Posted with audio link on Forbes.com.
When Robert Merton, MIT finance professor and Economics Nobel laureate, speaks, we should listen. Fifty years ago, Merton, together with Fisher Black and Myron Scholes, developed the Black-Scholes-Merton option pricing formula. When these three finance geniuses derived their remarkable equation, there was no formal option market. These days, 39 million option contracts are bought and sold daily.
Merton, together with Arun Muralidhar, Co-Founder of AlphaEngine Investment Solutions LLC and author of 50 States of Gray, has produced another marvelous brainstorm. It’s called Retirement Securities Bonds or RSBs.
RSBs are coupon-only bonds that would be issued by the U.S. Treasury. Their adoption would dramatically improve the wellbeing of current and future American retirees. Just ask Brazilian retirees who are now buying Brazilian-issued RSBs. In January, Brazil became the first country to adopt this new financial instrument. A host of countries is considering doing the same.
Every country adopting RSB is likely to have their own variant. But let me describe the U.S. RSB proposal. Unlike traditional nominal as well as inflation-indexed U.S. Treasury bonds, RSB wouldn’t pay principal. They would have a 20-year term and be indexed to per capita consumption. Indexing RSBs to our nation’s average living standard protects RSB investors against two risks — inflation and not keeping up with the Joneses.
Were U.S. workers managing their retirement preparation properly, they’d have little need for RSBs. Unfortunately, they aren’t.
Americans are increasingly being asked to take responsibility for guaranteeing their financial old ages. Back in 1980, 38 percent of private-sector workers were covered by employer-provided defined benefit pensions. That figure is now just 15 percent. Yes, two-thirds of private-sector workers have access to 401(k) and other defined contribution (DC) plans. But are they participating? And are those that do participate contributing sufficiently? And are those who don’t have access to employment-based retirement accounts saving on their own?
The answers aren’t pretty.
Of those private-sector workers with retirement account access, only 48 percent participate. Consequently, only one third of all private-sector workers are saving in DC plans, let alone saving enough in these vehicles. As for the one third of private-sector workers who aren’t covered by DC plans, only 16 percent report saving for retirement.
In sum, almost three-fifths of private-sector workers appear to be doing absolutely or essentially no retirement saving. The problem is worse among those with low incomes. A July GAO study shows that only 1 in 10 low-income workers have a retirement account.
These facts explain why our retirees’ typical retirement account balance is less than $100,000, why 40 percent of retirees are more than 50 percent dependent on Social Security, why 14 percent of retirees are wholly dependent on Social Security, and why almost 22 million more retirees would be living in poverty absent Social Security.
In short, our government, at enormous cost, has failed spectacularly in bribing workers, via massive tax breaks, to save. It’s time to try something new — something that won’t cost a dime.
Why Don’t Americans Save?
Retirement planning is no picnic even for the most financially responsible and sophisticated. It requires making and updating complex, interrelated saving, spending, insurance, and investing decisions on an ongoing basis — whether you are age 35 or age 85.
For the few of us with generous private pensions, which, like Social Security benefits, are protected against inflation, retirement planning is simple. Spend as your income arrives. Everyone else needs to transform retirement savings into safe, inflation-protected retirement income and retirement-account withdrawals.
Many of us can purchase additional real annuities on excellent terms from Social Security simply by delaying benefit collection. But we don’t. The typical household leaves $182,000 in lifetime Social Security benefits on the table by taking the wrong benefits at the wrong time — something that can be readily fixed.
Part of the compulsion to take Social Security as early as possible may reflect an ingrained belief that we will die on time — at our life expectancies. Superstition may play a role here. If I think about living beyond my life expectancy, I will jinx myself and die tomorrow.
The financial industry also routinely references life expectancy rather than our proper planning horizon — our maximum age of life. In so doing, Wall Street subtly persuades clients to take Social Security early — to get what’s theirs before they die. This, of course, leaves the financial system with more retirement assets to manage and on which to charge fees. But suggesting we’ll die when we should rather than when we might raises the potential for financial catastrophe — having to pay for yourself far beyond your expiration date.
