Many tax-preferred retirement accounts and 529 funds restrict investment choices to a small set of stock and bond ETFs or mutual funds. The allowable investments inside a 401(k) plan are selected by the plans sponsor. For example, the Thrift Savings Plan (TSP) offered to federal employees has several funds and an option for mutual fund investing but does not allow workers to purchase Treasury Securities directly through the Treasury or through a broker.
Most individual retirement accounts (IRAs) and brokerage accounts allow for direct investments in the stock of individual companies, Treasury securities, agency securities, and corporate bonds. Individual investors at Fidelity and Vanguard with an IRA account can purchase the same assets as investors with a brokerage account at the firm.
Individuals saving in plans that are not tax preferred can purchase bonds either through a brokerage account or through Treasury Direct. Series I savings bonds can only be purchased directly from the Treasury and are therefore not available for retirement savers or for people utilizing 529 plans for college savings.
Retirement savers with an IRA can purchase Treasury Inflation Protected Securities (TIPs) through their brokerage company. Whether this option is available through a 401(k) plan depends on the investment options chosen by the plan’s provider. Most 401(k) plans that I am aware of do not allow for direct purchases of TIPs.
Many financial advisors, including one mentioned in this CNBC article, favor the use of bond ETFs over direct purchases of Treasury securities. The prices of the bond funds touted in this article appear highly variable.
The use of bond funds instead of direct investments in bonds often results in inferior financial results. Both bond prices and bond ETF or mutual fund prices vary inversely with interest rates. The difference in financial exposure stemming from holding a bond and the financial exposure from holding a bond fund is that the bond holder can avoid losses by holding the bond until the maturity while returns for the holder of the bond funds are always dependent on interest rates.
All 401(K) plans have bond fund options. Many 401(k) plans have an option for short-term bonds that primarily invest in inflation protection securities. However, even short-maturity bond funds designed to protect investors from the eroding effect of inflation can result in substantial financial losses for investors.
The returns for VIPSX are -10.45 % over a one-year holding period and 1.02 percent over a 10-year holding period. Other short-term bond funds seeking to protect investors from inflation including STPZ and VTIP do not appear to be meeting their objective in the current macroeconomic environment.
There is one sure fire way to insulate your portfolio from inflation, the purchase of Series I bonds. However, the IRS imposes an annual limit on the purchase of Series I bonds, and Series I bonds cannot be purchased in IRAs, 401(k) plans or 529 plans. Most household with most of their financial portfolio inside a retirement plan cannot purchase enough Series I Savings bonds to insulate themselves from inflation.
The performance of both long-term Treasury bonds and bond funds has also been miserable. See BND, AGG, and FNBGX and look at the chart with the longest time span of historical prices.
Advantages of Direct Investments in Treasury Securities:
Investors who purchase a Treasury security at a positive yield and hold the Treasury security to maturity will never experience a nominal loss on the security.
However, many investors will sell a long-term security prior to its maturity.
Investors should not purchase either a long-term bond or a long-term bond fund when interest rates are extremely low, as they were during the pandemic, since at that time interest rates were certain to rise and bond prices certain to fall.
Investors can spread out bond purchases over several months to assure monthly access to liquid retirement assets. The purchase of six-month Treasury bills on six consecutive months would allow for monthly access to liquid assets.
The price risk of a Treasury security goes towards zero when the security nears its maturity date. An investor needing funds shortly before the maturity date could sell the asset without a substantial loss, even if interest rates rise. By contrast, short-term bond funds have no maturity date, hence the price of the fund will fall if interest rates rise.
Investors can match the maturity of bonds that they hold with future liabilities. This is an especially important feature for parents saving for college tuition who could match bond maturities with tuition payment due dates.
However, 529 plans commonly used for saving for college generally do not have an option allowing for direct investments in Treasury securities. Instead, the plans allocate investments into bond and stock ETFs or mutual funds. The price of funds inside college 529 plans, even the short-term bond funds, vary substantially with market conditions.
Both savers in 529 plans and savers in retirement plans often save through a life-cycle fund that shifts assets from stocks to bonds as investors near retirement. However, the component of the Lifecycle fund invested in a bond portfolio will fall in value when interest rates rise.
Both bond and stock funds fell in tandem during the past year. Lifecycle investing did not protect investors during the latest market downturn.
Most retirees put all funds in instruments without a maturity date and base disbursements on a guideline like the four percent rule. The four percent rule is not going to work if the value of both your stocks and bond funds simultaneously declines as they did most recently.
Retirees could and should purchase Treasury bonds and schedule the maturity of the bond for different dates each year. The retiree would even consumption and reduce depletion of retirement assets by consuming from maturing bonds when the stock market is low and consuming from stock ETF distributions when the stock market is high.
Retirees with assets in bonds that mature on specific dates are better prepared for retirement than retirees with assets that have all savings tied up in funds without maturity dates.
Concluding Remarks: The tax code provides preferences for investments in tax-preferred retirement accounts and 529 plans. Congress recently passed legislation mandating automatic contributions to 401(k) plans. Financial advisors strongly recommend use of these tax-preferred savings vehicles.
Tax preferred savings vehicle often have limited investment options.
Tax-preferred savings plans often do not allow for the direct purchase of Treasury or government agency fixed-income securities with specific maturity dates, which could be matched with spending obligations.
Moreover, financial advisors often advocate the use of bond funds instead of bonds with specific maturity date.
Congress, through the tax code and their mandates and financial advisors through their insights guide investors to suboptimal higher-risk financial choices.
David Bernstein an economist living in Denver Colorado has written extensively on health and financial policy including a recent article outlining a 2024 Health Care Reform Proposal and an evaluation of President Biden’s student debt discharge proposal.