The Stock Market is for Fun Money

Nassim Nicholas Taleb is a well-known scholar of mathematical finance.  Taleb teaches risk engineering at New York University.  He is also the author of a major best-selling book:  The Black Swan. In the world of personal finance, a “black swan event” is a massive change in investment  conditions which is either predictable or unpredictable. Either way, the black swan event  has a disproportionate impact on the finances of those touched by the event.

I would say that the market collapse of 2008-2009 qualifies as a black swan event for retirees, wouldn’t you?

Many would say that this was a black swan event because almost every asset category- even those thought to be non-correlated – went down together.

A corollary aspect of black swan theory is that people blind themselves to to the potential effects of black swan events on the world around them.  When they do occur, folks pretend that they knew it was coming all along,  expected it, and were prepared for it. This sounds like the investment and Wall Street finance community doesn’t it?

Taleb recently gave a speech in Canada that was critical of the stimulus policies of the U.S. government. Taleb believes that governments need to cut debt and refrain from bailing out failing companies. That, according to Taleb, is the only way that governments can shield their economies from the negative consequences of erroneous budget forecasts.

About forecasts, Taleb said this:

Today there is a dependency on people who have never been able to forecast anything. What kind of system is insulated from forecasting errors? A system where debts are low and companies are allowed to die young when they are fragile. Companies always end up dying one day anyway.

This over-dependence on financial forecasting applies to investment markets as well.

Taleb was critical of banks and securities firms because they do not properly warn investors of the risks when they invest their retirement savings in the stock market.

This leads to a key warning from Taleb’s speech concerning retirement investing:

People should use financial markets to have fun, but not as a depository of value. Investors have been deceived. People were told that markets go up regularly, but if you look at the last 10 years that’s not been the case. The risks are always greater than what people are told.

I wonder if Zvi Bodie and Taleb know each other?

Now you understand why I created the Failsafe Retirement System and why I am using it myself.

Here is a link to an article reporting Taleb’s speech.

Ten Year TIPS Auction Upcoming

It’s unfortunate that the frequency of TIPS Treasury auctions seems to be decreasing. Thus, I was excited to learn that an auction of TIPS with a ten year maturity has been tentatively scheduled for September 2, 2010. The official announcement date will be August 30. If you are still building your Failsafe Retirement Income Plan, this is an auction you should consider. Last month there was an auction of 30-year TIPS but that maturity date is beyond the scope of my income plan.

You can monitor auction calendar press releases here.

Don’t forget that TIPS should be owned in a tax-deferred account. For your taxable accounts, use I-Bonds.

Rethinking the Risk of Stocks

The mainstream investing media may finally be getting it. A recent “Ask the Expert” article from Money Magazine tells us that we should “rethink” the risks of investing in stocks.

Well, duh!

What is significant about this particular article is that it cites actual research to support the author’s premise:

After a 75% surge from a little more than a year ago, stocks have plunged 12% from the beginning of May through yesterday’s close.

Unfortunately, recent research from Morningstar and Ibbotson Associates suggests that stocks are more prone to these sorts of convulsions than you may realize.

In the article, the author recommends that prospective retirees “get guaranteed income.” That’s what I’ve been preaching here, for a year. The author suggests annuities. But what about inflation?

I think we will see more of this attitude adjustment toward equity investing in the coming months. Who knows – Zvi Bodie might become mainstream!

Reasons to Use Bonds for Retirement

Forbes recently published a focused piece summarizing the top reasons to use bonds for investing. Here are those reasons, in no particular order, and my comments as they relate to using TIPS and I-Bonds for retirement income security:

1.  Preservation of Principal. This is definitely number one on the list for retirement planning. Moreover, you cannot get any more secure than government-backed TIPS and I-Bonds.

2.  Saving. I have to agree with this one as well although purchasing TIPS and I-Bonds even right before retirement can be valuable to provide income 10-20 years down the road.

3.  Managing Interest Rate Risk. This is not important for bonds in a Failsafe Retirement Income Plan. What is important is managing inflation risk which TIPS and I-Bonds do but Forbes doesn’t mention.

4.  Diversification. I agree with this although not for the same reasons proposed by Forbes. Using TIPS and I-Bonds to meet essential retirement income needs gives you the safety and freedom to diversify and take risks with your other investments.

5.  Expense Matching. This means using income from bonds to match up with known future expenses. That’s exactly what a retirement income fund does.

