What follows is a discussion of these risks and how we believe investors canseek to mitigate them.

Inappropriate Asset AllocationSelecting an appropriate long-term strategic asset allocation that matches an investor’s goals, risk tolerance, and investment holding period is vital to managing funds set aside for retirement. In practice, this process takes a significant amount of time for clients and financial advisors to develop an understanding and to plan. This is time well spent—being too conservative or too aggressive could likely prevent an investor from meeting goals within theappropriate time period.

It was not that long ago that a fairly low-risk portfolio could have an expectedreal return high enough to support a relatively safe 3-4%-per-year drawdown.However, the recent extended low-interest-rate environment, aided by FederalReserve (Fed) policy actions, has made it much more difficult for investors to

even keep pace with inflation while maintaining a low-risk profile.Thus, positioning a portfolio too conservatively can pose a threat to the investor’s goals, since the goal for essentially all retirees is to maintain—or better yet grow—purchasing power, and a too-conservative position can erode purchasing power. Who does notwant to keep or even improve their standard of living in retirement?

One lesson learned from the financial crisis and subsequent GreatRecession is the importance of a well-balanced portfolio that includes a diversified mix of asset classes. During this period,investors flocked to fixed-income, driven by a variety of reasons,including preservation of capital and assuring future cash needs could be met. Looking at the flow of assets into different asset classes, the so-called “flight to safety” is clear (Chart 1).

However, it is also important to recognize the consequences of being too conservative in retirement planning. Using an extended time series of historical returns for the PNC Wealth Management asset allocation profile (Chart 2), it has been demonstrated that over any rolling 10-year period, taking less market risk has kept real returns tempered, and webelieve it could even result in drawing down more principal than originally anticipated during retirement. This is highlighted further by looking at the 10-year Treasury yield compared with the U.S. Consumer Price Index (Chart 3, page 3). With a 10-year Treasury yield around 2.8% it's unlikely a Treasuryportfolio will yield a positive real return in the current environment with long-term inflation in the United States averaging a little less than 3%. Thus, the cost of safety is extraordinarily high.

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Chart 2Historical Returns and Range of Returns by Asset Allocation Profile(Percentage Annual Returns, 1926-2012)

Source: Ibbotson Associates, PNC Wealth Management

Source: Strategas, PNC Wealth Management

Five Threats to Your Retirement

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Forecasting returns for different asset allocations over aninvestor’s investment holding period likely provides a picture thathelps frame expectations and thus allows for decision making.Being too conservative with an asset allocation exposes theinvestor to the risk of a negative real return over the medium tolong term (the cost of being too conservative). Conversely, therealso is a risk of being too aggressive, putting at risk capital thatmay need to be drawn upon in the nearer term.

Since accurately determining the short-term movement of stocks is unlikely, we argue that investors should focus on what is knowable and controllable. When determining their asset allocation, investors should focus on their:

n goals;n risk tolerance;n expected liabilities;n expected cash inflows;n investment holding period; andn personal situation.

Each of PNC Wealth Management’s six asset allocation profiles (Table 1) differs from the next in the stock/bond/cash weighting by about 15-20%. Theseincrements are just enough to result in materially different risk and return characteristics for each asset allocation profile. They are designed to minimizegaps or redundancies in the risk/return spectrum. The impact of these incrementsis for a variance of a little more than 0.5% in historical return. The risk spectrum has larger gaps in terms of worst one-year returns due to the largevariability of one-year stock returns, but the worst 10-year numbers are muchmore controlled. Historically, even the most conservative of the asset allocations has outpaced inflation, on average (Chart 2, page 2).

Importantly, with the high share of cash in the preservation portfolio and limited market risk, it is unlikely that this strategy will have a positive realreturn over the medium term, given the low nominal yields on safer assets.According to our calculations, over the 12 months ended June 30, 2013, cashreturned a hair over 0%; bonds (Barclays U.S. Aggregate Index) had a capitalloss of 0.69% due to rising yields; while stocks (S&P 500®) returned a sharplyhigher 20.6%. All told, a portfolio of 55% cash, 30% Barclays U.S. Aggregate,and 15% S&P 500 would have returned about 2.7% over the 12 months.Although outpacing inflation over that 12-month period, it is not too difficult toimagine a scenario in which the capital appreciation of stocks fails to make up

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Chart 310-Year Treasury Yield versus Inflation

Source: Bureau of Labor Statistics, Bloomberg L.P., PNC Wealth Management

Table 1PNC Wealth Management Asset Allocation Profiles

Preservation Conservative Moderate Balanced Growth Aggressive

Stocks 15.0% 35.0% 50.0% 65.0% 80.0% 100.0%Bonds 30.0 65.0 50.0 35.0 20.0 0.0Cash 55.0 0.0 0.0 0.0 0.0 0.0Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Source: PNC Wealth Management


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for the poor price appreciation of bonds and the scant yields of cash. This expectation for more restrained returns from bonds is in the context of history;capital appreciation of long-term government bonds has rarely if ever been thisstrong (Table 2).

