This May Be the Closest Thing to a Risk-Free Investment

On this episode of The Long View, our guest was Brett Arends, who’s been a columnist for MarketWatch, The Wall Street Journal, and others. We talked about income annuities, investing FOMO, the appeal of Treasury Inflation-Protected Securities, and why he thinks “Social Security is already in deficit.”

Here are a few excerpts from our conversation with Brett, who has written several books, including Storm-Proof Your Money: Weather Any Economy, Rebuild Your Portfolio, Protect Your Future.

‘TIPS Are the Real Risk-Free Rate’

Amy Arnott: You’ve also written about inflation, and we’re taping this toward the end of June, with the most recent inflation number of 4.2%. You’ve written that you think inflation could actually get worse and that TIPS look incredibly attractive today. Can you talk a bit more about that, why you think TIPS are attractive now?

Brett Arends: Sure. This is one of my favorite topics, and readers, I think, suspect, find it very boring. And it’s interesting why people will ask me why they would invest in TIPS. TIPS are US Treasury bonds, like the regular Treasury bonds that will follow on the 10-year or whatever, but the value is adjusted to reflect changes in the Consumer Price Index. They found somehow the world’s most complicated mechanism to do it, and even people who are experts admit that they find the mechanics overly complicated. However, essentially, all you need to know is that TIPS promise to pay you inflation, the inflation rate plus or minus depending on the price of the TIP at the time, plus or minus a certain amount. What I like about TIPS is that, essentially, your return can be measured in real purchasing power dollars. To me, TIPS are the real risk-free rate. There’s no point telling me, well, Treasuries are going to pay you 4% a year for the next 10 years, because I don’t know what inflation’s going to be.

If inflation turns out to be 5% a year, I’ve lost money. So, the 4%, I don’t know what that 4% is going to mean to my purchasing power. I don’t know in real terms whether I’ll be able to buy more groceries and rent a bigger place or fewer groceries and rent a smaller place, and so on, until I know what the inflation rate is. Whereas with TIPS, you know, you say, well, OK, so there’s a 10-year TIPS bond and it’s paying … Actually, I think at the moment there’s been quite a big move in the last couple of days in the markets, but I think at the moment it’s significantly over 2% real, as they say, which means a real return, inflation-adjusted return. Let’s say you buy a TIPS bond with a 2% real return. What that means is that, no matter what happens to inflation over the next 10 years, assuming Uncle Sam doesn’t default, no matter what happens to inflation over the next 10 years, you will get that inflation rate plus 2% a year over that period.

You can work out exactly what’ll happen to your purchasing power, exactly what real inflation-adjusted return you will get, what return you will get in real money. And so, to me, the interesting question isn’t why would you buy TIPS? It’s why would you buy so-called nominals? Why would you buy regular Treasuries? Now, if the regular Treasuries, if there was a big discount in the price, then I might buy the regular Treasuries. I might say, well, the market is now expecting 8% inflation a year for the next 10 years. That looks crazy to me. I would buy the nominals. But to me, the default purchase is our inflation-adjusted, inflation-protected bonds, not for technical reasons, but for ordinary, real Main Street people. It’s like you are saving so that you will have money to spend to meet your needs and wants over the years to come.

You don’t know what’ll happen to the price level over that period. Assuming the US government does not default on its debt, TIPS bonds are the only thing that will tell you exactly what you’re going to get over that period. So, I find it quite interesting. It may be one reason why I think TIPS are both neglected and usually underpriced compared with regular bonds because people just don’t seem to be interested in them. They don’t seem to understand them. And to me, as I said, I think this is the default risk-free asset because, essentially, I’m not taking any inflation risk. And if I assume, for the sake of argument, that the US government is not going to default on its debt, then I know how much I can earn in real money without taking any risk over the next five, 10, 15, 20, 25 years.

To me, TIPS are where you’d start. I’m much more reluctant to buy nominal or traditional Treasury bonds than I would be to buy TIPS bonds. As it happens at the moment, these real yields on TIPS bonds are very high by historic standards or, to put it another way, the bonds themselves are very cheap. You can actually now get 2% real return per year, even at the short end, even over bonds you own for three or five years. And if you go out, if you buy a very long-term TIPS bond, you can, again, assuming the US government doesn’t default, you can get 2.7%, 2.8% a year in real return over the next 30 years.

‘You Can Create a Guaranteed Lifetime Income Very Easily by Buying Annuities’

Christine Benz: You think TIPS are neglected, underutilized. Do you also think that for older adults who are looking to generate income from their portfolios, a basic income annuity is also underutilized, and that retirees should consider them more? Can you talk about that through the lens of, if we’re worried about inflation, should we be spooked by just locking in a payout from an annuity that doesn’t link itself to CPI in any way?

