Bonds, Budgets and Cash Balance Plans | Adviser Investments

Bonds, Budgets and Cash Balance Plans

What Does ‘Higher for Longer’ Mean for You?

Michelle Knight, Chief Economist

Please note: This article was originally published by Ropes Wealth Advisors (RWA), a subsidiary of Adviser Investments, before the markets closed on Friday, September 22, 2023. Click here for more on the partnership between our two firms.

“Higher for longer” was what many investors anticipated—and what they got—from the Fed at this week’s much-anticipated Federal Open Market Committee (FOMC) meeting.

Though it was not surprising, the news that the FOMC expects current elevated interest rates to last was not the update Wall Street was hoping for. The FOMC’s projections of the future path of interest rates showed one more hike built in for 2023 and effectively removed two cuts from 2024. It was the 2024 projections that slammed stocks hardest, dashing hopes for as many as four interest-rate cuts next year that would have taken rates back down to 4.5%. Now the best-case scenario is two rate cuts in 2024, taking the target fed funds range to 5.00%–5.25%, only 0.25% below where we are now.

In his press conference following the decision, Fed Chairman Jerome Powell emphasized that the Fed saw progress in recent inflation reports and is encouraged by the fact that the labor market cooled without the massive job losses often seen when rates rise. But he also stressed that the FOMC doesn’t necessarily consider its work finished. He vowed to move “carefully” with future rate decisions, noting that the FOMC has the flexibility to make small moves or no moves based on data because it raised rates so quickly and dramatically a year ago.

In the aftermath of the meeting, Treasury yields soared to new 16-year highs and the dollar posted hefty gains, putting pressure on stocks, which caused them to skid back to levels last seen in June. High rates tend to slow economic growth and hurt the consumer, calling into question Wall Street analysts’ double-digit earnings growth projections for 2024. We will need to brace ourselves for a sustained period in which the markets react to each incoming economic report, trying to gauge what it will mean for Fed policy.

Speaking of economic reports, the Conference Board Leading Economic Index (LEI) fell to 105.4 in August, meeting expectations but marking the reading’s 17th consecutive monthly decline. The LEI’s extended slide is the longest since the run-up to the 2007–2009 Great Recession.

The LEI indicates the economy “is heading into a challenging growth period and possible recession over the next year,” Conference Board economist Justyna Zabinska-La Monica said in a statement. The recent declines reflect weakness in new orders, deteriorating consumer expectations for business conditions, high interest rates and tight credit conditions.

On the other hand, weekly initial jobless claims fell last week to a seasonally adjusted 201,000, about 24,000 under expectations. That is the lowest weekly figure since January and an indication the labor market remains strong.

Finally, it was notable that existing home sales fell to a seasonally adjusted annualized rate of 4.04 million in August, down 15.3% from one year ago. Prices are up due to limited supply, though, with the median sales price of existing homes at $407,100. With U.S. homebuilding at a three-year low in August, the tight housing market is likely to continue, though it was noteworthy that building permits surged to their highest level in a year, which will hopefully alleviate some of the pressure.

Unfortunately, there were no signs of relief in the United Auto Workers (UAW) strike or congressional budget talks. At noon on Friday, the UAW union will decide whether to expand its strike against the Detroit automakers; currently, all sides are holding their ground on demands. Significant issues such as hourly pay, retirement benefits, cost-of-living adjustments, wage progression and work-life balance remain central to the discussions. [Ed. note: No resolution was reached Friday, and the UAW has expanded its strike.]

Meanwhile, for the second time this week, House Republicans failed to start debating on a key military funding bill after five conservative rebels blocked the measure over demands for additional spending cuts. With 10 days until federal funding expires and no resolution in sight, lawmakers are preparing for a government shutdown that looks increasingly inevitable.

With all that, what words of wisdom or encouragement can I offer to you this week?

Remember that no single Fed meeting or economic report tells the full story—the market has plenty of twists and turns. Your strategy must be about your needs and goals, and not about the often binary outcomes of market risks and opportunities. As disheartening as the strike, shutdown, interest rates and rising energy prices are to all of us, it makes sense to pause for a moment and reflect on where we are.

Not long ago we all wondered if our lives would ever be the same again during the pandemic. Progress has been made, but it is never a straight line. We may very well be about to bend and curve and even be bumped a few steps back with a mild recession. However, with careful planning and coordination, your financial plan will not break.

