Don’t make the same mistake as SVB with your 401(k) -Dlight News

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(Bloomberg Opinion) — The poor risk management at Silicon Valley Bank is perplexing. But what went wrong is actually pretty common. There is often confusion about what constitutes a safe versus risky asset, and misjudgments are often at the heart of financial explosions. Safe assets, as we properly define them, are the backbone of financial markets; We use them to price and measure risks.

But knowing what makes an asset safe is not always that easy and depends on the circumstances. You probably have the wrong safe assets in your retirement portfolio right now.

We tend to view government bonds as safe. They are liquid which means you can sell them fairly easily and quickly. Debt ceiling theatrics aside, it’s a safe bet the US government won’t skirt it. For this reason, the banking regulator classifies these assets as low-risk. But depending on your financial situation, not all bonds — even those from the US government — are safe.

Silicon Valley Bank offers us all a cautionary tale. It had short-term debt or deposits, which it funded with long-term debt—government bonds and mortgage-backed bonds. The problem wasn’t liquidity, as it’s easy to sell a US Treasury bond to raise cash. The problem was that when interest rates rose, the value of government bonds fell. Longer-dated bond prices move wildly as interest rates rise and fall, while the value of the bank’s liabilities (the deposits) did not change – and suddenly all of its depositors wanted their money. All banks have a similar mismatch between their assets and liabilities, but the nature of Silicon Valley Bank’s deposits, which were large, mostly uninsured, and mostly from tech companies that would need their money once interest rates rose, made it particularly risky.

In hindsight, this was obviously a terrible strategy. Not just because the bank doubled down on its bet that interest rates would stay low, but because it made the bet when interest rates were at record lows that would never last.

But to be fair, no one can predict the future, and it’s been a long time since bond prices fell by a large amount. Bond prices have trended upwards over the past 40 years. It had become a widely held belief that we had entered a new era of ever low yields and if interest rates went up, they wouldn’t go up too much. Perhaps some people assumed that the introduction of quantitative easing as a policy meant the Federal Reserve committed to keeping the entire yield curve low forever – this seemed like a reasonable assumption based on Fed policy in recent years 15 years was based.

Also pension funds in the UK Bet on low interest rates forever , and we’ll soon find out who else did, as a changing rate environment reveals where all the bodies are buried. Assuming that interest rates will stay low forever, short-term and long-term bonds are almost interchangeable from a risk perspective. They appear equally safe, with the only obvious difference being that longer-dated bonds offer slightly more yield.

The reality is that predicting interest rates is difficult and there are no guarantees. And whether long-term or short-term borrowing is safe depends on the nature of your liabilities. The only safe strategy is to hedge interest rate risk, for example by buying bonds with a similar maturity to your liability. Therefore, the Silicon Valley Bank had to shorten the duration his wealth portfolio. For the SVB, the safe haven would have been short-term debt such as 3-month or 1-year Treasury bills (or interest rate swaps, to achieve the same effect) whose value does not change significantly when interest rates rise. It would have sacrificed some of the return in exchange for less risk of more stable prices.

When you’re saving for retirement, you face the opposite problem. Short-term assets are your greater risk. Your liability is the need to fund your retirement expenses. This is a long-term commitment as you can expect to live at least 15 years past your retirement.

So think about the money you’ll be spending in retirement — say, $50,000 a year protected from inflation. The funding is comparable to issuing a long-term bond that pays out $50,000 annually (adjusted for inflation) for 15 years. So if you want to make sure you have $50,000 to spend in each of those 15 years, you can buy a bond portfolio with the same maturity: it will pay you $50,000, adjusted for inflation, every year, regardless of what happens to interest rates.

Two years ago, a bond with that maturity would have cost about $803,000. Last week it cost $665,000, almost 20% off. That may seem good now that rising bond yields essentially made future spending cheaper. Here’s another way of looking at it: Suppose you saved $803,000 and on your first day of retirement you used that money to buy a bond that would fund your spending for the next 15 years. Two years ago, that money would have given you $50,000 in annual inflation-linked income, but given recent bond yields, that same amount of money would buy you $60,000 a year. Your income has increased because interest rates have increased.

But here’s the thing that so many people overlook: Prices may go down — or up and down more frequently — in the future. Investing in short-term bonds amounts to not hedging your risk and leaves people vulnerable to wide swings in retirement income, sometimes good, sometimes bad.

The problem is that short-dated bonds are considered a safe bet in the fixed income industry because their prices are stable. Many savers invest their retirement savings Deadline fund, which shift your portfolio into short-term bonds as you approach retirement to ensure your wealth balance remains stable. The idea is that you can then take out a fixed percentage each year. But this strategy means much lower returns (less income), more risk, and no inflation protection. Most people can’t afford that choice, and it’s extremely risky in today’s inflationary environment.

So if you want security and predictability, you need to hedge risk and invest in longer-dated inflation-linked bonds before and during your retirement. Unfortunately, we probably still haven’t learned that lesson. In part because retirees came out on top this time as interest rates rose, though that may not be the case in the future. That is the nature of risk. And it shows why it’s easy to misjudge what’s risky and what’s risk-free—and why hedging is so valuable.

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To contact the author of this story:
Allison Schrager at [email protected]

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