6.  Long Term Planning. Forbes doesn’t mention long-term retirement planning but what could be more important for the individual bond owner?

As a final note, compare these uses of bonds with comparable uses of equities. Game over.

New I-Bond Rates

As many of you know, the Treasury updates interest rates for I-Bonds each May 1 and November 1. These updates include both the fixed rate component that will remain for the life of the bond and the inflation adjusted component that will remain in effect for the next six months.

On November 1, 2009 the Treasure announced that I-Bonds issued thereafter (and until the next update on May 1, 2010) will have a fixed interest rate component (real return) of 0.30 %. This is a slight but almost meaningless increase from the prior rate. The inflation-adjusted component of the I-Bond rate was increased to 3.06%. This is a significant jump because the prior rate was actually negative!

Thus, I-Bonds issued between now and May 1, 2010 will be earning 3.36%. That’s better than current short term CD rates but the fixed rate component is less than ideal. If you are debating whether to fund your retirement income plan with a purchase now, I would look first at TIPS bought at auction. Their fixed rate components have been better. You can look again at I-Bonds next spring when the government may have to increase rates to attract more buyers.

TIPS Buy Peace of Mind

The Wall Street Journal ran a story this week titled “TIPS Buy Peace of Mind, But at a Steep Price.

I understand and agree with the “peace of mind” concept but not so much the “steep price.”

This is how the article starts:

Inflation-protected US government bonds are generally a great core holding for ordinary investors. That’s especially true in uncertain times like these, when many worry that a spike in prices is just around the corner.

But here’s the secret of TIPS: You don’t buy them because you know where inflation is headed. You buy them so you don’t have to care.

Shares may boom or slump, inflation may rise or fall, but if you buy a long-term inflation-protected bond that pays 3% a year above inflation, that’s what you get.

Those statements sum up nicely why TIPS are integral to a Failsafe Retirement Income Plan.

But what about the “steep price” contention?

This is what the author says about that:

But their good performance means that many of these bonds are now distressingly expensive. That’s especially true for the shorter-term bonds, which mature within the next five years or so. Today’s bond buyers may not realize it, but they are locking in poor investment returns. With prices at current levels, longer-term bonds, particularly those maturing in 20 years or more, look like better values.

Here is the difference between this writer’s “steep price” concern and the proper use of TIPS in a retirement income plan. He is talking about buying and selling TIPS on the secondary market, either as individual securities or in shares of a TIPS mutual fund or ETF.  On the other hand, I recommend buying TIPS from the Treasury at auction (when they are issued) and holding them until maturity. That way you do not have to be concerned about fluctuation in values on the secondary market. These fluctuations are caused by differing interest rates and expectations for inflation.

I don’t want to worry about that. I want to use TIPS for guaranteed retirement income. By purchasing them with the proper maturities, you can buy and hold without any concerns about market value changes in the interim.

That’s what makes TIPS failsafe for your retirement income.

Variable Annuities Devalued

It seems that insurance companies are unhappy about their profit margins and risks in sales of variable annuities. To compensate, they are offering new “simplified” products. Unfortunately, these new annuity products have two characteristics that make them even less attractive to purchasers. Rates have increased and benefits have been watered down.

According to this article in the Wall Street Journal, financial advisors are less than thrilled about suggesting these new variable annuity products to their clients. I don’t blame them. Variable annuities are expensive to buy, expensive to own, and make it difficult for the owners to access the invested principal in case of financial crisis. Consumer Reports is very negative about this annuity devaluation.

If people would start earlier with a plan for guaranteed retirement income, they would have better, more secure options.

Turning Savings into Retirement Income

A Money Magazine reader recently submitted this question to Walter Updegrave, a senior editor and well known personal finance writer:

The 4% rule seems to have become the conventional wisdom for drawing money from your savings in retirement. But I believe the rule is flawed. I think it might make more sense to choose a percentage of your savings that you will withdraw annually and then just apply that percentage to your savings balance at the beginning of each year so you would have more money to spend in years when investment returns are good and less to spend in years when returns are bad. What do you think?

The response listed several available strategies for generating retirement income from available resources.  The discussion of the strategies included well-recognized flaws.

1.  Fixed Annuities. A fixed annuity can provide a predictable income. There are three negatives: (a) the security of the income depends on the financial stability of the insurance company; (b) you generally lose access to the principal; and (c) most fixed annuities are not indexed to inflation.

