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Published 7/26/05.
This commentary is about the possible ways to hedge a retirement. For
those readers who question the title, please consider that the Optimist
strives to provide an inspirational and uplifting positive message in each of
his writings. Today's message is Illegitimus Non Carborundium. That roughly
translates to Don't let the bastards grind you down! Although he admits that
this is a weird title, he is happy that it worked to capture your attention
for a few moments. The Optimist trusts that readers will not be too abrasive
with him.
A riddle to be solved
The word Carborundium also looks a lot like Conundrum which is currently a
very popular word that means a riddle or a puzzle. That seems like a good
segway to a conundrum that the Optimist has about how to hedge the value and
the purchasing power of a retirement. Before continuing to pose his
conundrum, the Optimist wishes to warn any readers who assumed that this
commentary would answer the title question. Although the Optimist may sound
like an irritatingly smug person who thinks he knows it all and is much too
sure of himself when he talks of silver and gold, the truth is that there are
many topics in which he is barely literate. The Optimist hopes that readers
will be able to shine light into the dark voids he has about this topic.
Why hedge a retirement?
A person who either recently has or soon will retire has a vested interest
in the equivalent of a substantial amount of equity. It is reasonable to
expect the company providing the retirement benefit to handle that equity
with care, and to take steps to protect most of the value of the retirement
equity from obvious concerns, such as a modestly rising rate of inflation. If
one anticipates a possibly substantial and potentially abrupt change in the
financial force field which impacts on that equity, however, then it might be
reasonable to consider supplementing the protective envelope that surrounds
the retirement equity. As with most true hedges, the focus is not on
investments which offer additional profit potential, but rather to
essentially purchase an insurance policy that returns a portion of the equity
that would have been lost due to events which cannot be otherwise controlled.
Assume no risk from the source . . .
There have been many unfortunate instances in which a company went
bankrupt and the employees lost much of the retirement equity they expected
to receive. That is a nightmare which not even the Optimist can present a
positive perspective about. For this discussion, however, we can contemplate
a much brighter prospect. Let's consider a company that will pay the
retirement benefits, and that has zero risk of any problem that might
negatively impact the ability of that company to pay all agreed benefits, in
full and on time. For example, let's assume for this discussion that a
hypothetical corporation has a monopoly on and manufactures really expensive
little widgets which the entire defense establishment adores. Obviously,
there will never be a slowdown in that company's earnings, and it's promises
to pay a defined set of retirement benefits are as safe as anything can be in
this troubled world. The Optimist hopes all of his readers work for a
comparable corporation.
. . . but other risks loom large
So why would one waste time and energy worrying about the defined set of
retirement benefits which our hypothetical company will certainly pay? The
answer is that there are potential risks which are not covered by the company
retirement plan. As one simple and relatively slow example, the retirement
payments will be indexed to increases in the CPI. Consider the impact if the
CPI does not move up as fast as the real cost of living, as the Optimist considers likely. The difference
between the higher costs due to more rapid rises in real inflation, minus the
lower gain obtained by indexing the retirement benefits to a slower rising
CPI, would be a consistent net loss of purchasing power. The inevitable
result of a continuous loss of purchasing power is that the piranha of
inflation would continuously eat away the muscle and meat from the retirement
plan's skeleton.
A helicopter symbolizes a more rapid concern. If on a bright and clear day
the sky darkens because the sunshine is blocked by millions of freshly
printed hundred dollar bills fluttering aimlessly down from a fleet of
helicopters chartered by the Fed, one might reasonably be concerned about the
purchasing power of a few hundred dollar bills obtained by cashing a
retirement check the following week.
Perhaps the most rapid risk could be visualized as a herd of large
elephants all trying to exit through a small fire door at the same time. That
pachyderm pandemonium is similar to the chaos that would ensue if the USA's
creditor nations all panicked and tried to dump their trillions of dollars
and bonds simultaneously. For a few days (would you believe years?!) after
that financial meltdown, it might be difficult to exchange a retirement check
for anything edible.
A note to deflationists
The Optimist apologizes for presenting a topic which will be of little
interest to investors who want to primarily protect against deflation. If the
USA is on a path to deflation in the not too distant future, then there is no
need to worry about hedging a retirement, or even to consider various
investment strategies. A deflationist would need only to convert all assets
to cash, or to a super safe T-Bond equivalent, and then wait for
precipitously plunging prices of everything to multiply the purchasing power
of cash. A retirement or Social Security check each month for a fixed number
of fiat dollars would automatically gain purchasing power during a
deflationary contraction. There would be no need to do much more investment
work than to sing another verse of "Don't worry - Be happy" as
falling prices everywhere magnify the wealth of cash equivalents. The ease of
positioning investments for deflation makes it tempting to convert to that
belief system, but the Optimist will not yield to the easy side of the force.
For the last 70 years, inflation has been the American Way of truth, justice,
and financial integrity. The Optimist steadfastly continues to support that
proud and time honored heritage.
What would a good hedge look like?