Feeling Bond Fatigue? You’re Not Alone

Tim Clift, Chief Investment Officer

We won’t sugarcoat it—bonds are stuck in a performance rut.

How did fixed income get here? A combination of high inflation and a rapid economic recovery caused the Federal Reserve to act. The central bank began its most aggressive rate-hike cycle in generations in March 2022. As a result, the bond market is down nearly 9% since then. Long-term bonds, which are the most sensitive to changes in interest rates, have fared even worse, down 21%.

Bond investors were hoping prices would stabilize following the Fed’s decision to hold interest rates steady last week. But Fed Chairman Jerome Powell’s statements on the economy and future policy reset expectations. More hikes are back on the table and rate cuts may be farther off than anticipated. The bond market declined in response.

We understand if you’re worried, particularly if you have a lower tolerance for risk or a big allocation to bonds in your portfolio. It may be hard to hear, but patience is essential right now and we believe it will be rewarded—here’s why.

  1. When bond prices fall, yields rise. This is true for individual bonds as well as bond mutual funds and ETFs. Higher yields mean higher current income—the silver lining when a bond’s value declines.
  2. Yields are a predictor of future returns. If you hold a bond to maturity, you know that you’ll receive a set amount of income each year and get your principal back when it matures. As of this week, the 10-year Treasury note is yielding 4.5%, so that’s a reasonable expectation for its annualized return until maturity. Similarly, a bond fund’s current yield is a decent indication of what its total return will be over the long term, as you can see in the chart below.

    This chart shows the SEC yield for a bond index fund and the trailing 10-year return. Yield has been a good predictor of returns.
    Note: Chart shows month-end SEC yields for the Vanguard Total Bond Market Index fund and the fund’s trailing 10-year annualized total return from Mar. 1993 through Aug. 2023. Sources: The Vanguard Group, Morningstar Direct.
  3. Bonds are a complement to stocks, not competition. Over 560 rolling 12-month periods since 1976, bonds and stocks both declined only 2% of the time. And bonds had negative 12-month returns only 12% of the time when stocks fell. This makes bonds well-suited to help mitigate stock market risk. We own bonds to reduce portfolio volatility and provide income. Bond funds and ETFs also offer the potential for growth over time.

In our core strategies, our long-standing approach is to not reach for yield—meaning we avoid funds with the greatest interest-rate risk, such as those holding long-term bonds. Instead, we focus on moderate- and lower-risk intermediate- and short-duration funds, which we believe offer a good compromise between income, total return and risk.

While we never enjoy periods of underperformance, we believe this approach is prudent for the foreseeable future. We think that bonds will show their value over time, and for now, we are seeing opportunity as higher yields make segments of the bond market more attractive from a risk-reward perspective.

Now more than ever, it’s important to maintain a long-term focus if you’re a bond investor. We believe you will be rewarded for doing so.

What Are Cash Balance Plans and Who Benefits From Them?

Kari Wolfson, CFP®, Partner, Wealth Advisor

Cash balance plans can be a game-changer for small business owners who earn a high income, are within 10 years of retirement and are behind on their savings. Here’s why.

These plans are a type of pension, but instead of being based on your salary, your payout in retirement is based on what is contributed. This makes cash balance plans more like a 401(k) or IRA than a traditional pension plan. They offer a great deal of flexibility, potential tax benefits and a higher contribution limit.

If you earn $250,000 or more a year through your business, cash balance plans allow you to take substantial deductions on your contributions, which could move you into a lower tax bracket. The plans can also help you avoid excess Medicare tax (levied on married taxpayers who file jointly with over $250,000 in income).

Since these plans allow for significantly higher annual contributions than solo 401(k)s or simplified employee pension plans—up to $398,000 in tax year 2023—they can be a good fit for high earners looking to make that final sprint toward a comfortable retirement.

Key Considerations for Cash Balance Plans

Small business owners weighing a cash balance plan should be aware of the higher administrative fees involved and the need for a consistent return on the assets within the plan.

Like a 401(k) or IRA, you can choose how the plan is invested. But a critical component of these plans is a guaranteed rate of interest on contributions, known as the interest crediting rate (ICR). The ICR is used to calculate each year’s contribution requirement. Losses in the portfolio will translate into higher contribution requirements to get to the ICR threshold. For this reason, lower-risk investments are typically the best choice.

The contribution requirement also means that these plans work best for businesses with predictable revenue—funding shortfalls could result in an excise tax penalty.