Misgauging longevity risk is one explanation for Americans’ miserable saving behavior. Another is the assumption that we can sit back and rely on Social Security and our employers to keep us solvent in retirement. A third is high payroll and income taxes that leave workers little wherewithal from which to save. A fourth is our assumption that market returns, particularly those on the stock market, will bail us out.
“Safe” Retirement Investing Can Be a Nightmare
Even those who save what should be enough for retirement and invest “safely” can end up in dire straits.
Take Joe, a hypothetical retiree who was age 70 back in 2008. At the beginning of 2008, Joe, acting on the advice of his hypothetical financial planner, Ralph, invested half of his retirement assets in the S&P. The rest he invested in bonds. Ralph’s pitch was the industry’s standard alternative “fact”: Stocks are safe in the long run. Ralph added, But to play it super safe, let’s put you in a 50-50, stocks-bonds portfolio.
A year and a bit later, after the stock market crashed 53 percent, Joe pulled out vowing never to return to that highly lucrative, but extremely dangerous casino. He reinvested, again on Ralph’s advice, 50-50. But this time, Ralph kept Joe super safe. He sold Joe a single-life annuity from a top insurance company and put the other half of Joe’s money in long-term Treasuries. Joe, now 85, is in robust health despite his financial nightmares. Why can’t Joe sleep? His portfolio has again been taken to the cleaners — this time by inflation.
Since 2020, prices have risen by 18.6 percent, reducing Joe’s spending power from his two “safe” nominal income streams by, well, 18.6 percent. Together, Ralph’s two “safe” investment plans have wiped out over a third of Joe’s retirement resources. Worse, Joe is terrified his nominal annuity, in which he’s stuck, will suffer even more real losses from inflation. He should be scared. Based on the latest monthly CPI data, annual inflation could well exceed 5 percent over the next 12 months. At a 5 percent annual inflation rate, Joe’s annuity will lose 40 percent of its remaining purchasing power over the next decade.
Recognizing this risk and kicking himself yet again for “his” investment mistakes, Joe’s just sold his Treasuries at their market values, i.e., at a huge loss (indeed, far more than 18.6 percent since the market anticipates future inflation), and reinvested in the stock market. In so doing, Joe may be setting himself for yet another major loss. The S&P’s price-earnings ratio has averaged 16 since the 1870s. It’s currently at 25.
Retirement Need Not Be a Financial Cliff Hanger
Back in 2008, Joe could have purchased Treasury Inflation Protected Securities or TIPS. TIPS are like standard Treasury bonds, but their principal is adjusted every six months for the prior six month’s inflation. Consequently, your coupon equals the bond’s original interest rate times the higher principal. Hence, the entire stream of nominal payments from TIPS — coupon payments and the final principal payment — are fully inflation adjusted.
That sounds and is really good. But there is an important caveat. Like all bonds, nominal, not real income earned on TIPS is subject to taxation. Hence, the inflation-related bump ups to principal are taxed, indeed they are taxed immediately, even though you may not cash out your TIPS for decades. There is one saving grace. If you hold TIPS inside an IRA, 401(k), or similar tax-deferred retirement account, the taxes due on the inflation protection are only levied at the time you make withdrawals.
Unfortunately, Ralph never suggested TIPS to Joe. No surprise. Many, if not most advisers seem unaware of TIPS. There’s also no managing involved in putting your client in TIPS. And if you can’t claim that you’re managing someone’s assets, you can’t charge a fee.
As for the general public, mention TIPS and you’ll get a blank stare. Moreover, the Treasury has done little to explain this complicated, but safe-against-inflation, if not taxes on inflation, saving vehicle. Moreover, buying a ladder of TIPS, i.e., TIPS of different maturities, to match the real retirement-asset drawdowns needed to maintain a stable living standard is challenging.
RSBs to the Rescue
Joe and everyone else needs a safe way to invest for retirement. Joe and everyone else needs to establish a living standard floor in retirement. Joe and everyone else needs to be able to compare their current living standard to their retirement living standard floor. If the former is far higher than the later, they need to save more, spend less, and invest to raise their retirement living standard floor. This is what economists call consumption smoothing. It’s the bedrock of economics-based financial planning.
RSBs would let Joe accomplish all these goals. To repeat, RSBs would be a new form of U.S. Treasury bonds. Unlike standard nominal Treasury bonds as well as TIPS, RSBs would pay only a coupon, i.e., a steady stream of real income with no terminal principal payment. All RSBs would have a 20-year maturity. And their coupon payments would be indexed to per capita U.S. consumption.
