Pension Geeks keep it flexible
Welcome to Known Unknowns, a newsletter that is all about flexibility these days, even when it gets expensive. A special welcome this week to all the new subscribers from the Compound, which I went on last week with Sam Ro and had a great time (as always)!
Some of you wrote me to ask how the world can be both less risky and more uncertain? I explored this question in last week’s Bloomberg column. I think of risk as the things we can measure, a probability distribution of probable outcomes. Risk can also be managed so that we can reduce downside risk. And in many ways, the world is less risky. We have gotten particularly good at dealing with the risks we can anticipate and, with so much data, are much better at measuring risk. We have more options for insurance or just avoiding risk entirely. Even when the pandemic hit, we were able to manage it—somewhat. We could pay people to stay at home, the Fed bought lots and lots of bonds to keep that market liquid, and we developed a vaccine in record time.
Uncertainty is all the things you can’t anticipate or measure. Right now, there is plenty of uncertainty, geo-political events, another COVID variant, to name a few. I have no idea what the world will look like in 3 months, let alone a year from now.
The distinction is important because risk and uncertainty demand different strategies. You can reduce risk by hedging or buying insurance. But the only way to deal with uncertainty is flexibility; in markets, that means liquidity and often holding cash. Though with high inflation, cash is no longer a low-risk strategy. So, we must accept more risk in addition to the uncertainty we face. Nevertheless, I still suggest looking for flexibility where you can, if you buy a house, buy one you can resell even in a down market, pay the premium for more liquid assets, and avoid excessive debt if you can. It seems things will be uncertain for a long time, but the good news is we have more tools to deal with the risk that creates.
I also explain how to manage retirement in an uncertain environment. Many people retired early in the last two years because work was not so great and felt like a health risk. The stock market also went way up, making retirement feel more achievable.
Then the market fell, inflation soared, and retirement plans may need to be revisited because of this uncertainty. However, I have another solution built for these uncertain times. Retirement income comes from three sources: Social Security, your assets, and human capital. Assets get all the attention, but the other two are equally, if not more important.
Assets are down and uncertain, and standard advice (say the 4% rule) says that means you should spend less. I think that’s unrealistic when prices are up and many retirees have barely been out the last 2 years, and the world is finally re-opening. That’s why the standard advice isn’t very good. Retirees need to explore the two other sources of income more thoroughly.
One maximizes Social Security by delaying (or pausing) it as long as possible. This is guaranteed and inflation-indexed; you’ll get no better deal in this market. But what if you need that money now? I suggest thinking about human capital or labor income. This does not necessarily mean un-retiring, which sounds grim. I mean thinking about a more flexible approach to work. Consider taking on the odd project or doing a little gig work throughout retirement. The good news is that the labor market is changing to accommodate the semi-retired, especially with the pandemic. Retirees can even try to structure their work to do more of the fun, enjoyable parts and less of the drudgery.
The work/retire binary never made much sense to me. Keeping a toe in the labor market is good financially and for mental and physical health. It is a valuable option and opens up the flexibility we need in these uncertain times.
Meanwhile, there is one big risk we have tools to manage, but so far are not—inflation. The Fed is in a bind. It wants to raise rates, reduce its balance sheet, and not harm the labor market. It thinks it can do this by raising rates to a neutral level, or to 2 or 3%, the point where Fed policy is neither expansionary nor contractionary—just neutral. The Fed is banking on the idea that if all the inflation pressure, supply chain issues, energy markets, and easy money will go away, inflation will too. This is in spite of the fact that wages are going up and expectations are starting to get unmoored. The Fed can hope it can tame inflation without harming any part of the economy. One economist calls this strategy “immaculate dis-inflation,” an expression I desperately hope will catch on.
However, this strategy seems stunningly ignorant of everything we’ve learned about monetary policy over the last several decades. But what can the Fed do? Raising rates will be hard to pull off. Real rates have been zero or negative almost consistently for decades. Markets are built for a zero-rate world, and raising rates poses many technical challenges. It does not help that no one on the Fed Board has much of a background in finance, let alone fixed income markets. I am more worried about financial stability than a recession now. Though I think we risk stagflation from policy errors.
But who knows? I don’t think many people realize there is often more art than science to monetary policy. We don’t know what the natural rate is that will bring us to neutral. I used to be 4 or 5%, now we think it 2%. Maybe it is higher now but lower than it used to be, so we don’t actually know where neutral is exactly. We really don’t understand the mechanisms of how low rates feed through the economy and impact inflation and unemployment. We don’t really know much about how expectations are formed or even have a reliable measure of them. This is especially true now that monetary policy acts through new channels, in the repo market and paying interest on reserves. Based on market commentary, you’d think the Fed can adjust rates to achieve a certain price level or unemployment rate, but this is not true. It is more uncertain than people realize.
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Until next time, Pension Geeks!