Higher Interest RatesFollowing the financial crisis and subsequent Great Recession, the United Stateshas been in an extended period of low short-term interest rates. The Fed-ledrecovery has been an important variable in recent years, contributing to the investment landscape. Assistance by the Fed in terms of monetary policy was always intended as temporary; however, and as the economy continues to slowly strengthen, realistic expectations continue to mount that the low-interest-rate party could be drawing to an end. The Fed is not planning for rates to rise meaningfully anytime soon. Nonetheless, the rise in interestrates continues to be an eventuality, even though we do not expect a steep rise in the near term.

The long-term view of interest rates is an important part of the retirement investing equation. Facing the eventual rise in long-terminterest rates, investors should evaluate their portfolios for this andother factors.

It is important to look at all asset classes’ potential reaction during times of higher rates. In particular, we take a moment to discuss fixed income. Flow-of-funds data suggest that investors have swarmed to fixed income in recent years in response to the financial uncertainty stemming from the financial crisis. This demonstrates theimportance of assessing asset risk as bond portfolios have grown. We believefixed-income investors can, with prudence, better manage risks through a long-term approach to investing and strategic diversification (Chart 4). Again weremind investors of the importance of fixed income to portfolios for preservationof capital, for income, and for low correlations of returns to stock returns, toname just a few considerations.

Table 2Long-Term Government Bond* Total Returns

Capital Income TotalDecade Appreciation Return Return1930s 1.9% 3.0% 4.9%1940s 0.9 2.3 3.21950s -3.0 3.0 -0.11960s -3.0 4.6 1.41970s -2.0 7.7 5.51980s 1.5 10.9 12.61990s 1.5 7.2 8.82000s 2.5 5.1 7.72010 to 7/31/12 4.9 3.3 8.3

*Ibbotson Associates Long-Term Government Bond Index

Source: Ibbotson Associates, PNC Wealth Management

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Chart 4Correlations of Barclays Aggregates to S&P 500

Source: J.P. Morgan, Barclays Capital, Bloomberg L.P.,PNC Wealth Management


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Loss of Purchasing PowerDespite inflation remaining below the long-run average, investors preparing forretirement should be aware of the threat of declining purchasing power. This hasparticular importance for investors thinking about retirement because inflationchips away at purchasing power over time—the reduction in purchasing poweris often difficult to see when it is happening, but it is very real. Short-term interest rates are likely to remain low into 2015, creating a difficult environmentfor earning a positive real (inflation-adjusted) return from short-term bonds andcash at tolerable levels of risk. In the past we have often discussed investing in alow-interest-rate environment, and this theme will continue to be importantthrough the near term. We will frame this discussion as investing during a timeof financial repression.

For some investors, the relative safety of investing in Treasuries or other high-quality fixed-income securities may still make sense. If unable or unwilling totolerate the higher volatility associated with equity investing, they may still findit appropriate to have a large share of a portfolio in high-quality bonds or cash.However, it is important to beaware that after adjusting forinflation, the return on suchinvestments is likely negative;thus, a dollar invested todaywill purchase less in the future.Taking a long-term view ofannualized returns, we showthe effects of inflation onreturns on several assetclasses in Table 3.

Furthermore, considering several times in history, including during the early 1940s when the government implemented fixed interest rates on Treasurysecurities, we believe that investors seeking positive real returns should avoidTreasuries when nominal rates are below average long-term inflation. If youassume inflation is about average through the near term, the inflation-adjustedreturn on a 10-year Treasury is currently negative. In fact, taking the roughly3% annual inflation rate as a constant, we see that real rates have never beenlower than they are now. The analysis changes when the actual year-over-yearCPI is used, but it is difficult to imagine anyone accurately predicting inflationduring the volatile 1970s and early 1980s (Chart 2, page 2).

It is important not to lose sight of where the bond market is in the context of history. Looking at the history of the 10-year Treasury note yield gives an idea of what a bull market in bonds it has been over the past three decades(Chart 5, page 6). Given the steady march downward, there does not appear to be room for yields to move much lower.

Financial repression occurs when a government implements policies that funnel money to itself that would have otherwise flowed elsewhere. As a result of these policies, nominal interest rates are lower than they would be in a more competitive market. These low nominalrates combined with inflation—even if inflation is around the current Fed target of 2%—is enough to erode the real value of investments.