Indexing to per capita consumption insures purchasers of RSBs against inflation, since per capita consumption rises with the general price level. But it also guarantees RSB owners that their RSB payouts will keep even with the economy’s overall living standard.
Do RSBs Represent a Risk to the Government’s Finances?
Whatever the cause of inflation, including the Uncle Sam’s making money the old fashioned way — by printing it, inflation provides additional federal revenues. There are two main channels. First, inflation waters down Uncle Sam’s nominal obligations. Second, federal taxes aren’t fully indexed for inflation. Indeed, in the case of asset income, there is no indexation. But when prices rise, per capita consumption as well as RSB payouts rise as well. So, Uncle Sam is hedged. He receives additional revenues to cover his higher RSB payments.
Holding inflation fixed, higher economic growth also spells higher per capita consumption and, thus, higher RSB payments. But higher growth means a larger tax base and more tax revenue. So, again, the government’s RSB payment obligation is hedged.
RSB Mechanics
The U.S. Treasury would sell RSBs at auction. Each RSB would pay off a “$100” coupon per year over the term of the RSB. The RSB’s term would be 20 years from the RSB’s start date. The annual coupon payment would be paid in 12 monthly installments. The initial “$100” coupon would equal $100 accumulated at the growth rate of per capital GDP through the RSB start date. Each subsequent annual coupon would be adjusted for that year’s growth in per capita GDP.
How Hypothetical Sally Would Protect Her Living Standard Via RSBs
Consider Sally, now age 58, who plans to retire at 65. Sally could purchase 2030 RSBs as well as 2045 RSBs. This would provide her indexed income between 2030 and 2050 as well as between 2045 and 2065, i.e., between age 65 and age 100. If Sally learns at, say, 79 that she has terminal cancer, she can sell her RSBs back to the Treasury or to private buyers at the prevailing market price. Alternatively, she can bequeath her RSBs to her heirs.
Duration, Indexation, and Taxation of RSBs
While I’ve taken Brazil’s example of issuing only 20-year RSBs, the Treasury could also issue shorter as well as longer duration RSBs. In addition, it could auction RSBs with the same future start date at any time prior to the start date. I should also mention that Brazil’s RendA+ RSB is indexed to inflation, not per capita consumption. The U.S. Treasury could choose that alternative as well. It could also offer two types of RSBs — one indexed to inflation and one indexed to per capita consumption. And, importantly, it could tax just the real component of RSB’s annual coupon payments. This is particularly important for workers without access to retirement accounts. Such workers aren’t able to defer the taxation of phantom (inflation-based) taxation.
Conclusion
Americans aren’t saving nearly enough for retirement notwithstanding being bribed handsomely with tax breaks to do so. RSBs can turn this situation around by showing workers what they do and don’t have for sure awaiting them in retirement. The conversation around the water fountain will switch from:
I’m sick of work, but terrified about retiring.
to
I have all my RSBs lined up and can retire as planned without a gnawing fear in my stomach that my investments will go south and I’ll end up eating catfood.
Plus, I’m practicing Upside Investing — investing some funds in the stock market. I’m treating my risky investments as lost until they’re found. Once I reach age 65, I’ll gradually sell off what’s there and use the proceeds to buy more RSBs.
This Upside Investing strategy produces only upside living standard risk. You should try it. Buy RSBs to create a retirement living standard floor — one that’s close to your current living standard. Invest what’s left in an S&P index. Yes, this may entail cutting your current spending. If so, you’ll realize you’ve been saving too little. Hence, RSBs will force you to do the lifetime budgeting that you, like me, have been avoiding for far too long.
Trust me. Following this advice will let you sleep at night.
My bottom line. The U.S. Treasury should issue Retirement Security Bonds and the sooner the better.
Economic Matters - The podcast is hosted by Laurence Kotlikoff and moderated by Alex Kotlikoff.
Laurence Kotlikoff is a Boston University Economist, a NY Times Best Selling Author, President of maxifi.com, and Author of Money Magic.
https://larrykotlikoff.substack.com/p/rsbs-can-rescue-our-retirements
