A Digression About Risk

I was planning to say a bit more about Required Minimum Distributions and Spigot Planning, but I will get back to that shortly. Today I want to respond to Anonymous’s comment to March 10’s post about annuities and how they can be used to create a Do-It-Yourself Pension. Anonymous astutely points out that annuities do not come without risk.

All an annuity is, at bottom, is the bare promise of an insurance company to pay you $X per month for the rest of your life. But if the insurance company goes belly up, what’s that promise worth? All states have back-up funds to rescue annuitants tied to a failed insurer. But only up to a stated maximum, which varies from state to state. And for the balance of your annuity? Well, you’ll get just pennies on the dollar, as would a creditor in any other bankruptcy.

So if you buy an annuity, of course you should—and will—check out how the insurer is rated by the rating agencies. Hah!! What good is that? In his comment, Anonymous pointed out that Executive Life was highly rated before it had to be taken over by the state of California. And we are all aware of the black eye the rating agencies gave themselves in the ongoing sub-prime mortgage fiasco. So annuities carry risk.

And so does every other investment available to you.

Let me repeat. Every investment in every one of your savings buckets carries risk. No exceptions. None.

Your challenge, which, unlike those Mission Impossible guys, you have no choice but to accept, is to moderate that risk as best you can by diversifying among different types of assets; and to be sure you are compensated with adequate potential reward for each risk you take on. Not so easy. But you have no choice.

Let’s look at some investment alternatives. Anonymous mentions a few.

Broad–Based Equity Index Mutual Funds. Good idea. But of course even well-diversified equity index funds will lose money when the stock market goes down. Consider that the S&P 500 (total return), a ubiquitous broad-based index, fell 50% from its peak on October 9, 2007 to yesterday's close. Is that risk of loss reason to avoid such funds? No. Because over the long run, the stock market has adequately rewarded investors, on average 9.62% per year from 1926 through the end of 2007. That's he geometric average, not the arithmetic average. The challenge—and it’s an intractable one—is to figure just how much of this particular risk you can stand, given your financial resources and your projected needs.

Bonds. Bonds are a fine fixed income investment, with less of the vertiginous ups and downs of the stock market. But they too carry risks, most notably (i) the possibility of default by the bond’s issuer, and (ii) loss of value if interest rates go up. Again, how much of these particular risks can you stand? And is the potential reward worth it?

Certificates of Deposit. Since CD’s are insured by the U.S. (at least up to a $100,000 maximum; $250,000 for just this year), they avoid the risk of default. But they don’t avoid the risk of loss of value if interest rates rise. And because they don’t carry default risk, they offer only low returns. Which creates its own risk of failing to keep up with inflation.

Treasury Inflation-Protected Securities (TIPS). These are great because they grow in face value with cost-of-living adjustments, and are issued by the U.S. government, so they have a lot of the risk bases covered. But they therefore carry a low real yield, and so create their own risk of failing to provide sufficient return to meet your lifestyle needs. And even these marvelous instruments fluctuate in value with the turbulent forces of the marketplace—millions of buyers and sellers with their diverse needs and opinions causing the TIPS’ value to go up or down for no discernable reason.

The larger point here is that there are lots of types of risk, so it’s difficult to compare one investment to another. Is the risk of default by an annuity insurer bigger or smaller than the risk of the stock market dropping? They’re apples and oranges. And there are too many facets of risk to make a simple comparison.

You can’t eliminate risk. It’s a fact of life. The best you can do is diversify it, so that not too many disasters occur simultaneously. And be sure you are adequately rewarded for the risks you’re forced to take.

To be continued.