Creating a Risk-Free Retirement Plan
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.”
Let’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.