Like It or Not, This Is Your Best Shot at Retirement

Here's what a friend wrote to me on Jan. 1, 2013:

I am trying to get a little more serious about saving for retirement. I have noticed that my IRA is currently [expletive deleted], returning 6% across the last eight years.

For context, the S&P 500 returned 39% in that time frame.

Following that moment of clarity, he took a two-pronged approach to his retirement savings. He put some of it in Vanguard target-date funds, which automatically allocate your money to broad stock and bond market index funds in appropriate percentages as you age -- this was my recommendation based on his experience and personality. He then invested some of his retirement savings in individual stocks -- his idea.

To his credit, almost a year and a half later, this New Year's resolution seems to have stuck. He's done well on his Vanguard funds and OK (but less well) on his individual stock picks.

But now he's scared of the stock market.

You see, whether you're in individual stocks or index funds, you're heavily reliant on the stock market. If the stock market drops dramatically, so does your retirement nest egg.

Perhaps worse for us humans, stocks seem specially designed to freak us out:

• When the stock market's up: We worry the good times have continued too long (that's why my friend is currently worried).
• When the stock market's down: We get scared the spiral will continue (recall how you felt in late 2008 and early 2009).
• When the stock market's flat: We get scared we're missing out on more immediate gains elsewhere.

It's scary, and the stock market isn't perfect, but when I look at the passive options available, I'm convinced it's my friend's best shot at retirement -- and mine, too. When I say "passive options," I mean the kind of investments that don't require you to start your own business or flip a house. These passive options are the ones that allow us to concentrate on our day jobs and simply sock our earnings away.

Let's review the options and do this process-of-elimination style.

The do-nothing approach
This is also known as stuffing cash under your mattress -- or, in more modern times, putting your cash in a checking account.

For security, it's hard to argue with this strategy. A million dollars put into a checking account today can be redeemed for that same million dollars one, five, 10, 30, even 100 years later.

That said, any grumpy old man can tell you the problem with this approach. Back in his day, a dozen eggs cost a quarter. And most folks reading this article can remember when gas was around a dollar a gallon. We don't need much of a history lesson to know that prices tend to go up. We've been lucky in the U.S. in our lifetimes: We've had some ups and downs, but in the last century, we've seen a compounded annual rate of inflation of around 3%.

The result is that even $1 million loses its buying power if inflation is given enough time. Let's put it in concrete terms. The average price of a new car is just over $32,000, so a million dollars buys you 31 of them today. Look what happens over time:

Imagine if we used a rate that was higher than 3%. At 6% inflation, you'd be down to five cars in 30 years, and you couldn't even buy a car with $1 million in 60 years!

Thirty years and 60 years may seem like long time periods, but I chose them for a reason. It's reasonable to assume that someone in their mid-20s will live another 60 years to reach their mid-80s. And a 65-year-old today could conceivably live another 30 years to 95.

For those of us without massive inheritances or lottery winnings, a checking account ain't gonna get us to retirement. In fact, too much in a no- or low-interest checking account gets us further away from retirement.

The tread-water approach 
Taking a step up from straight cash in a checking account, there are options that pay you interest. These options tend to rise and fall with the general level of inflation. The inflation rate over the last 12 months was 2%. Let's see how our basic options compare to that:

*Note: For the savings account and 5-year CD options, you tend to do a bit better using online banking options and a bit worse using traditional banks.

A savings account gives us incrementally more interest than a checking account but loses out to inflation (the same could be said of a money market deposit account). To roughly match inflation, we'd have to shop carefully and lock in our money for five years with a certificate of deposit -- the typical 5-year CD currently loses handily to inflation, but some online banks offer rates slightly north of the 2% inflation rate.

Keeping up with inflation doesn't sound awful; you basically keep what you can save. But one quick bit of math taught me that keeping up with inflation isn't good enough.

Let's say you are a good saver and started early in your 20s. Your goal is to retire 40 years later in your 60s with at least $1 million. You'd have to save $25,000 per year, every year, after taxes.