There are several ways governments areable to keep rates low. The two most relevant in the United States are:

n de-facto caps on interest rates; and n the creation of a captive domestic

audience.

The Fed’s purchases of mortgage-backed securities, agency debt, and long-termTreasuries have been an effective tool for keeping borrowing cost low in manymarkets. On the shorter end of the yieldcurve, the Fed is keeping its policy rates(federal funds rate, discount rate, andinterest paid on excess reserves) low. The best example of creating a captivedomestic audience is the regulatory standards created by the Basel Committee on Banking Supervision, which give a lower risk score for government debt than most other securities.

It is important to point out here thatwe are not judging the appropriateness of these policies and regulations.Regardless of our opinion, the fact remains that rates on Treasuries and other high-quality (low-risk) fixed-incomesecurities are likely to remain low. At thesame time, there is little reason to expectthat inflation will deviate too far from theFed’s soft target of 2%. Under these circumstances, real interest rates will likely be extremely low or negative, whichis a key feature of financial repression.

Over the past several decades, the UnitedStates has seen the effects of financial repression and negative real interest rates.According to research done by Reinhart andSbrancia, between 1945 and 1980, realinterest rates have been negative 25% ofthe time in the United States. 1 This createdinterest-cost savings of 3-4% per year,which helped the U.S. government reduceits debt load. This reduced debt burdencame at a direct cost to savers in theUnited States because the purchasingpower of their investments was reduced.Earning real positive returns on fixed-income investments in this environmentwas challenging.

Table 3Historical Average Annualized ReturnsJanuary 1926-July 2013

Real NominalS&P 500 6.82% 10.00%Long-Term Gov’t Bond 2.49 5.5430-Day T-Bill 0.52 3.51Inflation NA 2.97

Source: Ibbotson Associates, MorningStar, PNC Wealth Management

1Carmen M. Reinhart and M. Belen Sbrancia, “The Liquidation of Government Debt,” National Bureau ofEconomic Research Working Paper Series, Working Paper 16893 (March 2011).


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To analyze returns during a bear bond market you need to go back decades. Looking back at other bear bond markets, it can be seen that purchasing or holding long-term government bonds at very low yields bodes ill for portfolio returns. For example, if a 2.5% constant maturing 30-year bond was available in 1946, it would have fallen from $101 to $17 by 1981 or a decline of 83%. This was a significantly worse performance than the average return on U.S. equities over that time period.

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As the economy continues to strengthen, interest rates are likely to move higher as rates normalize. History shows that the 10-year Treasury yield should typically be around the nominal rate of U.S. GDP growth (Chart 5). With PNC Wealth Management’s nominal GDP growth estimates of approximately 3% in 2013 and 4% in 2014, the pressure is likely higher on interest rates. This could pose a problem for bondholders, particularly investors with outsized bond positions and long maturities.

Currently, with few inflationary pressures in the economy, the Fed hasmaintained its policy on short-term rates, stating that the federal funds targetrate will remain close to zero at least until either the unemployment rate fallsbelow 6.5% or inflation one to two years out appears set to move above 2.5%.Given that there is no sign that the inflation threshold will be hit anytime soon,the unemployment rate is more relevant. Even there, we do not believe the unemployment rate is likely to move below 6.5% until early in 2015, so weexpect that short-term rates will remain close to zero for another couple of years.

To be clear, one should not extrapolate this into the view that investors shouldown no bonds. A core belief of the PNC Wealth Management IntegratedInvestment Approach has always been to own securities for a specific purpose.Bonds continue to fulfill such a purpose—consistent income generation—whichis difficult to obtain elsewhere. One could also view high-quality bonds as aform of insurance, in that risky assets such as stocks are likely to do better overthe long term but are much more susceptible to large losses.

As opposed to a wholesale elimination of bonds from a portfolio, what are theimplications if interest rates remain low? In our view, investors should focus ontheir income needs and tolerance for price volatility when setting their bond allocations, but it would be wise not to count on any price appreciation in bonds when projecting future returns.

Within bonds, an allocation to non-Treasury fixed income, such as municipalbonds, corporate bonds, or absolute-return-oriented fixed-income strategies,could be appropriate. A benefit of such an allocation is that it provides extrayield over and above Treasury bonds. Also we have long discussed the merits of adding alternative assets to portfolios, including Treasury Inflation-ProtectedSecurities, as a method to retain purchasing power. For more information

2Sidney Homer and Richard Sylla, A History of Interest Rates, Third Edition, Revised (Hoboken, NJ: John Wiley & Sons, Inc., 1996).

