Category Archives: Finances

How Inflation Protected Mutual Funds Fail to Protect (Part One)

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Egg Balanced on ForksInflation protected bonds are a great way to protect your long-term savings and it’s easy assume that inflation protected mutual funds or ETFs are just as good, but that’s actually not the case.   There’s increased risk to savers who hold bonds in a mutual fund.  In this two part series, I explain some of the risks and why I don’t recommend using funds for this purpose.

The Benefits of Mutual Funds

Mutual funds are pretty convenient to an investor.  They are relatively easy to buy and sell and are managed by professionals.  They allow us to leave our investments in highly qualified hands.

Mutual funds are also very well advertised.  You can find out a lot about them because they are in almost everyone’s 401k. Mutual funds can be a win-win situation for the novice investor and the experienced money manager.  The problem with mutual funds and ETF’s is that they are inherently more risky than bonds because they have added exposure to market forces.

Preservation vs. Opportunity Investments

When we are saving, we intend to preserve our money for a specific point in time.  Mutual funds help us take advantage of investment opportunities, but they don’t commit to pay at a point in time.  We are able to pick a good management team and pay them to pick the best time to buy and sell stocks and bonds, but they don’t promise that our money will be there when we need it.

As I mentioned in the article: “Stressed about Savings? Divide and Conquer!”  it’s very helpful to divide your money into two separate parts before you start.  Mutual funds can be a valuable part of the opportunity side of your investing, but too risky for the preservation side.

The Safety of Bonds

Bonds have traditionally been a much better place to store money for long term savings.  That’s because bonds are loans with a due date.  When a bond matures, you get all your money back.  I discuss this at length in the article: “Why Bonds are Smart for Savings”

The danger bonds have is the possibility that your money won’t be paid back to you at all.  We do have to consider who we are loaning our money to.  Risky bonds are not good investments for savings either.  You can diversify them, but they are still not good preservation tools because you may not get all your money back when you need it.  Good quality bonds, however, can be seen as a good method of saving for the long term as long as they are adjusted for inflation. That’s because you have a reasonable commitment that you will be paid on time.  Mutual funds, on the other hand, don’t come with a commitment to pay anything.

Bond Funds

As safe as bonds are, you would think that putting bonds into a mutual fund or an ETF would produce the best of both worlds, but that’s not the case.  A surprisingly risky set of things happen when you put bonds into a fund.

When you invest in a bond fund, you are not owed anything anymore!  When you own a bond directly, the bond issuers legally owe you money on a specific date.  In a mutual fund, the bond issuers owe the fund money, but they don’t owe you anything directly.  This is very important to understand.  If you intend to insure your savings, then it’s better to choose a method of savings that provides you a direct guarantee.

You might be wondering why a bond fund would not be able to pass along the bond issuer’s guarantee.  There are some valid reasons.

Funds are Mutual, Bonds are Not

It’s important to understand that a bond fund is owned by a group of people.  This creates a problem for savers.  In order for a bond to preserve your money, you must hold that bond until it matures.  There is no money available until a bond matures, unless you are willing to sell the bond at the current market rate.  Funds, on the other hand, allow shareholders the ability to buy and sell at any time.  If all of the other shareholders had the same intentions as you, it might work well to use a bond mutual fund, but that isn’t the case at all.  There are some shareholders that may actually sell their shares before the bonds in the fund mature.  If enough people do that at the same time, it could force the managers to sell some of the bonds at a rate that is lower than what was paid for them.  As you patiently hold your shares, the value in the fund would go down because of what others decide to do.

Bond Market Exposure

What this tells us is that by putting a bond into a fund, it exposes the fund to the bond market which can be as unreliable as the stock market.  If the bonds are always held to maturity, they have no exposure to the bond market and there is nothing to worry about.  I have found that bond funds usually follow bond market prices, not bond maturity values.