Arends: Great questions. It’s a favorite topic. It’s fascinating to me that there has been so much debate about the so-called 4.0% rule, 4.5% rule, 3.5% rule, which is essentially a debate about how much money you can safely withdraw from your retirement portfolio per year when you retire. The 4% rule was coined by Bill Bengen, a financial advisor back in the 1990s, and he essentially said a balanced portfolio of stocks, US stocks, bonds, historically, what you could have done is you could have withdrawn 4% of your portfolio’s value in the first year and then adjusted that amount in line with inflation every year. And you could be certain, almost certain, historically, that it would last at least 30 years. Now, what I find very interesting about this is there’s an enormous amount of interest in this because people are very worried. They’re trying to say, how much can I actually spend in retirement?

When I look at immediate annuities, and I’m talking very specifically about income annuities, I’m not talking about all sorts of other things that are called annuities that are essentially investments in an insurance company tax wrapper. I’m talking very specifically about income annuities. It’s like an old-fashioned pension. You take a pot of money, you buy an annuity, and the insurance company pays you a guaranteed income for the rest of your life, whether you live five years or 50 years. And it’s all based on actuarial tables and so on and so forth. And what’s interesting is when I compare this 4% rule with what you can get from annuities with no risk, the numbers don’t really stack up. The risk of inflation is always the big worry about annuities. Basically, you lock in an income rate from annuities, and if inflation takes off, as it did in the 1970s, your payments don’t keep up.

So, in real terms, they fall. And there are, with the exception of Social Security, there are no, that I know of, no inflation-protected annuities because they’re very difficult to calculate in a way that would, I think, satisfy regulators. However, you can buy annuities that have a fixed annual step-up so that every single year, the payment goes up by a certain percentage. And you hope that either that will exceed inflation or at least keep up with inflation. Or, if it falls behind inflation, it won’t fall too far behind inflation. Now what’s interesting is if you go to the market today, these annuity rates have risen because they’re priced off bond yields. If you go to the market today and you shop around, if you are, let’s take—I just did these numbers literally before coming on here—if you are a 65-year-old woman, and you want to buy an income, a lifetime income annuity today, you would get a payout ratio of 7.7%.

That’s without any step-up. So in other words, you’ve exchanged the 4.0% rule for a 7.7%, nearly twice as much in your first year, but of course, there’s no inflation increase, but that’s a huge—you’re basically getting twice as much. So you could theoretically take that 7.7%, you could take half of that money, and invest it in the stock market if you wanted to, and you’d still have the 4.0% left over to live on. However, if you lock in annual increases, you are still way ahead of 4%. So, a 2.0%—that 65-year-old woman who wants an income annuity—if she locks in a 2.0% annual increase in her payout, the initial payout is 6.2%, roughly. This is the market when we’re speaking in June; it moves daily. If you lock in a 3.0% annual increase, you will have a starting payout of 5.6% at the moment, which means that essentially if you had a million dollars, your first year’s payout, you’d have $56,000.

And then every year after that, that sum would go up by 3%. Now, the Federal Reserve’s official inflation target is 2%. So, 3% gives you some leeway. I happen to worry that the new management at the Fed is going to reevaluate how they calculate inflation with the time-honored goal of reducing the headline rate even without reducing actual inflation. In other words, they’re going to come up with a more flattering number. And I think that they have an enormous … Because of the US debt burden, I think all governments, this one and any future governments, have a strong incentive to let real inflation rise beyond 2%. Even 4% annual inflation would be really helpful for the government’s finances over a five- or 10-year period. Without that, the government’s finances look extremely alarming. I wouldn’t be surprised if we have 3% annual inflation in real terms or even more.

But if you go on 3.0%, you’re starting with a 5.6% initial payout, going up from there. So, it’s interesting to me: Economists, people much smarter than me, economic theoreticians, professors, Nobel Prize winners, and all the rest of it, they sort of scratch their heads about what they call the annuity puzzle, which is why people don’t buy annuities. When so many people complain that we’ve lost the supposedly good old days of final salary [defined-benefit] pension schemes, they weren’t actually the good old days that people think they were, but actually you can create a guaranteed lifetime income very easily by buying annuities. And these things are heavily regulated at the state level. So as long as you go to a sound insurer, the risk that an insurer will default is minuscule. So your money is, that’s not really a major issue. People don’t want to give up the liquidity of having a large pot of money.

I guess they worry they’ve sort of lost control. They worry about what happens if I suddenly need a massive amount of money and my money’s all tied up in annuities. I can understand that. However, it doesn’t explain why people buy them so rarely. The sales are minuscule compared with the high-fee investment products known as index-linked and variable and all these other things, which are also called annuities. And it does not help the brand, because whenever I write about annuities, people say, “Dude, annuities are a terrible deal.” I’m not talking about those. I’m talking about this specific product. And my go-to website is always immediateannuities.com. And that’s essentially the basic marketplace. And every day, every hour, you could check what’s happening in the market and what the payout rates are. And I just think anyone who’s worried about outliving their money, this is where you start.

Valentina Djeljosevic contributed to this article.