You see the problem here. Most folks don't start seriously saving in their 20s -- and certainly not at a rate of $25,000 a year. Sure, salaries tend to rise with experience, but no matter how many years you're looking at, it's tough to save $1 million without investing help (and only harder if your "retirement number" is even greater than $1 million):

The tread-water approach -- with more risk
Now, up above, you may have noticed that longer-term Treasury bonds give us a little more yield -- but not that much more. A 30-year Treasury bond currently beats inflation by 1.3%.

And for that slight inflation beat, we're taking on more risk than most people realize. We think of U.S. government bonds as safe. In one respect, they are: When you can print your own money, you pretty much can't default unless you want to.

Just because there's little default risk doesn't mean there's no risk, though. For example, when you lock in a 30-year Treasury bond today at 3.3%, you're toast if interest rates (and inflation) skyrocket from these historically low levels. At that point, you either lose your buying power over the remainder of the bond, or you sell at a big loss in one lump sum (the market's smart enough to do the math and crush the price of the bond).

I've kept this vanilla with Treasury bonds, but there are other options such as corporate bonds and municipal bonds. Each offers a little bit extra yield but also introduces risks. Corporate bonds expose you to the same companies the stock market does. For your defined return, you miss out on much of the upside if the company does really well; however, you're more protected if the company fails (you are ahead of stockholders for the scraps in a bankruptcy scenario). Currently, a AAA-rated corporate bond gets you somewhere around an extra half-percent in yield versus a Treasury.

Municipal bonds, or "munis," are the bonds of state and local governments. Currently, a AAA-rated municipal bond gets you about what a Treasury would in yield, but with some potential tax advantages. While the federal government is extremely unlikely to default, a local government just may.

For even more yield, you can take on even more risk. Instead of Treasuries, you can buy the bonds of foreign governments. You can go the junk bond route with corporate debt. And you can go with sub-AAA-rated municipal bonds.

So, some combination of savings accounts, CDs, and the various types of bonds can deal with inflation. They can even help us beat inflation slightly if we take on more risk, but those returns must be tempered with the possibility of default or rising interest rates and inflation. Either way, they only bring us marginally closer to retirement.

Which brings some people to...

The gold-cures-all approach
I'm grimacing at the thought of writing about gold. Folks who love gold really love gold -- as you may see in the comments section of this article soon.

Many love gold because they see it as a store of value if we have massive inflation. I'm not entirely convinced that's true, but I'll table that discussion for another day. Instead, let's stick to the historical facts.

Wharton professor Jeremy Siegel made the definitive calculation. He looked at how much $1 invested in gold back in 1802 would be worth after inflation. The answer: $1.24. He made that calculation for prices in 1991. If you bring that forward to today (tacking on an extra two decades), you still wouldn't have $5. That means the historical real return for gold is less than 1% a year.

That won't get you in a hammock by the beach.

The exotic approach
We all want to feel smarter than the next guy -- perhaps especially in the world of finance. And unfortunately for us, Wall Street is constantly coming up with new ways to help us play armchair Goldman Sachs. For any problem (real or imagined), Wall Street has a product with a hidden fee and likely dubious returns.

Just know this: If the meat and potatoes of stocks and bonds won't solve your problem, it's highly unlikely that feces-infused arugula will.

Rather than list a litany of Wall Street's bad products, I'll share a real-life example. A friend came to me with a product that she didn't quite understand (red flag No. 1) but that sounded downright amazing (red flag No. 2).

It was a CD that was "market linked" to a commodity index. Her financial advisor explained to her that as with a CD, she couldn't lose money on it. Yet she would get to participate in the upside of the exciting commodities market. How could you go wrong in a "heads you break even, tails you win" scenario?

Well, after I dug in, I found out. This was a few years back, so I'll try to reconstruct the details as best as I can.

This commodity-linked CD had a term of six years. The interest rate you'd receive at the end of the period would depend on the performance of a basket of commodities (think oil, gold, soybeans, corn, live cattle, lean hogs, aluminum, etc.). If commodities dropped in those six years, you wouldn't be on the hook for the loss; you'd simply receive your principal back with zero interest. If commodities rose, you got to participate, but your gains were capped at 8.7% a year.

That doesn't sound so bad -- until you get to the fees.

