The Biggest Risk

If you've been around the financial planning business any length of time, you've likely run into the saying "The biggest risk is not taking one."



It is endemic to all financial instruments, indeed, all investments, that return is the reward for risk. It is axiomatic that the entity that takes risks gets the rewards.



Generic stock market returns are between ten and thirteen percent per year, depending upon who you ask and how you frame the question. Contrast this with the five or six percent that insurance companies will guarantee. You invest, you get five to six percent guaranteed. They use your money, they get the difference.



If you invest $100 per month at 5.5% from the time you are 25 until the time you are 65, the insurance company has guaranteed you about $174,000. If you annuitize that in a fixed annuity on a "Life with ten years certain" basis, you'd get somewhere between $1000 and $1100 per month if you're male. Ladies and gentlemen, that won't buy very much now, much less forty years from now with average inflation. Matter of fact, it's only about a 1.67 times overall return net of inflation.



Now $100 per month is a lot less than people should be investing for their own future, but it's indicative of the problem. Even if you contributed $1000 per month, which is more than most people can commit, between however many tax-deferred investments it takes, it's $1.74 Million, which goes to a payout of $10,000 or so per month if you annuitize at 65. Sounds like a lot of money today, right? But you're spending those dollars all in an environment where, at 3.5 percent inflation, $10,000 per month is about the equivalent of our $2500 per month now - and every year that passes in retirement, your money buys less.



Suppose, instead, you were to invest $500 per month - half what you had to come up with in the previous example - and invested it in the broader market, earning a 9 percent return, well below historical average market returns, and then in the final year you lost forty percent of your money due to a market crash? Think you'd be better off, or worse?



Slightly worse off, in raw numbers. $1.40 million ($2.34 million before the crash). For half the effort to save. This despite a major investing disaster at the worst possible time. But then let's say you manage to retain your intestinal fortitude, and instead of annuitizing on a fixed basis, you simply withdraw the same $10,000 per month we had in the previous example, while leaving it invested and generally earning 9%. Your money keeps increasing, and if you live to age 95, you leave 2.23 million dollars to your heirs, a sum that, if not so great as it sounds, will still buy a decent house in most areas of the country sixty years from now under our assumptions.



Now let's say that you want to live the same lifestyle, equal to $2500 per month now, that you have at retirement, so your monthly withdrawals increase by 3.5 percent per year. You didn't even have this option in the fixed rate examples. Your money lasts 19 years 3 months (plus a few thousand left over). Once again, for half the effort to save.



This is not wild risk taking. This is simply doing exactly what the insurance companies are doing, and assuming the investment risk yourself. Do not think for a minute that banks and insurance companies are insulated from failure if the market conditions go sour enough. They aren't getting the money to pay you from some kind of transdimensional vortex. If their investment results are bad enough so that they can't pay you, they won't. Government bailouts are also limited, and the government's guarantee programs are likely to undergo severe modification in the next forty years, as they deal with problems such as social security and medicare payouts that are much larger than what their pay ins will be. States, which generally stand behind insurance company guarantees, will not likely be in a stronger position than the federal government. Not to mention the kind of impact this sort of financial crisis will have upon government budgets.



Speaking of the banks, let us consider a hypothetical four percent CD, on a "taxed as you go" rather than tax deferred basis. Assume 28 percent federal tax rate, and 7 percent state and local. $1000 per month invested, every month for 40 years. How much does it turn into?



$842,800. As opposed to $1,044,600 just to break even with inflation at 3.5 percent per year and being able to buy the same stuff. I'd snark that you might as well bury it in a mattress, but in point of fact, that would only get you $480,000.



The point I'm trying to make here is that the so-called traditional "conservative" investments are anything but. If you aren't putting your money into investments where there is some market risk, then the only guarantee you have is the guarantee that it won't succeed, the guarantee that you will be living in poverty.



So in financial planning, the biggest risk is in not accepting some.



Caveat Emptor.