Survey results are in. Americans suffer serious anxiety over uncertainties presented by the prospect of retirement, and their anxiety worsens. The uncertainties keep some of us up at night. When and how we act matters.
Some people act like the old hound dog. The old hound dog story goes like this: Every day the old hound dog lays on the front porch. Whenever the neighbor walked by, he heard the dog moaning and whining. One day, the neighbor asked the dog owner why the dog was always moaning and whining. “He’s lying on a nail,” replied the owner. “Why doesn’t he get up off it?” asked the neighbor. The owner answered, “I guess it doesn’t hurt enough yet.”
A little of the old hound dog is in all of us. Getting up off the nail means addressing the nagging need to prepare for retirement. At Financial Fortitude, we know people facing the prospect of retirement can act by educating themselves. They can use new ways to invest for unexpected and known risks. They can recognize how much things have changed over the years. For example, we’ve all heard the rule of thumb saying we should keep 6 – 12 months of income in emergency cash. However, liquidity can be expensive because savers bypass investments with potentially higher returns.
The graph titled “Real Interest Rates” speaks to the circumstances savers face.[i]You could re-name the graph “The Saver’s Misery Index” because it explains why trends in interest rates and inflation have discouraged people from accumulating emergency cash. The trend has led them to assume too much risk. The blue curve is the monthly 3-month Treasury Bill rate minus the monthly inflation rate.[ii]The 3-month Treasury Bill rate is an index of short-term interest rates; it estimates the rate savers can earn. If the interest rate exceeds inflation, the blue line remains above zero and savers preserve or grow real value with their cash. However, if inflation exceeds the interest rate and the blue line falls below zero, then real value diminishes.
For most of the first 20 years recorded in the graph, the blue line remained above zero; savers could use no-risk cash accounts and still earn a small positive return. However, since 2002, inflation usually exceeded interest rates. Even though account statements showed small increases in value from interest payments, real value declined. Many investors decided it was better to earn a positive real return than let inflation erode their savings, so they moved emergency cash to investments with potential for higher returns than cash. However, higher returns are not free. They impose risk.
If risky investment values tank, would savers have been better off keeping their money in sub-inflation interest rate accounts? Maybe. Liquidity is valuable. It also comes with an opportunity cost that can be hard to resist. In our opinion, 6, 12, maybe 24 months or more of savings still make sense. A solid cash account, even if inflation slowly erodes its value, can help reduce retirement anxiety.
Perhaps the greatest anxiety among prospective retirees comes from the risk of running out of money. For 20 years or so, the rule of thumb to avoid running out of money suggested retirees annually withdraw up to 4% of the value of their investments.[iii]The rule is as good as any, but rules of thumb are meant to reduce uncertainty for the masses, not for individuals. Here are a few other rules of thumb some people erroneously think apply to their individual circumstances:
- 100 minus a person’s age reveals the allocation investors should make to stocks.
- Save 10% of pre-tax income.
- The 10, 5, 3 rule says you can expect an average return of 10% on stocks, 5% on bonds, and 3% on cash accounts.
Some people think these rules of thumb are true. This mentality can get people into trouble. It’s not what you don’t know that gets you in trouble. Rather, it’s what you thinkis true but is wrongthat gets you in trouble!
[i]Links for data used to construct “Real Interest Rates”: https://fred.stlouisfed.org/series/TB3MSand https://beta.bls.gov/dataViewer/view/timeseries/CUUR0000SA0.
[ii]More precisely, the real interest rate in this graph equals the rolling 12-month average monthly interest rate on the 3-month Treasury Bill minus the rolling 12-month average inflation rate for the same months. The inflation index uses the “CPI-All Urban Consumers” series.
[iii]Here is the oft-quoted original reference for the 4% rule: Bengen, W.P. (1994). Determining withdrawal rates using historical data. Journal of Financial Planning, 7(4), 171-180.