Professor Zvi Bodie of Boston University said something that really shaped my thinking about retirement savings. He said that we should think about retirement savings more like we think about insurance. When I tried that, I realized that it caused me to challenge the advice about retirement that I often hear and read about. It exposed something that I was seeing that I knew didn’t seem right as I was planning for retirement.
Assurances are not Guarantees
Fund managers want you to invest in their products, but they don’t give guarantees. They are careful to have disclaimers so that we understand that we could actually lose our money. That’s worth taking time to consider. Professor Bodie says that these management companies are in a far better position to understand risk management than the common person, yet they refuse to guarantee that you will even have your retirement savings when you need it. They give assurances, but they refuse to give a guarantee. Professor Bodie says that the reason they don’t give a guarantee, is that they can’t. Instead, they leave the risk of the investment with the person who is least knowledgeable about what they are doing.
A good thing to ask ourselves is: “Why can’t they give a guarantee when they are managing the money?” The answer is: “Because the investments they use are risky and they know it.”
Professor Zvi Bodie does a great job of explaining the problem here in his video:
Follow the Money
As I considered this, I realized that part of the problem may be in how we pay our money managers. If they were forced to wait for years before getting paid, that might work better for us, but that’ s pretty impractical for them. By not being rewarded through the results of our long-term savings, it creates a conflict of interest between our goals and the goals of our managers who get paid every year. Perhaps if we paid our money managers by the hour for their time spent advising us, it would be better, at least when it comes to retirement advice. There may be good advisors out there that would be willing to get paid like that, but we have to change the way we think about our retirement in order to hire them. I have found that I don’t need to hire someone to manage the insurance part of my savings. It is possible to manage your savings yourself because it doesn’t require day-to-day changes. Since there isn’t much to manage, it doesn’t present a whole lot of income for money managers. Perhaps that’s why they don’t have much to say about inflation protection.
Is it really Savings?
I think that there is terminology that retirement fund managers should not be using. They often refer to the money that we put into mutual funds or the stock market and other volatile investments, as our “retirement savings.” In my opinion, the money we are putting into those kinds of investments is actually being treated as “retirement savings ventures.” Since no one is committed to maintaining a specific amount of money in those accounts, I don’t think that it can legitimately be called: “savings.”
When we use the word “savings” we naturally think of money in a piggy bank or money in a banking institution. In those places, our money is insured in some way. Our piggy bank is locked in our house and our bank accounts even have deposit insurance from the federal government. We naturally expect that when we return to our bank, we will find the same amount or more than we left in it, but that’s not how most “retirement savings” accounts work in my experience.
Unfortunately, we need to be on guard when money managers use the term: “savings.”
Insuring our Savings
There are ways to insure savings, and some of them come at a cost. We know that insurance has a cost because many of us have insurance for other things like healthcare, our cars or a house. Insurance costs something because someone else is bearing a risk for us. When we think of something as important as our retirement, doesn’t it make sense to insure that it will meet our basic needs? Sure there are things in retirement, like golf or fancy vacations, that we don’t really need. I’m not talking about that necessarily, but what about food and medical needs? What about the power bill or visiting family for Christmas? Do we want to become a burden on our adult children when it can be avoided?
Zvi Bodie brings up an interesting point in another place. He suggests that we consider the fact that we are willing to pay $1000 for fire insurance for our house even though it is very unlikely that our house will burn down. The chances are very small, yet we still pay for it. That’s because we believe that the seriousness of not having a house outweighs the fact that it is unlikely to happen. What good a house if I am unable to live in it in because my retirement savings has disappeared? It doesn’t really make sense to protect the house and not protect my income.
Two Categories of Retirement Funds
Thinking about retirement in this way leads to dividing our retirement funds into two parts. One part is the part you reasonably believe you can’t do without in your old age. The other part is for things that you hope for, but that are not critical to your survival. When we divide it up like this, and get insurance for the critical part, it can lead to peace of mind knowing that our critical retirement needs are guaranteed to be there for us.
Retirement Insurance Options
When it comes to ways to insure the critical part of your retirement, you might be imagining a large piggy bank or perhaps a bank CD. If you have been reading my blog, however, you know what I think about that. Both piggy banks and CD’s are not usually inflation protected, which means that they are not a guarantee. They fail to be a guarantee because you don’t know what the contents of your piggy bank will buy in 30 years when you need it.
There have been CD’s that were “inflation-linked” in the past but I have not seen any in the last few years. Hopefully, demand for them will increase and they will be offered again in the future.
One obvious form of retirement insurance is Social Security. It is inflation protected and it’s definitely something to consider when thinking about your critical retirement savings. Social Security is likely to go through some changes in the future, but I expect that something very similar to it will be available for a long time to come.
Company or Government Pensions
If you happen to have a job that offers a pension that adjusts your payments for inflation, you are in a good position. When I say pension, I mean the old fashioned kind that doesn’t require that you manage the money and that does provide a written guarantee. Pensions that don’t adjust for inflation, are helpful but they don’t guarantee that you won’t run out of money to pay your expenses in the distant future.
Be Careful With Insurance Annuities
Other insurance products are provided by insurance companies by way of inflation adjusted annuities. I would just make sure that the inflation adjustments are connected to actual inflation and not a flat percentage increase each year. It’s important to understand how much you are paying for that insurance up front too. Beware: Insurance companies use the word “guarantee” in a similar way that fund managers use the word “savings.” Make sure you know what they are actually guaranteeing. Guaranteed percentages are not the whole story. You also need to know the exact amount of principal the percentage is calculated against. If the principle goes down with something other than inflation, it’s not much of a guarantee. Also remember that if the guarantee isn’t in writing, it’s still not a guarantee. Insurance companies do and have gone out of business. Zvi Bodie recommends splitting up your funds between companies.
The Equity in our homes really is a form of inflation protection. Because a house is a physical thing that represents one of our important needs, it’s automatically inflation protected. Its value goes up with inflation because a house is still a house no matter what the value of money is. Just having your home paid off is big part of insuring your retirement.
This presents an option for those who have no heirs or have no other choice. Many of us spend our lives paying the bank to own a house. The tables can be turned. It is possible to sell the equity to the bank and have them pay you to live in your own house. That’s what is called a reverse mortgage.
Once again caution is needed. Make sure to read everything in any contract to make sure that the bank isn’t taking too much for themselves in the deal. They may woo you with assurances that the remaining equity will go to your heirs, but I am told that this is often not the case because of high fees. Again, there’s no guarantee.
Another thing to consider is selling your house to your heirs, with permission to continue living in the house as long as you can. Working a deal with your loved ones could be a practical option and it can be a win-win situation with them.
Inflation Protected Bonds
My favorite option is to use Treasury Inflation Protected Securities and I Bonds for savings that I want to insure. I do have to do a bit more work myself, but fees are low or non existent. These are just boring government bonds that usually don’t make a whole lot of interest, but they do one thing very well: they protect long-term savings from inflation and that’s what I’m looking for when it comes to protecting the critical part of my retirement savings.
I have a spreadsheet that tracks your TIPS and helps you see your inflation protection in action. Learn more here
Copyright © Troy Taft 2018