Want to hear a crazy story? I know a guy whose entire retirement portfolio is invested in US treasury bonds.
The conventional wisdom on retirement savings says that to make the biggest gains and beat inflation, you should hold stocks approximately equal to 100 percent minus your age. But most lifecycle retirement funds—the typical default investment for a 401(k)—are even more aggressive than that. Vanguard’s Target Retirement 2010 Fund, for example, is for people retiring in 2008-2012, and it holds more than 50 percent stocks.
If you planned to retire in January 2009, however, your portfolio would have been mauled by the stock market implosion. Maybe that crazy guy—Boston University business professor Zvi Bodie, who we’ll talk to in a minute—isn’t so crazy.
Is there a better way to save for retirement? First, let’s hear the argument for stocks.
“The fact of inflation running, what, 3 percent on average back to 1914, that’s the reason why Americans should invest in stocks,” says Debra Morrison, a certified financial planner with Trovena.
Inflation can eat your retirement savings alive. If I were retiring today, a million bucks would be plenty for me to retire on. But I’m 34. When I retire, assuming 3 percent inflation, that $1 million will be worth the equivalent of $400,000. I intend to live a long time, and that’s not enough money.
Morrison has stern words for the conservative investor: “Let me shop the world for you for some CDs, some laddered treasury bills, or laddered any kind of debt instrument. I will do that only if you will guarantee me a restaurant that will charge the same price for a meal in ten years—or three years, let’s not go absurd. Find me a car dealership that in three years charges you the same amount for a car that you pay today, you find me a hospital that’ll charge you the same amount for a bed. That is the risk of loss of purchasing power, otherwise known as inflation.”
Beating them both
Hey, wait a minute. I understand what Morrison is saying. But couldn’t I invest in something as safe as a CD but guaranteed to keep up with inflation?
Sure I can. It’s called TIPS: treasury inflation-protected securities. These are US treasury bonds that are guaranteed to beat inflation (although they rarely beat it by much). You can buy the directly from the federal government at TreasuryDirect.gov or buy into a TIPS mutual fund from any of the major brokerages. (A similar instrument is the I Bond, a US savings bond you can also buy at TreasuryDirect or from a bank.)
That’s what Zvi Bodie invests in, every last dollar of his retirement portfolio. “My Keogh plan is invested directly in the securities,” he says. “My 403b is in TIPS mutual funds.”
Should you invest in TIPS? To find out, I had a conversation with my imaginary twin brother, Jack.
Matthew: Hey, Jack. Do you have health insurance? I do.
Jack: Of course not, Matthew. You are such a chump. Our grandparents are in their 90s and still going strong. We work safe, boring desk jobs. The worst thing that’s going to happen to us in the next thirty years is a stubbed toe. When we’re 65, I’ll be showing you videos from my round-the-world cruise, while you’ll have been vacationing in Tacoma.
Matthew: Just because the probability of a bad outcome is low doesn’t mean it’s not worth buying insurance against it. I have the peace of mind of knowing that my family is protected financially in a crisis. When I look back in 30 years, I’m not going to say that money was wasted just because I didn’t have a heart attack.
Jack: You’re spending hundreds of dollars a month for that peace of mind. You’re imagining the worst things that have happened recently and assuming they’ll happen to you. Why not barricade yourself inside your apartment and never come out, while you’re at it?
You know what? Jack is probably right. In fact, I hope he’s right: I don’t want to collect on my health insurance in a big way. But I still pay for it.
No financial advisor would tell you to go without health insurance. Buying TIPS instead of investing in stocks is like buying retirement insurance, and for the average American, it would cost about the same amount: several hundred dollars a month more than going without insurance.
So why don’t financial advisors tell you to buy retirement insurance by investing in TIPS?
I asked Bodie to referee the argument between me and Jack. “Each of us has some of both brothers in our heads,” says Bodie. “We buy insurance and we gamble. That is one reason why I advocate a 90/10 strategy for most middle income people. Ninety percent safe (TIPS and I Bonds) and 10 percent equity index call options, ‘hot’ stocks, or lottery tickets.”
Morrison disagrees. “How can we protect these folks that are going to be retired for forty years, some of them, against running out of money?” she asks. “I think an accurate exposure, or at least a minimal exposure, to stocks is one insurance policy.”
Adjusted for inflation, the stock market has returned, on average, 4.5 percent over the long term. (That’s according to those bearish folks at the Wall Street Journal.) TIPS will return less than that. Right now, with both inflation and interest rates low, TIPS return much less: under 2 percent. I can hear my imaginary twin brother laughing already.
That’s exactly the point. Safe investments cost more. When we see inflation again, TIPS will keep up. Stocks might.
It’s up to you. Do you want to buy retirement insurance or roll the dice?
Disclosure: I don’t own any TIPS. But I’m thinking about it.