Let’s consider some of the risks the bond market exposes an investor to.  Remember that the bond market is just a place to buy and sell loans that haven’t been paid back yet.  The market is subject to what buyers and sellers perceive about the future.  Since these loans are dependent on an interest rate,  investors are exposed to the potential that the bond’s interest rate will seem small in the future compared to newer bonds and other investments that become available.  Since investors want to hold loans with the largest payout, the loans with the lower interest rates would lose market value.  They could even lose enough value that they temporarily fall below the original principal.  If a fund manager is forced to sell at that point to pay a mutual fund shareholder, it deeply hurts the fund.  Since you own a share of that fund, it hurts you too.  When you buy a bond directly, you can hold the bond and ignore the market.

Click here to go on to part two…

Why Bonds are Smart for Savings

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Colorful Eggs in Small Colorful BucketsBonds are one of the easiest and most common ways to save money for the long term.  There’s a good chance you already own one.  If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond.  CD’s are quite a bit different than other kinds of bonds, but they have many things in common.

Rather than going over different kinds of bonds, I’d like to explain why  they are a good investment for those of us saving for future needs.  In a previous article, I described two ways of looking at our investments.  Bonds are very useful for the part of our savings that we intend to preserve.

Bonds Eliminate Timing Risk

I mentioned back in my introduction to TIPS that bonds are actually a  type of loan.  CD’s are loans that you make to the bank.  If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how.  If you have had a CD before, you know that it has an end date.  That’s how bonds work.  They “mature.”  When they do, you get your money back.

Because bonds have a due date, they are great for eliminating timing risk.  Bonds come with a promise to return your money on a specific day.  If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account.  When the CD matures, you get your money back and all the interest right when you need it.

You can imagine what might happen if you put that money in a mutual fund for two years.  If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans.  It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.

Certificates of Deposit and Inflation

Taking out a two year CD might not be that bad.  At the time I write this, CD rates are still quite a bit lower than the rate of inflation.  When that is true, you end up paying the bank to hold and protect your money.  That’s not always a bad idea.  Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?

I Bonds vs. CD’s

You might consider I Bonds for a two year holding time or more.  You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea.  If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest.  It’s still better than most bank CDs at the time that I write this.  After five years of waiting, you can take the money out any time.  If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one.  You can find out more about I Bonds in another article.

The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation.  There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point.  The problem with that is that interest rates and inflation are not really linked.  The will of the government is in between.   Governments occasionally force interest rates lower as a way to “fix” the economy.  As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.

Using a Bond Ladder

Ladder with fruitYou may have seen an article or heard someone at your bank talk about putting some money in a CD ladder.  This arrangement helps you take advantage of changes in interest rates over time.  It’s another way to attempt to deal with inflation issues as well.

The idea is that you split up your money, and buy CD’s or bonds with different maturity dates.  For instance you might buy one for six months, another for one year and another for two years.  The idea being that every six months you would have a CD coming due.  When it does, it allows you choose whether you need to use some of the money or put it back into another CD.  It also allows you to take advantage of changes in the interest rates as they go up.

When you are trying to save your money for later, bond ladders have much different purpose.  When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates.  Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing.  When we are dealing with the preservation side, what we concern ourselves with is timing.  We just need to ask ourselves: When do I need this money?  In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.

Here’s an example.  Suppose you need your money in 15 years.  It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures.  You can think of your needs like buckets of money.  Let’s say that you have one bucket for each year during your retirement.  You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.

Beware of Bond Mutual Funds

Bond mutual funds don’t have a maturity date.  Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds.  That’s because the fund share prices change every day based on market forces, not inflation.  I plan to explain that more in an article about mutual funds.

A Smart Way to Plan

Bonds are a great way to plan because they are based on time commitments.  Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.

Stressed about Savings? Divide and Conquer!

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Piggy Banks

JamesCube (Pixabay)

Trying to decide what to do with the money you have can be stressful.  There are plenty of people willing to “help” you invest your money, but they rarely agree on how.  Just leaving it the bank doesn’t seem right, but neither does losing it all in the market.  I have found that dividing my money into two parts reduces the stress and gives me confidence.

Protection vs. Opportunity

There are two very different points-of-view when it comes to investing money.  It’s possible to look at money as something to protect for some point in the future.  It is also possible to look at it as an opportunity for gain.  Both perspectives have benefits, but they require that we invest in different ways.

When we look at money from a protection point of view, we want to make sure that we don’t lose it.  Our concern is not about future gains, but about having something at a specific time.

When we look at money from an opportunity point of view, we are willing to wait in order to get a big gain.  We’re hoping to use money in order to get significantly more, but we can’t really control the timing of it.

These two points of view, are at odds with one another.  Like the old saying goes, you can’t have your cake and eat it too.  We can’t protect something and risk it at the same time.  When we choose opportunity, we also choose to risk not having our money at a specific point in time.

Many of the professionals in the financial world are more focused on opportunity than they are on protection.  It’s good to keep that in mind when you seek help.  If your intention is to protect, you probably won’t need professional help.  With a little education, you should do just fine on your own.

Insurance vs. Investments

Those who intend to preserve their money are better off thinking about it like they would insurance.  That’s because when you preserve, you are saving what you’ve already earned.   You’re just making sure that it’s there for you when you need it.  A preservation mentality is helpful when you are saving for specific things.  Those things might include maintaining or buying a car.  Other things include buying a house, paying for college or for paying for retirement.  Preservation is good for those things that you already know that you will probably need.

When you want to use your money to take advantage of growth opportunities, insurance doesn’t really make sense.  That’s because you’ve accepted the risk that your money won’t necessarily be there at a specific point in time.

Promise vs. Potential

When we make a decision about where we put our money, we need to decide whether we care more about having a promise that our money will be available, or that we have the potential to gain when opportunity arises.

These kinds of financial arrangements are at odds with each other but they both have their place.  If there was no potential for gain, there wouldn’t be a way to have something to preserve.  If there was no place to save your money, how could you keep what you have gained for a time that you need it?

Determine Your Timing Related Risk Capacity

When I say “timing related risk,” I mean the kind of risk you expose yourself to by not having money when you need to use it.  Considering your timing related risk capacity is a good way to decide whether you should preserve or speculate.

source: nattanan23 (Pixabay)

If you don’t have any savings at all, then you are at risk whenever something doesn’t go right.  You really don’t have any capacity for timing risk.  If you have no extra money and your car’s transmission fails, you would immediately be in financial trouble.  It’s important to have emergency savings and not having it definitely qualifies a timing related risk.

There are other timing related risks you may have.  Retirement is an important one.  You can calculate the amount of time that remains before you plan to retire and the amount of money you might need for the rest of your life from that point.  These projections expose a risk.  If your retirement money isn’t there when you need it, you will probably suffer.  Other things have timing related risk too, like buying a house, paying for college or paying for family vacations.

When we think about risk, we need to consider what we would feel like if our money wasn’t there when we need it.  If the money you are thinking about isn’t going to be needed for a particular time in the future, then opportunity investing is probably a good idea for you.  If you know what the money is intended for, then preservation investing would probably be a better idea.

A Helpful Separation

I have found it helpful to separate my money into two distinct parts.  One is the part I intend to preserve as savings.  That part includes my emergency savings, the part of my retirement savings that would pay for my basic retirement needs and any other amount of money that I would rather preserve than take risks with.  These may include funds I intend to use as an inheritance or a donation.

The other part is for investments that I believe will eventually be profitable.  For these investments, I accept that I don’t know when they will be profitable and I am willing wait.

Less Stress

By taking your savings and setting it aside as something you intend to preserve, you don’t have to worry about how much money it makes.  As long as it keeps up with inflation, it will still be there for you.  The rest you can use to do some investing.  That’s the part you may want to have an investment professional help you with.  If things don’t go quite as well you expected them to go, you can rest assured that your savings is still intact.

Thinking of Retirement as Standard of Living Insurance

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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:

Is it really Savings?

I think that there is terminology that retirement fund salespeople 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 are actually “retirement 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.”

Guaranteeing our Savings

There are ways to guarantee 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.

Guaranteed Retirement Options

When it comes to ways to guarantee 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.

Social Security

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.  There’s more about this investment in the article: Possibly the Most Popular Inflation Protected Investment.

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.

Home Equity

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.

Further Reading

How to Buy an I Bond
If you are ready to get some I Bonds right now and protect some of your savings, I’ve made some step-by-step instructions to help you set up your Treasury Direct account and purchase your first I bond.