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How The Fed Is Threatening Your Retirement

The Fed has announced an ambitious plan to buy at least $600 billion of fixed income securities to help stimulate the economy. But the Fed's actions pose a risk to your retirement security.

The Fed's strategy is something called "quantitative easing" or "QE" as investors have taken to calling it. Let's take a look at why this is a threat to your retirement:

First, in all retirement portfolios, investors should have a portion of their assets is safe, fixed income securities, such as US Treasury bonds and high quality corporate bonds. This is portfolio management 101 when it comes to retirement assets. As the Fed intervenes in the markets and lowers interest rates, they simply make it harder for you to build assets for retirement or live off your money.

Instead of making say 4% to 5% on your fixed income investments, you now stand to make 2% to 3%. That means it's going to be harder to accumulate enough money for retirement because your return is lower.

  • On a $100,000 investment, if you earn 5% for 20 years, you'll have $265,000 for retirement. If you only earn 3%, then you'll have $180,000, which is 32% less. So the Fed is basically punishing those who are trying to save for retirement.
Or if you're retired, it means you're earning less interest and will have to either cut back on your spending or eat into your principal.
  • What's basically happening in the bond market is that the Fed's activities are pushing interest rates below their historical averages. Generally, in the aggregate bond market, investors can expect a return of somewhere between 2.5% to 2.75% above inflation. With inflation expectations currently running at about 2% for the next 10 years, that means rates should be closer to 4.5%. Ever since the Fed announced it was thinking of embarking on the QE plan earlier in the year, interest rates have plummeted.
Second, and more importantly, is that the Fed is likely sowing the seeds for another debt fueled asset bubble somewhere. Easy money fed the housing boom and bust. And this is even easier money; so somewhere, some asset is going to go up in price as a result of easy money. And it will eventually come crashing down as investors realize the price increases are not the result of fundamental improvements. But today, it's hard to tell where this bubble will manifest itself.

The danger for you is that you end up participating in that Fed fueled bubble. As interest rates fall on safe fixed income investments, investors get impatient and begin to take more risk with their money in an attempt to earn a higher return. This pushes them into riskier asset classes like emerging market bonds, high yield bonds, floating rate funds, commodities and stocks in general.

Now, there's nothing wrong with owning these asset classes, but what is a problem is owning them as a substitute for your safe, fixed income assets. If you remove your safe money, you have no defense in your account, and open yourself up to another crushing decline in your retirement funds.

  • Remember that debt fueled asset bubbles can run for a long time, and appear to be based on fundamentals. That's exactly what happened in housing. As prices skyrocketed, it provided the illusion of real growth. Consider that the next bubble will probably present you with the same tempting returns.
Quite simply, the Fed is daring you to maintain your discipline. And they're betting most investors won't. Basically, the Fed and Wall Street would like your money to go into riskier ventures to help stimulate the economy. But the sad thing is, at some point, somewhere, this will end badly. And the economy will have been stimulated at the expense of your retirement plan.

Bottom Line. Don't let the Fed bully you into taking more risk than you should.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

Above material does not constitute investment or tax advice; consult your individual financial advisor prior to making any financial decisions.