Rethinking Retirement


The Keys to Managing Your Money for the Long Haul

Chris Farrell

Yes, creating wealth by investing in equities is important. But in old age, you can't 'eat a rate of return.' Managing downside risk matters just as much.



To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. -- Warren Buffett

When it comes to managing money you're saving over the long term for your retirement, how do you picture yourself? Are you a risk-seeking money manager or a risk-averse buyer of insurance? The difference represents one of the great divides in practical finance, especially in the 401(k) era. Much of the Wall Street marketing machine and investment commentary assumes you're a risk-accepting, wealth-creating manager of your savings. The tactics of the risk-avoiding buyer of insurance is left for the proverbial widows and orphans of society. Big mistake.

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The Wall Street money-management framework has held sway for much of the past three decades. Workers are encouraged to invest for wealth. That means they should embrace the volatility inherent in riskier assets to earn a higher return on their savings. Wall Street says that workers should create portfolios with a high probability of reaching a well-heeled retirement. The core investment animating the Wall Street framework is equities. Stocks are superior long-term investments compared with any other asset class, including bonds. The real risk with retirement savings is being too cautious with your money and earning a meager return.

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But the "stocks for the long haul" mantra has become somewhat muted now that bonds have trounced stocks in the total-return sweepstakes for a considerable period. For instance, long-term U.S. government bonds returned 29.9% in 2011, measured by the Barclays U.S. Aggregate Government-Treasury-Long index. That compares with a 2.1% return for Standard & Poor's 500-stock index. Over the past five years, the annualized total-return figure is 11% for bonds and -0.3% for stocks; the ten-year performance figures are 9.0% and 2.9%, respectively. Still, the concept of managing personal finances with a goal toward maximizing returns dominates, even if it's leavened with a greater appreciation of the risks that go along with owning stocks.

The insurance framework for managing money isn't new, but it wasn't getting much of an audience until the Great Recession devastated retirement portfolios and family finances. Its proponents emphasize putting money into safe investments first. The goal is to limit the downside rather than to reach for riches.

The starting point for constructing such a portfolio isn't the long-term expected return on various financial assets. Rather, it begins with the prospects for your job and your career over a lifetime. Stocks are too risky to be the core portfolio investment of the average worker, proponents say, even if held for the long haul. In essence, with this framework the goal is to ensure that your standard of living won't fall below a certain level in old age. Risk becomes loss.

The emblematic investment of the insurance perspective is Treasury inflation-protected securities, better known as TIPS. U.S. Treasuries are the world's most creditworthy securities, and TIPS offer the added advantage of hedging against inflation by offering an interest rate that's tied to changes in the consumer price index. TIPS happen to have done well in recent years, posting total annualized returns of 13.6%, 8.0% and 7.6% over the past one, five and ten years, according to the Barclays U.S. Treasury Inflation Protected index. Investors are snapping up TIPS, despite the fact that yields have actually fallen into negative territory recently, because they're worried that inflation will rise in coming years (which would hike the CPI-linked rate on the bonds).

Still, the goal of investing in safe assets such as TIPS, Treasury bills, FDIC-insured certificates of deposit and the like is to have the minimal sums of money you need when it's time to pay the bills with your savings. "What we ultimately care about is meeting our goals," writes Zvi Bodie, a finance professor at Boston University, and Rachelle Taqqu, a certified financial analyst with New Vista Capital LLC, in their new book, Risk Less and Prosper: Your Guide to Safer Investing. "You can't eat a rate of return."

What I like about the insurance framework promoted by Bodie, Taqqu and others is that it takes seriously the idea that how you save and where you save is all about what you want out of life -- your goals, your desires, your values, your lifestyle. Their human-capital investment paradigm focuses on matching incomes and savings with the timing and costs of goals. Downside risk matters, especially with savings set aside for old age. They recommend putting money into two pots: safe savings, to cover your minimum goal-oriented needs, and riskier investments, such as stocks, for "aspirational" wants. "In general, the greater your uncertainty about future income, the more you should restrict risky investments," they write.

I basically buy into the protect-from-downside-risk framework. However, its proponents often seem to underestimate how difficult it is to accomplish. Many of the investments that inform the approach -- TIPS, TIPS ladders, I-bonds and various annuity products -- are hard to understand and analyze. It also seems to be getting harder to accurately project income over the next couple of years, let alone a lifetime. Many young adults stumble out of college and struggle through their first couple of jobs seeking a career path. Job and career security, as well as industry and occupational stability, are fading, too, caught between the brutal pincers of technological upheaval and a hyper-competitive global economy.

Put it this way: How confident are you about your earnings projections considering Corporate America's relentless drive to downsize, right-size, restructure, reengineer and outsource jobs? No one plans on getting divorced, but many couples part ways, with devastating effect on their finances. Stuff happens. "When we imagine future circumstances, we fill in details that won't really come to pass and leave out details that will," writes psychologist Daniel Gilbert in the bestseller Stumbling on Happiness. "But foresight is a fragile talent that often leaves us squinting, straining to see what it would be like to have this, go there, or do that."

Life is uncertain. You can't escape risk. It's the human condition. And it's at this realization the Wall Street framework and the insurance perspective cross: We all need to save more and create a healthy margin of financial safety.



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