Your Risk-Free Investments And Annuities Are Not As Risk-Free As You Think
Most investors know that investing in stocks is riskier than investing in bonds. And those who are exceptionally risk-averse tend to keep their money in CDs or money market funds. For safety in retirement, especially in the wake of the 2008 recession, more and more retirees have additionally been putting their money into annuities, which guarantee a certain payout for the remainder of their lives.
When asked about the risk of these various investment choices, most people express it in terms of losing money. With that perspective, they believe that CDs, money market funds, annuities, and even mutual funds that invest in US treasury bonds are all risk free. The problem is that investment risk should not simply be measured in terms of losing money, but additionally – and perhaps more importantly – in terms of how close the actual return is to the expected return. Let’s analyze a couple of these various investments in this context to better understand what the risks really are.
First, let’s take money market funds. Except under very rare circumstances, you are unlikely to lose any money investing in them. Suppose in 2006 you invest $100,000 in a money market fund paying 5%, for the purpose of saving to buy a $20,000 Mini Cooper. You don’t want to touch the principal because you are saving it for your retirement. If interest rates remain constant, you’d expect to get $5,000 each year, making it possible to buy that car in 2010, four years later. However, interest rates actually declined during that period, significantly reducing the returns you got from your investment. By early 2010 the return on money invested in money market funds had plunged to nearly 0%. So forget that Mini Cooper you had been planning on; at that point you would have saved up only enough for a used Civic. You didn’t lose any money with your investment, but at the same time the investment failed to provide the return you needed to fund your goal.
What about US treasuries? By all measures they are the most risk-free investment on the planet. The only way you could lose money or even get less than the promised return would be if the US government defaulted on its obligations. While that has happened in the long-ago past, it’s a very unlikely scenario (at least let’s hope so) for the present.
BUT – buying a US treasury bond is not the same thing as buying a US treasury bond mutual fund. If you buy the bond directly and hold it until maturity, you will get the return you expect. But the net asset value (NAV) or price of a fund investing in treasuries varies based on the aggregate price of the bonds the fund is holding at any given time. If after you invest in such a fund, interest rates were to rise, or demand for treasuries were to decrease, the current price of all the bonds held by the fund would drop, thereby reducing the fund’s NAV. Take the T. Rowe Price US Treasury Long-Term bond fund, for example. Panicked investors rushed to buy treasuries in 2008 when the economy and stock markets collapsed, pushing the price of those bonds to record levels. The fund returned over 23% that year. In 2009 demand for treasuries began to drop as those investors became more comfortable selling their treasuries and investing in riskier assets providing higher returns. The result was a loss of almost 11%. That’s quite a variation in returns in such a short period of time. You not only would have gotten less than the return you expected in 2009, you would actually have lost money. So much for a risk-free investment.
The risk with annuities has two components. First, there’s the risk that you don’t receive the expected payments. That’s because the guarantee is from the insurance company, not the government. If your insurance company were to go bankrupt, and no other company willing to absorb its assets could be found, the annuity would be protected by your state’s Life & Health Insurance Guarantee Association. But only up to certain limits. In California annuities are protected up to 80% of the present value of the remaining payments, not to exceed $100K. That amount is likely to be significantly lower than what you had originally planned on.
Second, if you purchased the annuity to provide a certain level of income during retirement, inflation would put you at risk of achieving that goal, even if the insurance company remained viable. If the inflation rate averaged just 4% per year starting when you bought the annuity at age 65, by age 83 your annual or monthly payment would enable you to buy only half the things you had originally expected the annuity to provide. Again, the risk has to do not so much with money, but rather with the achievement of a goal for which the annuity was purchased.
CDs have elements of some of the above risks. If the bank fails, your principal is insured, but you’ll lose any accumulated interest. If you’re saving for something over a period of years, inflation could leave you holding a lot less than you had originally expected to need.
This is not to suggest that one should not invest in any of these alternatives. All the above investments, as well as stocks, bonds, and commodities, represent viable alternatives for portfolio growth. But it is important that you understand the actual risk that you are taking with each and every investment you make. We quantify risk as the standard deviation (think variability) of returns over time, and you can find 3-year standard deviation data for most publicly traded investments on Morningstar.com. Remember that risk and return are highly correlated – the higher the return, the higher the risk. Understanding all the elements of that risk will definitely help you make better investment choices.