This table shows the pros and cons of cash balance plans.

The ICR is also where those higher administrative fees come in. You will need to hire a certified public accountant or actuary to administer your plan. They will make sure the plan is compliant with IRS regulations and handle the contribution calculations each year.

If you will be offering the plan to employees, note that you as the plan sponsor are responsible for all contributions on their behalf—unlike a 401(k), employees are not permitted to contribute to their cash balance plan.

Is a Cash Balance Plan Right for You?

If you think a cash balance plan might be a good fit for you, call us today and we will connect you with a small business wealth advisor specialist.

Since we are already managing your account, we can provide valuable perspective to make sure your cash balance plan works in harmony with your overall strategy, especially since they are typically paired with a 401(k) or IRA funding plan. We will collaborate with the plan administrator on the documents and on streamlining the annual contribution requirements. And when you’re ready to take payouts from the cash balance plan, we’ll help find the best solution for you, whether that’s annuitizing, taking a lump sum and rolling it into an IRA, or something else.

Strategy Activity

Please see below for a summary of the trades we executed over the week through Thursday and our current tactical strategy allocations.

Dividend Income

No trades

AIQ Tactical Global Growth

Sell iShares Expanded Tech-Software Sector ETF (IGV)

Buy Cash

AIQ Tactical Defensive Growth

Sell iShares Core S&P 500 ETF (IVV)

Buy Cash

AIQ Tactical Multi-Asset Income

No trades

AIQ Tactical High Income

Sell iShares iBoxx USD High Yield Corporate Bond ETF (HYG)

Sell iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)

Buy Cash

Adviser Market Update

  • If Congress does not pass a budget this week, the government may be forced to shut down as early as this coming Sunday. Past shutdowns have negatively impacted consumer confidence and spending, slowed the economy, and disrupted the reporting of data that agencies like the Fed depend upon to make policy decisions. That said, even though shutdowns create uncertainty that harms the standing of U.S. debt as the world’s safe-haven investment, it’s unlikely that a short one would cause a recession.
  • The Federal Trade Commission (FTC) has opened an antitrust lawsuit against Amazon. The FTC alleges that the online retailer’s pricing practices are anti-discounting and force retailers to use Amazon’s logistics services to remain competitive. It’ll take time for this case to play out, but as of Wednesday’s market close, Amazon’s stock had declined 4% since the news broke on Tuesday.
  • Oil prices have risen more than 25% since the start of the year and are approaching $100 a barrel. Higher energy costs have a noticeable impact on consumers’ bottom line, affecting our commuting costs, travel expenses and grocery shopping. It’s possible prices could rise from here, given the agreement between Russia and Saudia Arabia to curtail supply through year-end.

Please note: This update was prepared on Thursday, September 28, 2023, prior to the market’s close.

This material is distributed for informational purposes only. The investment ideas and opinions contained herein—including but not limited to the Your Question Answered section—should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio.

Purchases and sales of securities listed above represent all securities bought and sold in each strategy during the period stated. Each strategy’s portfolio generally includes more holdings in addition to the transactions listed above and in some cases the securities listed above may only represent a small portion of the particular strategy’s complete portfolio. Further, the securities listed above are not selected for listing based on their investment performance; thus it should not be assumed that any of the securities listed above were profitable or will be profitable, nor should it be assumed that future recommendations will be profitable. Clients and prospective clients should only make judgements about a strategy’s performance after reviewing the strategy’s composite performance information. There is no assurance that each security listed above will remain in the strategy’s portfolio by the time you have received or read this email. Securities are listed for informational purposes and are not intended as recommendations. Existing investor accounts may not participate in all transactions listed above due to each account’s particular circumstances.

You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.

Past performance is not an indication of future returns. Tax, legal and insurance information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice, or as advice on whether to buy or surrender any insurance products. Personalized tax advice and tax return preparation is available through a separate, written engagement agreement with Adviser Investments Tax Solutions. We do not provide legal advice, nor sell insurance products. Always consult a licensed attorney, tax professional, or licensed insurance professional regarding your specific legal or tax situation, or insurance needs.

Companies mentioned in this article are not necessarily held in client portfolios and our references to them should not be viewed as a recommendation to buy, sell or hold any of them.

For a summary of Adviser Investments’ advisory services and fiduciary responsibilities to our clients, please review our Form CRS here.

© 2023 Adviser Investments, LLC. All Rights Reserved.