401(k) plans provide most investors an easy way to save a considerable amount of money for retirement, which is why it is not surprising to see many investors with a majority of, if not all, their assets in their 401(k) plans. So, if you are within 10 years of retiring and all of your retirement assets are in a 401(k) plan, how do you apply the Ten Year Rule?
The Henssler Ten Year Rule is that any money you need within the next 10 years to cover spending needs should be placed in fixed-income investments held to maturity to protect principal. However, 401(k) plans generally have limited options for investment, as plan participants often have 15 to 20 funds from which to choose. Buying fixed-income investments, such as individual bonds, isn’t an option unless you have access to a self-directed brokerage window feature in your plan.
With circumstances like these, we recommend individuals who are within 10 years of retirement and have their assets tied up in a 401(k) plan to begin shifting the money needed to cover liquidity needs in retirement to bond funds offered within their plan. The reason is that this money should be protected from the volatility of the equity markets. You want an investment that will keep pace with inflation to protect your purchasing power; therefore, achieving high returns is not the goal. Bond prices may fall under some market conditions, but they generally don’t fall as far or as often as stocks.
Bond funds do not have a maturity date, and your shares may be worth more or less than you paid for them when you sell. You can lose money in a bond fund. Bond prices tend to move in opposition to stock prices. When the market is rolling along reaching new all-time highs every week, bond returns tend to be relatively low. As economic conditions make companies more profitable, that can lead to inflation, causing the Federal Reserve to increase interest rates hoping to slow inflation. Rising interest rates cause existing bond prices to fall; therefore, if you have a bond fund that is holding bonds at a lower interest rate than what is currently being issued, the value of the bond fund will likely decrease. The underlying investments in a bond fund are constantly maturing or being sold with new bonds being added. As interest rates change, the value of the bond fund can increase or decrease. This is why it is nearly impossible to match the investment in a bond fund to your exact liquidity need.
Ideally, you’re looking for a bond fund that uses U.S. Treasury bonds as the underlying investment. Bond funds are generally categorized by the duration of the underlying bonds, which give you an indication as to how sensitive the bond fund investment is to interest rate changes. Long-term bond funds carry more interest rate risk than short- to mid-term bond funds.
All that said, bond funds can offer a more predictable return than stock mutual funds. With bond funds, you should be able to avoid a surprise 20% drop in value a few months before you need to cash out. When investing in individual bonds isn’t an option, bond funds can be a good choice.
We definitely recommend avoiding high-yield bond funds because these often carry an “equity-like” risk profile—not a risk you want for money that you’re trying to protect. We also recommend an in-depth analysis of the target-date fund options available in your plan. Target-date funds take control of your allocation out of your hands. You want to retain as much control as possible to ensure your portfolio fits your specific needs. You may also consider a money market fund option within your 401(k) to fulfill short-term liquidity needs.
If you have questions regarding your retirement allocations, the experts at Henssler Financial will be glad to help: