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Creating a Risk-Free Retirement Plan

This article was written by in Investing. 16 comments.


Or, how to invest like a grandmother.

This is a guest article by Pop. Pop writes about the intersection of behavior, economics, and personal finance at Pop Economics. He writes about investing for a living and turns famous economics figures into pop art for fun.

I’m young, as I bet a whole bunch of you are. And because I’m really just a few years into my career, I have a whole host of paths I could take to get me to retirement. The conventional path — which you see in personal finance magazines, target-date retirement funds, and financial adviser crib notes — says you can save a small portion of your income, say 10%, invest most of it in stocks, and be set for your aged 65 retirement.

That’s all well and good. But most of it’s based on a simulation of stock and bond returns. Go to any financial planner or retirement calculator and they’re likely to run a Monte Carlo simulation to show you the probability that their investment plan will get you to your target. You stick in your savings rate, income, asset allocation, etc. and the program spits back a conclusion that reads something like: “With this plan, you have a 93% chance of meeting your goals.”

BernankeLet’s just pretend the numbers are accurate. You might walk away from that exercise feeling pretty good about the plan. But what if we turn the language around. What if the program told you, “You have a 7% chance of not being able to retire?” Doesn’t feel so great now, does it? In the not-so-distant past, my company announced it would lay off 700 employees of its 10,000-strong workforce. Somehow it didn’t comfort me that I had a 93% chance of keeping my job.

And, if nothing else, this was the kick in the head that I got from the financial crisis. A 7% chance or 5% chance or 3% chance of missing my retirement goal seems small, unless it’s me who ends up on the unlikely side of that statistic. And that’s what a lot of baby boomers who retired in 2007 or plan to retire soon are realizing now: They’re part of the unlucky 7%.

Well, there is another way. And it’s not one of the newfangled investment products that financial planners are hawking to increase your diversification. No, it’s really a throwback. Back to a time when we didn’t rely on out-sized returns to make retirement possible. In fact, it wouldn’t be so inaccurate to call it “The Grandmother Plan.”

You see, my grandmother was a child of the Great Depression. She saw firsthand how the stock market can both create great wealth and destroy it, seemingly at random. So if you reached a point where you didn’t trust the stock market anymore to grow your money, what did you do? You stuck it all (or nearly all) in Treasury bonds. They’d give you a return three or four percentage points below that of stocks, most of the time, but you never had to worry about losing money.

Today, the ultimate safe investment isn’t Treasury bonds, but their more modern cousin, Treasury Inflation Protected Securities (TIPS). Like Treasuries, these are backed by the federal government. So they’re not going to default. But in addition, their principal is adjusted yearly for inflation. Of course, you could argue that the government underestimates inflation — and this is true. But it gets closer to preserving and slowly growing your money than any other product I’ve seen.

A few economists have argued that retail investors should put all their money in TIPS. You might find that unappetizing. I do too. But instead, some other economists have advocated a middle road. Here’s how it works.

1. Decide what minimum standard of living would be acceptable.

Actually I think the kind of people who read this blog are going to have the easiest time accomplishing this, because you’re already motivated and have self discipline. The problem with most retirement calculators is that they leave out an important element: Humans’ ability to adapt. If we’re running low on money, we spend less. We don’t just carry on until we’re bankrupt. (OK, some people do, but this is a personal finance blog after all.)

To that end, decide right now what your minimum acceptable standard of living would be in retirement. How much could you live on? Would you be willing to, say, move from New York to Wisconsin if it meant you only had to replace 60% of your income instead of 80%? Would you be willing to give up the 4-bedroom house with a yard for a cheaper and lower maintenance condo?

Remember we’re talking worst-case scenario here. This isn’t your “dream retirement.” This is what you don’t want to put at risk. I ran the numbers myself, and I think I’d be willing to live on 70% of what I’m making now (adjusted for inflation, of course). It would certainly involve moving to a lower-cost city — I live in New York City — and it would involve cutting down from two international vacations per year to one. I’d have to eat out less often, and might have to cut out cable TV. Not the perfect life, but I wouldn’t be eating cat food either.

2. Save and invest so that minimum living standard is guaranteed.

Now that you’ve decided what minimum retirement you don’t want to risk, invest so you don’t risk it. Save everything you need to virtually guarantee that retirement by putting it in TIPS. This means that in retirement calculators, when they ask for an estimated, inflation-adjusted return, you’re going to want to put in “2%” instead of the more typical 6% or 8% if you were investing in stocks.

If you want to be especially conservative, don’t include Social Security benefits. I personally don’t think they’ll ever disappear completely, but will kick in at a later age and give you a smaller benefit. And if you’re young, remember that your income is likely to grow faster than inflation as you get promotions and raises. So your income before retirement might be more like $100,000 in today’s dollars if you income at age 30 is $50,000.

What are you likely to conclude? To guarantee your minimum retirement, you’ll probably have to save at least 20% of your income if you’re in your 20s or early 30s, but more like 30% to 40% of your income if you’re in your 40s or 50s. Of course, older folks can simply work for a few extra years beyond retirement age to close that gap a little. But I bet all but people getting started early are going to decide it’s too difficult to save enough.

Calculating exactly what you need to save is pretty difficult. Try using a retirement calculator that lets you adjust your expected return, or go to a financial planner for a 5-hour sit-down, letting him or her know what you’re trying to do. I found a good resource to be the T. Rowe Price retirement income calculator. If you put your desired allocation as 100% short-term, your portfolio earns about 4.75%. With inflation averaging about 3%, it’s a rough approximate of what you’d earn over a long period of time in TIPS. But again, ideally after doing the back-of-the-envelope calculation, you’d find a financial planner to get you started.

Another complicating factor is where to put the money. Many 401k plans don’t yet allow you to invest in TIPS bonds or funds. So you’ll have to find the closest alternative available to you or invest in TIPS outside your 401k. You’ll want to put them in an IRA, if possible, so you’re not taxed each time the principal adjusts for inflation.

I can hear jaws hitting the floor right now. Yeah, that’s a lot of money to save. Probably a lot more than you’re saving. But you know what? That’s the price of safety.

3. Take a risk on the rest.

If you’re able to save more, what do you do with the remainder? Take a risk. Put it in stocks or non-Treasury bonds. Do the things that personal finance mags suggest you do. If you end up approaching the 10% historical average return that you’ve heard so much about, great! If not, no big deal. Because you’ve already sewn up the retirement you need.

Some investors, like Nassim Nicholas Taleb, take this method to extremes. After putting what you need in Treasury bonds, he recommends you really roll the dice, say, on biotech stocks or a clean energy start-up. If you hit oil, the argument goes, you’ll get rich even though you only devoted a small amount of your portfolio to it. If you don’t, no big deal — you’ve locked up what you need anyway.

And all this ends up being a really complicated way of saying this: There’s more than one path to retirement. You might decide you’d rather take the more traditional path. But just keep in mind that it sucks to be in the unlucky 7%.

Editor’s note: The original version of this article cited Boston University’s Zvi Bodie as a proponent of investing entirely in TIPS. Bodie doesn’t not agree with this characterization and has written to Consumerism Commentary explaining his position, which is identical to the central thesis of the article written by Pop. You can read Bodie’s comment below.

Updated January 17, 2011 and originally published February 1, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Pop writes about the intersection of behavior, economics, and personal finance at Pop Economics. He writes about investing for a living and turns famous economics figures into pop art for fun. View all articles by .

{ 16 comments… read them below or add one }

avatar RJ Weiss

If a well diversified portfolio of stocks doesn’t outpace 4.75% over the next 40 years we’re all in trouble. Yes you avoid inflation risk with this strategy, but there is a big opportunity cost for a young investor to get involved with TIPS for this amount of time.

One question I had is when you did the calculation, what time horizon did you use?

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avatar Evan

What about other safe investments?

What about annuities? Muni bonds (not Cali lol)? etc.

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avatar RetirementInvestingToday

In my opinion nothing is risk free even from the government. Just ask patriotic UK people who in 1917 gave money to the government as War Loans.

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avatar Pop

@RJ, Thanks for the comment. Yeah, it just depends on what you’re willing to gamble. I mean, a 93% chance is pretty good! But unfortunately, it’s not like you get to get to retire more than once if you’re unlucky. It’s infrequent, but Treasury bonds do beat stocks over 40 year periods. Check out this chart: http://bit.ly/bel5W6. I’m not sure which calculation you’re referencing, but generally, the longer your time horizon, the easier it is to invest in low-return but safe investments. So if you have 40 years until you retire, you might get away with saving 25% of your income. If you’re just a few years away, it’s probably too late to make a major adjustment.

@Evan Sure, there are lots of other “middle ground” investments that offer slightly higher returns in exchange for slightly higher risk. It just depends on what you’re comfortable with. The risk of a TIPS investor < the risk of a muni bond investor < a stock investor. By annuities, I assume you mean stuff like equity indexed annuities that you can use as a savings vehicle (rather than an immediate annuity that you'd use when you retire). I haven't seen how those are priced nowadays. A couple years ago, it seemed like there were too many fees involved, but I'd have to look at that again.

