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Comfort Has a Cost

Jonathan Clements

INVESTING IS MESSY. Get used to it.

In the financial markets, you’ll typically pay a high price for certainty. That price is paid in lower investment returns, and sometimes also in greater financial hassles. Yet I see investors paying that price again and again.

Consider equity-indexed annuities. Investors imagine they’re getting stock market returns without any downside risk. But in truth, what they’re buying is an overhyped investment that captures only a portion of the stock market’s gain, plus there’s a hefty back-end sales commission if folks cash out early.

Even good investment products that offer some measure of certainty can turn out to be so-so choices. At issue is everything from Series I savings bonds to certificates of deposit (CDs) to holding individual bonds to maturity. None of these is an unreasonable choice for a modest portion of your money. As nervous investors ponder their likely portfolio performance, all three strategies offer the sort of comforting numerical precision that can make investing seem less scary.

Still, while these strategies provide an escape from stock market turbulence, they also all have drawbacks—and the certainty they apparently offer can prove illusory:

  • Series I savings bonds can’t be sold in the first 12 months and there’s a three-month interest penalty if you sell in the first five years. What about after that? While you’re typically guaranteed to earn at least the inflation rate, and perhaps a small fixed return on top of that, you could find you’re falling behind inflation once taxes are figured in. In fact, the higher inflation is, the worse your after-tax return will be. How so? Suppose your I bonds merely match inflation and your tax bracket is 22%. If inflation is 5% and hence that’s also your yield, you’d fall behind inflation by 1.1 percentage points once income taxes are deducted. What if inflation is 1% and thus so is your yield? You’d lose far less to Uncle Sam—just 0.22 percentage point.
  • CD owners also face withdrawal penalties if they cash out early. And while a CD’s nominal return may be certain, its after-inflation, after-tax return sure isn’t.
  • Individual bonds can be treacherous to sell if you need to unload them before maturity, plus they represent an undiversified bet and you can’t easily reinvest your interest payments, like you can with a mutual fund. What if the issuer doesn’t go bust and you hold to maturity? While the nominal return on conventional, fixed-rate bonds may be known with some precision, your after-inflation, after-tax return is up in the air, just as it is with a CD. Given all that, I’m baffled that investors prefer the illusory safety of individual bonds held to maturity to the much greater safety offered by bond mutual funds.

That brings me to a retirement-income strategy that’s lately enjoyed some buzz: building a laddered portfolio of Treasury Inflation-Protected Securities, or TIPS, with the bonds maturing gradually over the next 30 years, thereby delivering a guaranteed, inflation-protected income stream. Indeed, there are folks I respect—and consider friends—who have endorsed this strategy.

No doubt about it, there’s a mathematical elegance to the strategy and it offers an appealing degree of performance certainty. I’ve even had readers suggest to me that a TIPS ladder is all a retiree needs and that I’d be a fool not to take advantage, especially given today’s relatively high after-inflation yields offered by TIPS. Am I a fool? I have money in TIPS mutual funds, and I think building a TIPS ladder is a clever strategy.

But I’m still not wildly enthused, for four reasons. First, what happens if you live longer than 30 years? Unlike Social Security or an immediate annuity that pays lifetime income, a TIPS ladder doesn’t offer longevity insurance. What if it’s year 25 of your 30-year TIPS ladder, and death is nowhere in sight? That’s not the sort of conundrum I want to face in my 90s.

Second, building a TIPS ladder is complicated. To see the array of bonds you might need to purchase, try TIPSladder.com. Just one of the problems: There aren’t TIPS maturing every year for the next 30 years. In fact, to construct a TIPS ladder for a client, an advisor I know—who’s an expert on the topic—told me he had to spend 30 minutes on the phone with Vanguard Group’s bond desk, specifying which bonds to buy and in what quantity. And remember, this is a guy who knows what he’s doing.

Third, while keeping up with inflation is often presented as the gold standard for retiree income, those who meet this goal may find themselves feeling shortchanged. How come? The standard of living rises not with inflation, but with per-capita GDP, which has climbed 1.7 percentage points a year faster than inflation over the past 50 years. Suppose your neighbors’ income rises with per-capita GDP, while you merely keep up with inflation. After three decades, your inflation-adjusted income will be the same, but theirs will have climbed 66%—and you may find yourself feeling increasingly poor.

Finally, if you had 10 years or longer to invest, why wouldn’t you own stocks rather than TIPS? Sure, there’s the “if you’ve won the game, stop playing” argument. But owning some stocks may allow your standard of living to keep up with per-capita GDP growth, while also leaving a larger bequest to your children and your favorite causes.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.

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