POINT OF VIEW

Don’t believe everything you read DECEMBER 2015

CAPITAL MARKETS INSIGHTS TEAM

Contrary to popular wisdom, a rise in interest rates may be a blessing in disguise for some investors preparing for retirement. To appreciate this point, it helps to see both sides of the retirement equation. The “story” as thumb-nailed by conventional pundits has three easy pieces:

Timothy Noonan, Managing Director

self-sustaining U.S. economy emboldens the Federal 1 AReserve to increase interest rates; so pushes the stimulus genie back into the bottle 2 Doing in time to forestall an inflationary spanking; this is going to be bad news for investors because the 3 But bond allocations in their portfolios will lose value in step with the rise in rates.

Sophie Antal Gilbert, Director of Communications

This concern stems from the understanding that an increase in rates pushes down bond prices. That can be frightening for investors approaching (or already in) retirement, who typically have a large allocation of their nest egg invested in bonds. But, the impact of rising interest rates goes beyond only bond assets to also include stock assets and, importantly, retirement liabilities. It’s possible that, when interest rates rise, especially should they do so faster than expected, the negative effect on the investor’s bond assets is outweighed by a larger positive effect on their total liabilities. Rising rates reduce the value or “cost” of future retirement spending. If the positive effect of a rate rise on the investor’s total liabilities outweighs the negative effect on their bond assets, higher interest rates may end up being a boon for the investor. The change in monetary policy may improve the investor’s financial preparedness for retirement without the investor having done anything differently. An important message for investors (maybe the most important one in the year to come) is how a rise in rates may help them be better financially prepared.

NOT FDIC INSURED

– MAY LOSE VALUE – NO BANK GUARANTEE

Todd LaFountaine, Program Director

Johann Schneider, Program Director

An investor’s financial preparedness 1 for retirement improves if any of the following occurs: The investor’s assets go up: Build a nest egg (assets) large enough through saving and investing to cover the cost of future spending needs (liabilities) The investor plans to spend less money in retirement: Lower the total amount of liabilities needed in retirement The cost of funding the investor’s liabilities goes down: Lower the cost of future liabilities, thus requiring less assets

If the positive effect of a rate rise on the investor’s total liabilities outweighs the negative effect on their bond assets, higher interest rates may be a boon for the investor.

When interest rates go up, both the asset and the liability sides of an investor’s balance sheet are affected in the following ways: Bond prices fall, so a portion of an investor’s asset portfolio is likely to experience a decline; Historically equity prices have risen, so a portion of an investor’s asset portfolio is likely to increase in value; The cost of funding retirement liabilities may come down on all (not just a portion of) retirement liabilities So the really interesting question, once you can see both sides of the equation, is: which half of the investor’s balance sheet (assets or liabilities) decreases more in response to an interest rate increase? We turn to an illustration to help us measure this. Meet Diane. Diane is 65 years old and has diligently accumulated a nest egg worth $1,500,000 in a balanced 40% stock / 60% bond portfolio. She is looking forward to retiring at the end of the year and wants to confirm with her advisor that she is on track financially for that goal – even after a rise in interest rates. Her advisor runs a simulation comparing her current financial preparedness and her preparedness following a hypothetical 50 basis point rise in interest rates. To help clearly highlight the impact of higher interest rates for Diane, her advisor assumes that the value of her equity portfolio will remain constant and her bond portfolio has a duration of 5 years (typical of an intermediate bond portfolio). Exhibit 1: Diane’s financial preparedness to retire BEFORE

AFTER

50 basis point rate rise

$1,500k $1,518 k

1

50 basis point rate rise

=

99% FUNDED

$1,477k $1,446k n

=

102% FUNDED

ASSETS

Russell Investments // Point of View // Don’t believe everything you read

n

LIABILITIES

We adopt the same math large pension funds do to measure financial preparedness for retirement: the funded ratio – the value of an investor’s assets divided by the value of an investor’s retirement expenses (liabilities) as one lump sum. An investor is considered “underfunded,” or at risk of running out of money in retirement, if their funded ratio is below 100% (assets worth less than their liabilities).

// 2

Rather than devastating her retirement plans, the interest rate rise actually increases Diane’s financial preparedness for retirement.

THE RESULT2: Diane’s advisor is pleased to be able to reassure her. Rather than devastating her retirement plans, the interest rate rise actually increases Diane’s financial preparedness for retirement from 99% funded to 102% funded. This is due to the decline in the value of the liabilities (in the denominator) being greater than the reduction in value of the assets (in the numerator). In other words, as a result of higher interest rates, Diane has improved her preparedness for retirement despite her bond allocation losing a small amount of money.

Going deeper into each of these effects, when interest rates go up: Bond prices go down THE FED’S INFLUENCE This is simply the mathematical relationship between bond prices and bond yields. But, the size of the decrease is dictated by the timing and pace of the interest rate increases. The more telegraphed and gradually central bankers raise interest rates, the less severe the decrease in bond prices tends to be. SHORT-LIVED PORTFOLIO IMPACT Bond returns are made up of two components: price return and coupon return (or capital appreciation + interest income). A move up in interest rates reduces the price component of existing bonds in the market and subsequently raises the coupon component of new bonds issued to the market. The net result is that, over time, the negative price change of existing bonds may be eventually offset by the higher coupon rate of newly issued bonds included in a diversified bond portfolio. Hence, negative performance in the bond portfolio doesn’t persist for long. THE ACTIVE ADVANTAGE Active bond managers can offer investors a line of defense against the decline in value of their bond portfolio. That’s because active bond managers generally have more flexibility when faced with rising interest rates compared to their passive peers. By anticipating the timing and pace of interest rate changes, active managers can position bond portfolios to dampen the negative effect that higher interest rates have on bond prices. Passive bond managers, in contrast, are bound to their portfolios until there’s a change in the benchmark – which will be reactive to (rather than anticipatory of) any change in the market.

