In Search of Safety
While understanding financial theory is nice, it’s the application of the theory that takes place when money is invested to pay for future retirement spending.
→ If real positive returns from stocks are probable but never promised, and inflation may erode the value of bonds, where can investors find a safe asset?
Robert Merton, an economist and Nobel laureate in Economics, had this to say about finding safety when planning for retirement:
“Most DC schemes [401(k) plans] are designed and operated as investment accounts, and communication with savers is framed entirely in terms of assets and returns. Asset value is the metric, growth is the priority, and risk is measured by the volatility of asset values. The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful—even misleading.” ⇣
↳ Professor Merton explains further by providing the following example:
“Imagine that you are a 45-year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Let’s assume for simplicity’s sake that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no payouts for 20 years and then pays the same amount (adjusted for inflation) each year for 20 years. If you had enough money in your retirement account and wanted to lock in that income, the obvious decision is to buy the annuity.”
So, there we have it. The best risk-free asset to provide a safety net in retirement will preserve a set amount of inflation-adjusted income when you need it. This is an important distinction– safety means something different when comparing 401(k) values to the amount of retirement income those asset values will provide.
For U.S. investors, there are currently two primary vehicles designed to provide a set amount of income at a defined point in the future, (1) TIPS (Treasury Inflation Protected Securities) and (2) guaranteed income annuities: both single premium immediate annuities (SPIAs) and deferred income annuities (DIAs). ⇣
⇢ TIPS are issued by the U.S. Treasury and provide a real yield at purchase along with a floating inflation component linked to CPI-U. (Note: there are specific tax issues unique to TIPS that make holding them in IRAs and 401(k)s ideal, so make sure to research things fully.) Second, guaranteed income annuities, while not backed by the full faith and credit of the U.S. Treasury like TIPS, do provide an income benefit, with many contracts providing the option to adjust payments by some underlying inflation rate.
“How much of a safety net should be incorporated into a retirement portfolio?”
A few additional words regarding annuities are required. First, annuities come in many flavors. The specific type of annuities we’re discussing here are income annuities, which are akin to buying your own personal pension. Investment annuities, whether fixed, variable or indexed are often not attractive investments. Second, when purchasing an income annuity, the contract owner and income beneficiary do take on the credit risk of the issuing insurance carrier, so due diligence is required.
With the appropriate safety asset defined, the question remains, “How much of a safety net should be incorporated into a retirement portfolio?” Everyone will answer this question differently. The trade-off is quite simple, receiving an assured return over an uncertain one is expensive—in finance, certainty costs more. Of course, we must deal with uncertainty in many aspects of our lives, and to do so we come to some kind of compromise. Structuring your retirement portfolio is no different, and every investor’s portfolio will look differently based on their own personal preferences. ⬥
Investment advisory services provided by Forward Wealth Management, LLC. Past performance may not be indicative of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.