Those who do not have faith that deflation will soon solve many investment
concerns have a conundrum of their own. How should they hedge the impact of
events which hopefully have a low probability of occurring, but which could
be catastrophic to an unhedged portfolio? Before getting on with possible
answers, it might be helpful to review the general characteristics of an
effective hedge. Obviously, a good hedge should protect the equity of the
investment in focus. It should also be not too expensive, and it should index
benefits to inflation. A sometimes overlooked but essential requirement for a
good hedge is that there must be a solid guarantee that the agreed benefits
really will be paid when the need arises.
Consider flood insurance as an example. If you are the proud owner of a
house that would cost $200k to construct again, then you have a substantial
amount of equity to protect. If the house is located in a 100 year flood
plain, then there is a possibility of a once in a lifetime flood which could
destroy your house. Although the probability of a catastrophic flood is low,
it would be prudent to spend a few dollars as insurance against disaster.
However, the cost of the insurance must be carefully considered. It would
make no sense to spend $thousands each year to protect against a very low
probability of losing $200k, and even $hundreds might be an excessive annual
cost. Although $200k may be adequate to reconstruct the house today,
inflation could raise that cost to $220k next year and to $250k the year
after. The proceeds from the insurance should be indexed to real inflation,
not just to the flat line fiction published as the CPI. Finally, one must be
very confident that the insurance company will pay the benefits when the need
arises. If the company that is collecting the premiums each month has all of
its assets and many policy liabilities in the same 100 year flood plain, that
company might be too busy talking to its bankruptcy lawyer to return your
frantic phone calls.
So, how should we hedge a retirement?
There seems to be enough background here to let us focus on the title
question. No more theory. It is time now for specific nuts and bolts answers!
After considering the monochromatic offerings the Optimist can present,
however, readers might shout Nuts!, and bolt from this discussion. This is
the best the Optimist can do. Buy more silver and gold. That seems to pass
most of the "Does it walk like a duck?" test. If the retirement
value is lost, or other investments deteriorate, or the house is destroyed,
equity will remain in the gold and silver, and that equity would be easily
available to use for financial reconstruction. The annual costs of owning
silver and gold are relatively low, the value of silver and gold will
probably rise faster than inflationary increases in costs,
and silver and gold will still be there for you when many companies are
fighting for position at the take a number machine outside the bankruptcy
courts.
Since we are all close friends, and you are very understanding of his weak
moments, the Optimist can confess that he did briefly harbor another thought.
If the coming bad times will coincide with rising long term interest rates,
then a simple hedge would be to sell short a T-Bond future, and to
subsequently just roll it forward. As with most simple solutions, however,
his one has a potentially fatal flaw. Long term bonds might not drop! Despite
rising real inflation and a world wide economy that is booming (that
description mostly applies to Asia of course), long term rates have
persistently declined instead of rising as would be rationally expected. To
paraphrase Keynes, market insanity can be an asphalt roller if you let your
finances be the pavement. If a financial force beyond comprehension is intent
on further depressing long term interest rates, the Optimist cannot recommend
getting crushed by the weight of a T-Bond short position. Those readers who
have a talent for identifying major trend changes soon after the peak,
however, might consider purchasing a T-Bond put with a strike that is far out
of the money. The time decay of the option premium could be thought of as
similar to the monthly cost of an insurance policy. Just as with an insurance
policy, the buyer would hope to lose the full cost of the purchase price
because the cataclysmic event which is needed to profit from the policy would
be terribly traumatic for everyone. As a certifiable optimist, I am
prohibited from dwelling on such thoughts, so I will end my attempts at
finding possible solutions to the title question.
Readers will tell me where to go!
The Optimist suspects that a few readers may occasionally entertain
financially pessimistic viewpoints. He hopes those readers will share their
perspectives on what would be a great hedge for a really bad situation in the
years to come. As always, reader comments are welcome, and selected excerpts
will be appended to this discussion.
A reader comments (added on 7/30/05):
On your article about hedging retirement, one hedge that occurs to me
is to buy a small farm. (Realizing that a big one might be out of the reach
of most people). Being able to grow your own food would be a key hedge if
things really hit the fan. Also realize that land will appreciate (at least)
with inflation, your only cost is the taxes. In some cases, though, you can
rent the property for the cost of the taxes, so it is a wash.
the Optimist:
This is an excellent suggestion. One could extrapolate this thought to the
purchase of any essential business enterprise that would generate positive
cash flow. If you can get a long term fixed rate mortgage loan on a farm (or
used car repair shop, or self storage facility, or any other business that is
likely to prosper as consumers are forced to focus their spending on
essentials rather than luxuries), such that the monthly payments for mortgage
and taxes are less than the retirement payments you will receive, then the
net positive cash flow generated by the business could be a partial
substitute for the retirement income which was reallocated to pay for the
purchase. As real inflation increases the prices at which the business
products sell, the positive cash flow will increase while the loan payments
remain constant at a lower level than the retirement income. By converting
the retirement payments to pay fixed loan costs, while the profits from the
essential business can grow without limit, one would hedge the value of the
retirement income against the probable inflationary threat ahead. Another
advantage of purchasing a farm is that one would have an alternative place to
live when rising levels of crime makes living in cities less desirable.
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