Equity prices tend to rise Since the early 1970’s the Federal Reserve has undertaken eight interest rate hiking cycles, so there is some precedent to today’s situation. Analyzing the historical data reveals that in the three months, one year and five years following those initial rate hikes, the S&P 500 Index was positive, annually returning 2.0%, 6.2% and 11.1%, respectively.

Russell Investments // Point of View // Don’t believe everything you read

For illustrative purposes only. Results will differ based

2

on the individual circumstances of investors and fluctuations in both assets and liabilities.

// 3

Historical capital market returns after first rate hikes3 Average returns for last eight rate hike cycles

MARKETS EX-US MARKETS ATE BONDS OVERNMENT

12

11.1%

10

8.9%

8

Returns (%)

IES AL ESTATE DS

Higher interest rates lower the cost of the future stream of retirement liabilities.

Exhibit 2

6.2%

6 4 2

2.4%

2.0%

0 -2

-0.5% FIRST THREE MONTHS

FIRST YEAR

FIVE YEARS ANNUALIZED

n

U.S. STOCKS

n

U.S. BONDS

Of course, there’s no telling that the next rate hike cycle will bring the same result – unlike bonds, equities do not have as direct a relationship with interest rates. But, it is true that equity markets tend to do well in periods of economic growth when company revenues are growing and consumers are spending. Those types of strong economic environments are also what prompt central banks to raise interest rates in an effort to fulfill one part of their dual mandate: controlling inflation. So, the good economic environment that leads to interest rate increases also generally forms a good basis for stocks to do well.

The cost of funding retirement liabilities comes down Higher interest rates can lower the cost of the stream of future retirement liabilities – specifically they increase the discount rate (interest rate) used to calculate the liabilities. Said differently, higher interest rates lead to a higher discount rate, which means the cost of liabilities goes down. To illustrate this, it might be helpful to revisit our hypothetical investor, Diane who had $1,518,000 in future retirement liabilities. To make the example simple, let’s assume today’s date is January 1st and she will retire at the end of the calendar year, on December 31st. That means she needs assets of $1,518,000 on December 31st to cover her retirement liabilities. The question is, what asset size does Diane need today (January 1st) in order to make that happen? That depends on the discount rate. The discount rate is the interest rate required for a given amount of money today (January 1st) to reach $1,518,000 on the retirement date (December 31st). Further let’s assume the money is held in a simple savings account that

Russell Investments // Point of View // Don’t believe everything you read

Source: Federal Reserve Bank of New York,

3

Stocks: S&P 500® Index (1970-1978) and Russell 3000® Index (1979-12/31/2014), Bonds: Barclays U.S. Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

// 4

makes only one interest payment at the end of the year. If the discount rate was 5% then she would need $1,445,714 ($1,518,000/1.05) today in order to have $1,518,000 by year-end. If the discount rate was increased to 10% then the investor would only need $1,380,000 ($1,518,000/1.10) to reach the desired retirement funding level. Notice that, as the discount rate increases, the amount of money needed today (i.e. cost of retirement liabilities) decreases.

What are the characteristics of investors who might benefit most from a rise in interest rates? Younger investors – The more time available before the assets are drawn down, the more benefit gained from a higher discount rate. Investors with smaller allocations to bond assets – The less conservative an investor is, the smaller the allocation to bond assets which means a smaller portion of assets that can be negatively affected by an increase in interest rates.

The bottom line So, as you can see, rising interest rates don’t necessarily spell doom for retirement portfolios. Remember: 1. Don’t believe everything you read in the headlines. 2. Consider both sides of the retirement equation – assets and liabilities. 3. Measure the impact of rising rates in personal terms. God bless us, every one! Tim Noonan

Russell Investments // Point of View // Don’t believe everything you read

// 5

For more information, contact your Russell Investment sales and service team at 800-787-7354 or visit www.russell.com. Fund objectives, risks, charges and expenses should be carefully considered before investing. A summary prospectus, if available, or a prospectus containing this and other important information can be obtained by calling 800-787-7354. Please read a prospectus carefully before investing. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the cover page. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. Indices and benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Index return information is provided by vendors and although deemed reliable, is not guaranteed by Russell Investments or its affiliates. Due to timing of information, indices may be adjusted after the publication of this report. The S&P 500® Energy Index is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ Risks of asset classes discussed in this presentation: Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds. Bond investors should carefully consider these risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide, including Russell Financial Services, Inc., member FINRA. Russell Investments is part of London Stock Exchange Group. Copyright© Russell Investments 2015. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. Russell Financial Services, Inc., member FINRA, part of Russell Investments. First used: December 2015 RFS - 16242

Russell Investments // Point of View // Don’t believe everything you read

// 6