Given all the back and forth in Washington these days, with policy meetings and dramatic proposals to revolutionize retirement, I’ve got retirement-income solutions on the brain. So here’s a modest proposal for providing “Retirement Income Security for All.”
The U.S. Treasury could create, and sell at auction, a new set of transferrable debt securities that obligate the Treasury to pay holders $10 of interest, adjusted for inflation, at the end of every month, forever (well, at least until the Treasury either buys them back or defaults). These securities—actually perpetuities—could be bought and sold on a secondary market, and would have a market price like every other form of marketable Treasury debt.
When saving for retirement, individuals could buy them in an IRA or 401(k)—or perhaps more easily and cheaply, in a separate mutual fund account. Before an investor entered retirement, he could just use the periodic payments to buy more income. And once he had bought as much guaranteed income as he wanted, any ongoing payments could be invested elsewhere. In retirement, investors would just spend the payments instead of reinvesting. These securities or fund shares could be bought or sold at any time, and they would be bequeathable at death.
For individual savers/retirees (and even perhaps defined benefit plan managers), these securities would eliminate the issue of trying to build a ladder of income from bonds or other instruments with various maturities and structures, while simultaneously dealing with the issue of “running out of money.” They never mature, so they don’t run out. They would be backed by the federal government from inception—so no bailouts or complicated “backstops” or “reinsurance programs” needed for bankers, pension or fund managers, or insurers that turn out to be unable to meet their obligations. And the payments would be indexed to the CPI, so no inflation risk.
There’s no question such securities would solve the issue of providing people “guaranteed retirement income.” So why don’t they exist? Or, more correctly, why don’t they exist anywhere other than in very small amounts in the U.K.? (Though the British version is not indexed for inflation. In the U.K., this form of government debt is called a consol, short for “consolidated annuity,” and it has a very long and interesting history.)
A few reasons are easy to see, even if we set aside—for just a second; don’t worry, tea-partiers—the glaring issue of how wisely the government might use the proceeds from such a securities sale.
First, these securities would not be cheap. In a world with a flat term structure of real rates, the price/value of perpetuity is the payment per period divided by the interest rate per period. As of March 9, 2010, the real interest rate on the new 30-year TIPS (just issued in February) was 2.18%, or roughly 0.182% per month. If the yield curve were flat at that level, it would mean a current value for a $10-a-month perpetuity of $5,581. In other words, $25,000 of annual guaranteed income would cost $1.16 million. Pretty steep.
Second, while these securities would by definition provide truly guaranteed income, their market values would fluctuate every day with interest rates, like every other bond. Suppose these rates rose to 3%: $10 a month forever is now worth only $4,000, a “loss” of 28 percent. Suppose rates instead fell to 1.75%: $10 a month forever would be worth $6,857, a gain of 22 percent. Quite a roller-coaster ride.
But of course, retirees wouldn’t care about this, because all retirees are looking for is “guaranteed income,” right? Wrong—and this is a point that, to date, I just haven’t found a way to communicate effectively: Retirees very rationally place a huge value on flexibility, as they may suddenly need or want to spend resources at a point in time rather than slowly and steadily over time. Since they can’t know when that time might be, this kind of interest rate risk is a huge deal, and they have a need to diversify it, as well as other risks, across “states and dates,” as the economists say. Hence even totally flexible guaranteed income is ultimately of somewhat limited value. It just isn’t the same thing as financial security, by a long shot, if you ever have a need to spend it in a hurry.
Finally, what about the issue of what our government would do with the proceeds from the sale of these securities? We all have our own opinions on that, I’m sure. If it isn’t something wise and reasonably productive, it could potentially affect the odds that payments would actually be made in perpetuity—meaning that even “government-guaranteed income” isn’t, ultimately, unconditionally guaranteed income. (Of course, swapping these securities for existing debt wouldn’t create any new problems of this sort.)
But the bottom line is that even though we could clearly provide flexible, real, strongly guaranteed income if we wanted to, doing so would not be cheap for those buying it, and, even more importantly, would not be the same thing as providing retirees financial security. There is a very strong logic behind prudently drawing from a diversified portfolio, in conjunction with Social Security and other pensions or annuities, even if there is some market risk still involved. I’m confident that truth won’t change, regardless of what new proposals come out of the retirement experts in Washington.
Still, I guess Don Quixote had a certain charm.
• This blog post is in no way intended to be an official policy proposal on behalf of Vanguard or the author.
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• Diversification does not ensure a profit or protect against a loss in a declining market.