Her broker would take a chunk, and so would the originating bank that conceived this unnatural beast of an instrument. I wish I had the exact fee amount handy -- as you can imagine, the broker didn't spell it out in a neat calculation. But I remember estimating it, and it was darn expensive. Let's say 5% a year.

So, after fees, that "you can't lose money" promise becomes an outright lie. If commodities went down, you were locking in losses of 5% per year. If commodities went up, the most you'd get was 3.7% a year.

For comparison, back then you could get an FDIC-guaranteed 2% on a plain old, totally safe five-year CD -- no matter what happened with the price of lean hogs.

The bottom line on exotic stuff is all the cliches you've ever heard: There's no such thing as a free lunch; if it sounds too good to be true, it probably is; if you don't understand it, don't buy it until you do; and so on.

This finally brings us to...

The stock-based approach
The case for stocks is pretty darn easy to make, based on past returns.

The U.S. stock market has had an annualized return of around 9% before inflation and 6% after inflation going back to 1871 or 1928 -- or pretty much whenever you want to start your reminiscing.

Let's take a quick look at how that stacks up against your other options in 30 years' time:

• If you did nothing, a 3% inflation rate would take your dollar and reduce it to $0.41.
• If you treaded water with some combination of checking accounts, savings accounts, CDs, and short-term Treasuries, your dollar would still be roughly a dollar. I didn't include gold, but in the past gold has roughly broken even. As for the exotic instruments that financial professionals peddle, you'd be lucky if they matched the "do nothing" option.
• Bonds would get you almost $3 for your $1. Ibbotson Associates has the 20-year Treasury note historically returning 2.4% after inflation. To make a fair comparison, I juiced that up to 3.5%, assuming some higher-yielding non-Treasury bonds were thrown into the mix.
• Stocks would double bonds' performance and turn your $1 into almost $6.

The stock domination is even greater if you extend the time period to 60 years:

So, that $1 turns into just $0.17 if you do nothing, but almost $33 if you buy stocks.

To revisit the car example we used before, recall that a million dollars today could buy 31 cars. If you did nothing, after 60 years that would be about five cars. If that money were in stocks, you could buy over 1,000 new cars!

OK, I think you get the idea. Historically, U.S. stocks have done very, very well. But maybe you're like Mark McGwire, and you're not here to talk about the past. After all, no one can predict the future, so why should we expect that stocks will beat all these other instruments as they have in the past?

Here's the argument that convinces me.

Take a second and think of the most capable, driven person you can think of. Wouldn't you love to profit off of their work?

How about Howard Schultz's work? Or Warren Buffett's? Or Jeff Bezos'? Or Mark Zuckerberg's?

That's what buying stock in a company is. While you're at home barbecuing with your family and friends, these obsessive geniuses are focused on making their businesses bigger, faster, and stronger. Buying stock in their companies allows you to go about your day and benefit.

So, if you buy a broad basket of American stocks, you're basically buying a stake in American ingenuity. Buying the S&P 500 gives you exposure to the success of Schultz, Buffett, Bezos, and Zuckerberg -- along with the legacies of Steve Jobs, Sam Walton, and Henry Ford. That's referencing just seven of the 500 companies.

And if you expand to a broad basket of stocks from around the world, you're buying a stake in humanity's progress.

Is that really true? Well, yeah, it is. The primary reason the value of stocks has beaten inflation over time is that we've grown more productive as a society. Humanity has progressed from a one-job society in which we spent each day fighting for survival to being prosperous enough to support the job title of "life coach."

The innovators are making money off of all this progress. Cash ignores this progress. Bonds let you lend money to these folks. Stocks let you profit right alongside them.

The ideal mix of stocks, bonds, and cash in the core of your portfolio will depend on your life situation and your emotional characteristics. That said, if you plan on being around for more than, say, five years, stocks should be part of your portfolio -- and probably a bigger part than you think. Otherwise, you're basically betting against humanity.

Good luck collecting on that bet if you're right.

As for me (and hopefully my friend), I plan to continue regularly adding to my stock market holdings over time and remain heavily invested in the stock market through good times and bad. It's my best bet against inflation, no matter when I decide to retire.