Savings, Cashouts Rise for 401(k)s

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BOSTON (TheStreet) -- When QE2 set sail, the quantitative easing move by the Federal Reserve -- buying roughly $600 billion of Treasuries over the next nine month -- was intended to calm economic waters by lowering long-term interest rates.

But while home buyers and corporations may stand to benefit, many retirement plans could take a hit, especially those with a large exposure to bonds and bond funds.

QE2
For some, the Federal Reserve's QE2 plan -- short for Quantitative Easing -- looms as large as the QE2 itself, or the Queen Elizabeth II cruise liner.

David Kelly, chief market strategist at JPMorgan Funds, is no fan of the Fed's move.

"Investors need to be sure they recognize that the Federal Reserve is manipulating and twisting the bond market," he says. "The problem with this sort of morphine drip of quantitative easing is what happens when they remove it and what the hangover is."

"There are a lot of different scenarios here, but they all have one thing in common -- they end badly for the bond market," he adds. "If the Federal Reserve pulls out sharply at the end of this, and goes cold turkey, you could see a big jump in long-term interest rates. If they try to extend the process by coming out with a QE3, then eventually it is going to lead to inflation, and that's bad for the bond market.

"When they let it go, long-term interest rates will rise, and that means when people look at their 401(k)s or other retirement plans, this is not a time to be overweight long-term fixed income. This is a time actually to be a little overweight stocks and underweight fixed income. Within fixed income it should be pretty short duration, so you are not very exposed to a big increase in interest rates."

Kelly's advice to shift back into stocks comes after what he calls a "lost decade" for that market.

"When you look at the very low yields in corporate bonds and treasury bonds, and then you look at the relatively high earnings yield on stocks because you have relatively low forward P/E ratios, this really is a very good time to be overweight on stocks versus long-term bonds. If anything, QE2 only underlines that."

Kelly takes issue with the fact that QE2, in its effort to spark increased credit supply, will do so by pitting younger generations against older folks trying to prepare for, or live out, their retirement. He sees the move as unnecessary.

"I do think the economy will grow on its own," he says. "The economy right now is kind of like a teenager ready to go off to college, and at this stage the parents should stop fussing and let the kid go. Washington should let the economy grow, because it will grow on its own. A lot of older americans, in particular, are living off very diminished fixed income with very low interest rates coming off CDs because of this very easy monetary policy."

"The other thing is that the Federal Reserve has got this idiotic idea -- and I say idiotic with all due respect because I know they are trying to do the right thing -- but I don't understand why they say interest rates will be low for a long period of time. If I was trying to encourage somebody to borrow money to buy a house, or to start a business, I think I'd tell them that interest rates won't be low for a very long time," he says. "This is something that would be obvious to any street vendor selling oranges on the side of the road. Would they tell you to come back tomorrow because there will be better oranges? No, they'd say it's the last of the oranges. Every salesperson in america knows to say 'act now' and what the federal reserve is saying is 'don't act now.'"

Kelly offers some advice for those concerned about their retirement investments.

"What people need to do is get a stream of income, but they need to get it from diversified sources," he says. "I think it is important to diversify, first of all, within fixed income itself. Don't just go with safe long-term, high-quality bonds. I think you need to diversify across asset classes. It is very important to have dividend-paying stocks as part of an income solution. Also, diversify around the world. There are actually better dividend-paying stocks around the world than there are in the United States and, also, REITS around the world tend to have higher dividends."

Barnaby Levin, managing director of HighTower Advisors and former director of wealth management for Morgan Stanley, shares a similar concern: that older Americans will no longer have the degree of safety or returns the bond market has brought them in recent years.

"A lot of individual investors went very very conservative and maybe swore off stocks altogether," he says. "When you talk about 401(k)s and IRAs, this is going to be the more conservative money, in general, and they probably have a lot of bonds and bond funds in their portfolios from when they went out of stocks."

"In IRAs, what people often do is extending maturities because the yields are so low on short-term bonds that in order to get any kind of return, you need to go out 10, 15 or 20 years," he adds. "It's still pretty bad, but seems better. Except that, if they do that, when interest rates rise, those go down in value the most. People are losing principle, and the whole idea of buying a bond is not to lose principal."

Levin also suggests that investors stay away from long-term bonds and stick with short durations in the post-QE2 environment.

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