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Source: Bureau of Economic Analysis, Bloomberg L.P., PNC Wealth Management


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regarding TIPS please see our white paper Neither Fish nor Fowl: A TIPS Primer. All told, we believe investors will likely continue to face low rates over the nearterm. This has many benefits to an economy that is in the midst of a tenuousrecovery. However, this environment is not without costs to investors, who must be cognizant of the potential erosion of purchasing power when building aretirement portfolio. In 2010, PNC Wealth Management began advising clientsto consider a tactical allocation to leveraged loans within the recommended profiles in order to provide some defense against a possible rising-interest-rateenvironment. In addition, we added an allocation to global bonds to furtherdiversify away from low developed-country yields. Recently, PNC WealthManagement added an absolute-return-oriented fixed-income strategy tacticalallocation (see July 2013 Investment Outlook, Breaking the Bonds).

Rising Health-Care CostsThe consequences of a reduction in purchasing power are magnified whenapplied specifically to health-care spending. Although it is not the most pleasantof topics to think about during the planning-for-retirement phase of life, it mustbe considered that health care will make up a larger share of consumption thanin the younger years—currently health care is 15% of the average annual spending per person (Chart 6). This spending is just an average and, as onewould expect, health-care spending rises with age, according to a report by theBureau of Labor Statistics.

The price of health care has been increasing rapidly over the past 70 years,which has likely already caught some retirees by surprise and is a reason government spending on health care (Medicaid and Medicare) has soared. The headline CPI has averaged a 3.7% year-over-year increase since 1948, while the medical care component of CPI has averaged a 5.5% year-over-yearincrease (Chart 7).

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Chart 7Consumer Prices: Headline and Medical Care(1/30/48-7/31/13)

Source: Bureau of Labor Statistics, PNC Wealth Management

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Chart 6Health-Care Expenditures Share of Personal Consumption (3/31/59-6/30/13)


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The fast-paced rise in health-care costs is problematic, leaving retirees on an uncertain path with government spending on health care unsustainable. To further this point, we look at the Congressional Budget Office’s estimate of growth in key entitlement programs as a percentage of GDP over the next 39 years.

At the current projected rate of growth, these entitlement programs will take up the entire tax revenue by 2050 if the ratio of tax receipts relative to GDP stays near the long-term average (Chart 8). These forecasts suggest that reforming entitlement outlays will need to be a key part of any meaningful fiscal reform.

Coming up with a plan to address long-term fiscal issues is a daunting task. Although much uncertainty remains, it is not too hard to imagine a scenario in which government spending on health care declines (Medicare), while the cost of health care continues to rise faster than headline inflation.

These potential headwinds from health-care costs could result inmore (inflation-adjusted) dollars being allocated to medical care. This type of scenario is difficult to prepare for, but should be considered when developing a plan for retirement.

Changes in Net WorthThe threat of a sharp decline in net worth feels ever more pertinent in the context of the Great Recession (Chart 9). Once a person is nearing or has entered retirement, the ability to recoverfrom a negative wealth shock (a decline in house or equity prices) is greatly diminished. For the most part, there is no additional paycheck that can be invested to make up for the loss of principle. It is also more likely that risk appetite is too low to accept enoughmarket risk to recover from the shock. This is largely a timing problem. And as the financial crisis illuminated, a sharp drop in asset prices at the wrong time can be particularly troublesome tothose approaching retirement age.

We believe a sharp decline in home prices is the bigger of the threats, given the historical recovery period. This point is furthered by the June 2012 Federal Reserve Bulletin, “…Although declines in the values of financial assets or business were important factors for some families, the decreases in median net worth appear to have been driven most strongly by a broad collapse in house prices.”

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Source: Congressional Budget Office,PNC Wealth Management

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Chart 9Changes in Net Worth

Source: Federal Reserve, PNC Wealth Management

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Chart 10U.S. Households’ Real Estate Assets as aPercentage of Total Assets (3/31/59-3/29/13)

Source: Federal Reserve, Bloomberg L.P., PNC Wealth Management

3Jesse Bricker, Arthur B. Kennickell, Kevin B. Moore, and John Sabelhaus, “Changes in U.S. Family Finances from 2007 to 2010: Evidence from the Survey of Consumer Finances,” Federal Reserve Bulletin 98 (June 2012): 1.


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Home ValuesThe decline in home prices has weighed heavily on net worth, and remains a formidable threat for retirement. According to recent Fed data, a primary residence makes up almost 30% of family assets, the largest single asset (Chart 10). Such a high concentration of a largely illiquid asset can quickly change the path of a retirement plan.