@RetirementInvestingToday Yep. We're not going to get something absolutely risk-free until there are bonds "backed by the full faith and credit of God."

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avatar Tracy

Hi Pop…. great advice here. I was one of those planning to retire in the next few years. I am still going to make it thanks to a great employer funded retirement plan and new personal financial habits that will allow me to live on exactly what you recommended here. However, many of my colleagues were planning to retire this year or next and have had to completely revamp their plans to deal with the losses to their portfolios due to the recession. People don’t think it can happen to them, and then it does.

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avatar Ken

I think it comes down to your risk tolerance. While the market in the last 2 years has been abysmal, someone might can invest 50% of investments in stocks if thier gut ells them it’s ok and they can sleep at night. TIPS can still make up the other 50% if they so desire. You also have to take into account your present age and how much different investments can do for you long term. Interesting post. Good job.

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avatar Zvi Bodie

Hi Pop:
Apparently you have not read my book, Worry Free Investing. You write:
“A few economists have argued that retail investors should put all their money in TIPS — Boston University’s Zvi Bodie seems to be the loudest proponent of this.”
In my book and in my articles I advocate a strategy identical to the one in your article. Please stop spreading a false impression of my advice. In return I will send you a free copy of Worry Free Investing.

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avatar Pop

Hi Mr. Bodie, Thanks for the correction. I’ll ask Flexo to strike through it immediately. I haven’t read your book, and must have gotten the wrong impression of your views from an article somewhere. Regardless, I’m glad I’ve inadvertently agreed with you. Seems like good company.

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avatar SteveDH

I’m not young, in fact I’m retired, and it bothers me that so many seem to see retirement as a finite event where all other actions somehow stop. I have one of those 95% successful retirement scenarios but it is not stagnant. The software I’m familiar with provides guardrails that gauge progress AFTER retirement starts. There’s the ideal scenario and the acceptable scenario. If you drop below the ideal and start heading towards acceptable, you modify, adjust, or adapt either your investments or your spending. As long as your income exceeds you base spending needs and there some left over for more adventurous activities don’t fret about that 5 to 7 percent risk – it might shorten your life – and, ironically, MAKE your plan successful.

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avatar Britt

Over the short-term, this might be a good strategy. But just as bubble mania causes people to make irrational decisions about their money, post-Depression grandmothers also made irrational decisions.

Like you state, TIPS are based on the government’s official inflation figures, which necessarily a reflection of reality. But the price of a can of Coke 40 years from now will reflect the inflation reality. Therefore, over the long-term, you’re much better off in stocks. Not necessarily certain stock-oriented products. But I’ll wager a share of The Coca Cola Company at today’s moderate price will absolutely trounce the return on any government security over the next 30 to 40 years.

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avatar Avi

This is an unfortunate example of why stock investing is so risky. You might want to check out what Coca Cola’s real return for the last 40 years was before you place your bet on it for the next 40 years.

In the long term we are all dead, short of that stocks are never not riskier than TIPS.

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avatar Evolution Of Wealth

You make a great point with Monte Carlo simulations. The bigger problem with them are outliers. Years like 2008 when you have a big, unpredictable downward swing. This creates an instance where your 7% failure rate doesn’t mean 700 out of 10,000 employees will be laid off. It means that there’s a 7% chance the whole company will go under and you all will be fired. The outlier has such a big affect that it doesn’t ruin your chances compared to other people but ruins everyone’s chances independently.

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avatar Rob Bennett

This article makes points that very much need to be heard. I view today’s dominant model for understanding how stock investing works (the Buy-and-Hold Model) to be truly dangerous stuff for the long-term investor.

I see problems, however, with the idea of being ultra-conservative with the portion of your retirement portfolio that you need to live on and then taking more risks after you have accumulated that amount of wealth. Isn’t that approach going to slow down the journey to the point where you have enough to live on dramatically.

I favor an approach of taking valuations into consideration when setting your stock allocation. The historical data shows that the long-term risk of investing in stocks at times of moderate and low prices is virtually non-existent. On the other hand, the long-term risk of investing in stocks goes sky high when valuations are double fair value; at those sorts of prices (the prices that applied from 1996 through 2008), money market accounts offer a superior long-term value proposition. Why not teach middle-class investors these important lessons? Would that not solve the entire problem?

If we invest heavily in stocks when the long-term return is good, we get the wonderful returns. And if we lower our allocations when risk goes off the charts, we avoid the pain of stock crashes. A big plus is that, if most investors followed this approach, stock volatility would be greatly reduced. Each time prices got out of hand, people would sell and that would bring prices back to reasonable levels. So we would never again see insane bull markets or the insane bear markets that inevitably follow from them.

