A modest proposal
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.
Notes:
- This blog post is in no way intended to be an official policy proposal on behalf of Vanguard or the author.
- The link to Wikipedia will open a new browser window. Except where noted, Vanguard accepts no responsibility for content on third-party websites.
- Diversification does not ensure a profit or protect against a loss in a declining market.
This idea is about as probable as a cheap insurance policy that would pay the difference over 30 years if the SP500 failed to return an average of 10%.
And every financial advisor “promises” that is what we can expect based on past performance whenever they run the numbers on how much do you need to save in order to not outlive your money in retirement.
I think that the idea is a good one but the format needs to be in the private sector. I would like to know what would happen if when it was time to contribute to Social Security we gave an option to purchase an annuity. The type of annuity could be similar to the life stratagies funds that fund companys sell presently. These annuitys would convert to less risk as the participant reached retirement age. Former president Bush had a good idea in privatizing S.S. but the wrong approach. We also have placed so many other entitlements onto the original idea that the we are just where the lawyers in government -Congress- wants us. Totally confused.
With the exception of inflation-protection, what you’re describing sounds like it could be easily replaced by a mutual fund made of a basket of federal-government securities of various durations. For the purposes of doing some clear-cut social good, throw in a broad collection of muni bonds — munis backstopped by the federal government. And so (minus the federal gov’t muni default protection) right now a person could simply invest in such a “product” (i.e. a mix of bond mutual funds) if they were able to figure out the appropriate mix. (Caveat: as the example of California demonstrates, having no federal “backstop” rightly throws the consequences of fiscal irresponsibility back on the states. But on the other hand why should individual investors with good intentions be punished by irresponsible state governements?)
But the above isn’t good enough. As you point out with the TIPs example, the cost of inflation protection is steep. So this where Social Security steps in — to provide some measure of inflation protection. Maybe there should be a kind of federal “inflation protection insurance” a person could buy. Nah — it’s called Social Security. Correct me if I’m wrong, but can’t a person buy more Social Security by making additional payments, up to some maximum?
This is not exactly a new idea, but a well tested one. It was originally invented, like most financial instrument, by the Venetians in the Middle Ages. They called it the prestiti. It was used as an annuity and allowed Venice to finance its wars. Later, in the 18th century, the English adopted it and called it the console. It was again a sort of tradable annuity. The consoles lasted till 1949, when they were traded in for something modern. I think currently the Dutch instituted something similar for financing governmental debt. All this shows that this an excellent, time tested idea.
John, as a retirement savings enthusiast and also a backgammon enthusiast, I like your idea with one condition: the securities would have to be called PIPS (Perpetual Inflation-Protected Securities)!
The perpetuity is actually only a partial answer to the problem of retirees who need guaranteed retirement income. A better solution would be to allow citizens to directly buy a government guaranteed annuity that is indexed for inflation. Insurance company annuities are a seriously flawed approach to dealing with this problem due to the safety issue. It is difficult to be confident that a company will be there in 30 years. High ratings from the rating services don’t provide much comfort, as demonstrated by the high ratings given to subprime mortgage obligations before they became “toxic” and by the high ratings given to insurance company AIG prior to failure. While AIG was rescued by the US Government, there is no Federal guarantee behind insurance companies, so failing insurance companies are ordinarily allowed to fail. Insurance companies are regulated by the states, not by the Federal Government. The states generally back only a modest $100,000 in annuities through state guarantee funds or “guarantee associations”. Those guarantee funds have their own problems and are often slow to pay in the event of an insurance company failure. A Federally backed annuity could be sold either directly by the US Treasury (the insurance companies would probably object) or backed by a Federal Guaranty agency similar to the PBGC.
A very good comment above on March 29, although I fear that even the federal government is getting to a point where its financial security and its high ratings are becoming questionable.
In my post above, I expressed the (mistaken) supposition that a person can buy extra Social Security “credits”. In the process of doing a Google search for someone RE this very subject, this blog and my posting (above, using the search words “buy extra Social Security”) came up first. I want to correct my mistaken supposition. Apparently you cannot buy extra Social Security “credits”. This is from http://www.socialsecurity.gov:
Question
I need 40 credits for retirement benefits, but I only have 32. Can I just pay in to buy the other 8 credits I need?
Answer
No, you cannot buy credits.
The only way you can get credits is by earning wages in a job that is covered by Social Security or by having net income from self-employment.
If you work for a federal, state or local government agency that is not covered by Social Security, you don’t pay Social Security tax and you don’t earn credits for monthly benefits based on those earnings. If you pay Medicare tax on those earnings, you do earn credits toward qualifying for Medicare at age 65.