There are a couple of reasons this could be a threat.

n For people attempting to retire and move to a more retirement-friendly state—for weather or cost of living reasons—the decline in home prices and the extended lack of liquidity in many real estate markets are acting as constraints, impeding the planned retirement move.

n Many soon-to-be retirees are now coping with the fact that their largest asset is worth a lot less than previously anticipated. This is potentially causing a postponement of retirement or forcing changes to goals.

The housing market is now recovering, which is having an important effect onconsumer confidence and economic outlook. Because real estate tends to be aconsumer’s biggest asset, rising home prices have a marked impact on consumerbalance sheets. Home prices, while still off a low base, appear finally to be adding much needed value back to homeowners’ balance sheets (Chart 11).While the big picture certainly looks much improved from the deep recessionarydays, real estate tends to be local, and home values have improved in some areasmore than others, affecting investors differently, sometimes dramatically so.

Given our current expectations for a modest housing recovery, it will take untilaround 2020 for house prices to reach their pre-housing-bubble peak. Thismeans the decline in wealth is essentially permanent for many people nearingretirement. For individuals still far away from retirement, we believe these concerns should be remembered and factored into retirement planning.

One way we recommend protecting your retirement from an unexpected declinein wealth is by setting proper expectations. Scenario testing a retirement plan fora drop and prolonged suppression of house prices is one option. Of course thatdoes not prevent the hardship, but it will help with setting proper expectationssurrounding an individual’s retirement planning.

Market Timing Considerations and Net WorthOne does not have to look back in history very far to see the consequences of declining equity prices on household net worth. The S&P 500 declined more than 50% peak to trough between October 2007 and March 2009. The S&P 500 hit 1,565 on October 9, 2007, and bottomed at 676.53 on March 9, 2009. This translated into a massive decline in equity.

However, historically, equity markets have bounced back fairly quickly. Withbetter economic news and accommodative easing, markets have recovered, andthe trajectory of recovery has picked up steam. For example, if you invested in

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Chart 11Housing Prices (3/31/00-6/31/13)

Source: Federal Housing Finance Agency, Bloomberg L.P.,PNC Wealth Management


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the Balanced total return portfolio in October 2007—in hindsight the worst time in the past 70 years to purchase equities,the portfolio would have returned more than 16% as of June 30,2013 (this is a simple example using a hypothetical asset allocation).On August 2, 2013, the S&P 500 hit a new all-time high of 1,709,before pulling back on concerns regarding an eventual Fed tapering of quantitative easing.

The point we make here is that well-balanced portfolios tend tobounce back over reasonable time frames. Thus, although severe market moves may be painful and scary, they are less likely to bedetrimental to a retiree’s net wealth in the long run.

To be clear, the ride has been bumpy, and while from a technical perspective the recent rally makes sense, it is our view that investorscontinue to feel some apprehension. The disconnect centers aroundthe tangibility of economic recovery. While clear in some areas, it is sluggish in others. There are continued concerns about quantitative easing and future Fed policy in the United States and globally about a slowdown in China, among other issues.

In the wake of the 2007 financial crisis, there has been a persistent outflow of investment from stocks into bonds (Chart 12). While 2013 has seen some inflows into stocks, the Great Rotation—the asset allocation shift back to stocks from bonds by investors—is just starting to be seen. As we noted earlier, the flocking to fixed-income by investors in recent years had merit, given the strong returns experienced until recently.

Finally overall we note that despite the challenges households have faced in terms of declining net worth, whether in investmentportfolios, home prices, or other asset dislocations, net worth hasnow fully recovered and exceeded its prerecession highs (Chart 13).Our discussions here note the importance of asset allocation in totality to position an investor’s portfolio for various scenarios. For example during the financial crisis, when stock market valuations erodedportfolios, at least on paper fixed income provided a salve to investors with cash needs. A long-term approach works best, in our view, in positioning portfolios for near-term and long-term market and economic scenarios.

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Chart 13Net Worth of U.S. Households and Nonprofits

Source: Federal Reserve, PNC Wealth Management

The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services andlending of funds through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNCDelaware Trust Company. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is notprepared with respect to the specific investment objectives, financial situation or particular needs of any specific person. Use of this report is dependent upon thejudgment and analysis applied by duly authorized investment personnel who consider a client’s individual account circumstances. Persons reading this report shouldconsult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report wasobtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in thisreport and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in thisreport nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, taxor accounting advice. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, or the Federal Reserve Board. Securities involve investment risks, including possible loss of principal.

©2013 The PNC Financial Services Group, Inc. All rights reserved.


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Chart 12Net Mutual Fund Flows into Bonds and Stocks

Source: ICI, Morningstar, PNC Wealth Management

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