Rob

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avatar Zvi Bodie

I just came across this column by Stuart Fowler in the FTFM section:
Avoiding risk is not the way to make money
By Stuart Fowler
Published: February 14 2010 10:30 | Last updated: February 14 2010 10:30

Here is my response:

In his column, Mr. Fowler has misinterpreted my recommended approach to personal investing. In our book, Worry Free Investing, Ian Sykes and I advocate safetyFIRST, not safety ONLY. We begin the investment advisory process by defining a minimum future level of income or wealth that the client wants to attain for sure. That determines a certain minimum amount that must be invested in inflation-linked bonds each period. (It is a function of the real rate of interest on these bonds.) If the client is willing to save and invest more than the minimum required to achieve her “floor”, then the additional amount can be invested in equities or other risky assets in the hope of achieving a higher level of future income or wealth.
Ironically, this appears to be very similar to the process that Mr. Fowler follows in his investment advisory business. Perhaps he and I are in violent agreement. I reproduce below the summary of the 6 step process in our book:

Six Steps to Worry-Free Investing
The essence of this book’s worry-free investment approach can besummed up in the following six-step process:
1. Set goals. Make a list of the specific goals you want toachieve through your saving and investment plan. For example, “I want to continue to live at my customary standard of living after I retire,” or “I want to pay for my children’s college tuition at Harvard.”
2. Specify targets. Determine the amount of money you will need to achieve each goal. These amounts become the targets of your plan. The very definition of risky or safe investing will depend on the target. TIPS and I Bonds have substantially lowered risk if the goal is retirement, but for college saving, special tuition-linked accounts are safer.
3. Compute your required no-risk saving rate. Figure out how much you need to save as a fraction of your earnings on the assumption that you take no investment risk. For many people, it is appropriate to count your house as a retirement asset
4. Determine your tolerance for risk. Using as yourbenchmark the lowered-risk plan you have created in Steps 1–3, evaluate how much risk you are willing to take. Your capacity to tolerate investment risk should be related to the riskiness of your projected future earnings and your ability and willingness to postpone retirement if necessary. The safer your job and your future earnings, the greater your tolerance for risk in your investments. The more willing you are to postpone retirement if your risky investments perform badly, the greater your tolerance for risk.
5. Choose your risky asset portfolio. After deciding how much of your wealth you are willing to put at risk, choose a form for taking the risk that gives you the greatest expected gain in welfare.
6. Minimize taxes and transaction costs. Make surethat you are not paying any more in taxes, fees, or otherinvestment costs than is necessary.

Chapter 7 of Worry Free Investing is entitled Taking calculated risks in the stock market. It explains and elaborates on step 4 above. One of the ways we explain to get maximum potential gains while still maintaining the minimum floor is to invest a small part of one’s portfolio in equity index call options. We have been called reckless for even suggesting this possibility. But our view is that the stronger your safety net, the higher you can aim your trapeze.

If Mr. Fowler interprets the book to mean that we advocate taking no equity risk exposure, then we were not clear enough in our explanation.
In any event, I hope that he avoids the fallacy of thinking that equities become safer in the long run, and that he makes it clear to his clients that equities are very risky even in the long run. Unfortunately, many investment advisors try to persuade their clients that you can get the equity risk premium without taking the risk as long as you have a long time horizon. That advice is a threat to their financial health.

Sincerely,
Zvi Bodie

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avatar K Smith

The risk of a TIPS investor is less than that of a muni bond investor and a stock investor only if you buy into the idea that it is impossible for the US government to default on its obligations. Many are unaware that US has in fact declared bankruptcy in the past – twice. Based on the amount of the off the books debt currently carried by our nation, and the recently enacted new trillion dollar entitlement program, doubt continues to grow about our nation’s ability to fulfill its obligations. A bet on TIPS is a bet on the continued solvency of the US government. Caveat emptor – let the buyer beware.

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avatar Jimbo

Mr Bodie,
I have read your book more than once and found it very informative and out of the box thinking. While no one can be sure what style of investing is the best, yours does seem very safe orientated with a high value put on extra saving. Here are a few of my concerns regarding TIPS. First of all I believe the CPI completely understates inflation. I think that is very obvious especially in this ecomomy. 2nd, since TIPS have only been around since 1997 they have never been tested in a hyper-inflation type of enviorment which I believe is a strong possiblity in the near future. 3rd, with the massive printing of money (QE 2 and who knows how many more) and the massive debt this country has, isn’t a treasury default a very real and maybe near possibility? Will TIPS survive in these type of enviorments?

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