2. 4% Withdrawal Rule. This strategy states that you begin year 1 by withdrawing 4% of the value of your retirement income fund. You maintain that withdrawal amount each year, adjusted by the rate of inflation. For example, if in year 1 your income fund had a value of $500k, and the inflation rate is 3%, in year one you would withdraw $20,000. In year two you would increase your withdrawal amount by 3% to $20,600. There are two problems with this scheme. First, if the market tanks like it did in 2008 – particularly if early in your retirement – your money is likely to run out way before you do. Second, if the market does well, you will end up with a lot of money that you could have used for discretionary spending. Instead, it will go to your heirs.

3.  Fixed Withdrawal Rate. This is what the reader proposed. Instead of maintaining a constant withdrawal amount (4% of your year-one retirement fund) adjusted by inflation, you apply the 4% rate to the value of your retirement fund at the beginning of each year. In this way, if the market declines, so does your withdrawal amount. Although this strategy is likely to extend the life of your retirement income fund, your income and lifestyle can change significantly from year-to-year. That is counter-productive to what we want in our retirement.

What is the answer? To me, the answer is a Failsafe Retirement Income Plan, using TIPS and I-Bonds, to provide your basic income needs. What is left over you can invest for discretionary income.

TIPS Auction and I-Bond Reset

The Treasury has scheduled an auction of five-year TIPS on October 26, 2009. (To be more precise, with an issue date of 10/30, these TIPS will have an actual duration of four years and six months.) The official announcement date will be October 22.  The last 5-year TIPS auction was on April 23, 2009. Those inflation protected securities carried a fixed interest rate of 1.125% and a high yield of 1.278%.

If you are looking at five-year TIPS as part of your retirement income plan, make sure that they fit in with your actual retirement date and/or that you will be prepared to sell and replace them with new TIPS issues when they mature.

If you are interested in I-Bonds (which you should be), be aware that the Treasury will announce the new fixed interest rate on November 1, 2009. This rate will apply to all bonds sold from November 1 through May 1, 2010. There is no official formula for determining or even predicting what that rate will be. Some speculate that the rate will be increased from the present measly rate of 0.1% because these will be the first I-Bonds that can be purchased with federal income tax refunds.

Also, based on this week’s government release of the official Consumer Price Index data, we now know what the inflation adjusted component of the I-Bond interest rate will be for the next six months.  The March 2009 CPI-U was 212.709. The September 2009 CPI-U was 215.969, providing a semi-annual CPI increase of 1.53%. Based on the official formula, the inflation-adjusted (variable) interest rate for the next 6 month period will be 3.07%. This is quite a turnaround from the -5.56% rate for the current period, which brought the total I-Bond rate down to 0%!. (The rate cannot go below zero.)

If you already own I-Bonds, keep in mind that the rate adjustments may not affect your holdings immediately. New rate periods for existing bonds begin every six months starting with the month in which your I bond was issued. For example, if you own an I-bond that was issued in January, the new rate periods for that bond will begin in July and January.

Keep working on that Failsafe Retirement Income Plan!

The Truth About Stocks Aftermath

I received my November issue of Money Magazine today. I was curious about any reader reaction to last month’s interview with Zvi Bodie which the magazine titled “You Can’t Handle the Truth About Stocks.” The editors printed two reader letters responding to the interview. One had this to say:

I wish more people had the guts to expose the truth on investing. Fear and greed motivate investors to take risks. If people considered 4% a “normal” return, they would hardly have to take any risk at all.

Clearly this writer is a Bodie fan. I like her point about what people consider to be a “normal” return. Maybe the huge bull market in the late 1990’s was bad for our collective investing psychology. Too many of us seem to be hoping or even expecting a return to those “good old days.” I think they have a long wait.

That was the attitude of the other writer, who had this to day about Bodie’s views:

[W]ho wants to deprive himself to save 30% of his salary and work like a dog until age 75? Rolling the dice on stocks is a lot more appealing.

This “investor” certainly doesn’t believe in the principle that the pain of discipline is much less than the pain of regret. By this I mean that he is unwilling to make lifestyle sacrifices now to insure that he will have a self-supporting lifestyle when he retires. This is the same attitude that led to our current economic crisis.

What happens if he loses that “roll of the dice?” It’s not our problem. Bodie warned him, didn’t he?

By the way, which of these letters to the editor do you think was printed with a larger font? You guessed it – the Bodie skeptic received top billing. After all, so much of Money Magazine is supported by advertising from the investing industry.