Every financial tool protects you from one risk while exposing you to another. Good planning comes from combining your tradeoffs wisely.
“Those who would give up essential Liberty, to purchase a little temporary Safety, deserve neither Liberty nor Safety,” Benjamin Franklin wrote in 1755.
Benjamin Franklin was writing about liberty—not investing—when he warned against surrendering essential liberty for temporary safety. Still, his words often come to mind in my work. Investors who trade all growth for safety may ultimately wind up with neither
That’s not quite right, either. The better statement is simpler. There is no such thing as universal safety.
Safe from What?
Plenty of things are safe—from a particular risk. Certificate of Deposits (CD), for example, protects you from the drastic price declines that accompany stock investing. Within federal insurance limits, they also protect your principal.
But that safety comes at a price. Money locked in a CD remains exposed to inflation, which can quietly erode purchasing power. Protect yourself from one risk and you often become more exposed to another.
So let me restate my assertion. There is no such thing as universal safety. Or, borrowing from economist Thomas Sowell, there are no solutions. There are only tradeoffs.
Her Principal Was Safe. Her Lifestyle Was Not
I hammered this point home in my opening chapter of It’s All About the Income. Maria wanted to be safe with her investments, to take no risk. She used banks. Her principal remained safe, of course, insured by the U.S. government, as she carefully had it divided into sufficient accounts to keep each one within Federal Deposit Insurance Corporation (FDIC) limits and conform to its rules.
But she lived on the income, which relied on interest rates. When these collapsed by 90 percent, how safe was her portfolio?
Maria’s IRA remained intact at $500,000. You could call it safe. Yet the income catastrophically collapsed from $24,000 a year to $2,000.
Her principal was safe. Her lifestyle was not.
I pointed out the paradox that we all live on income, but we tend to define safety in terms of the value of principal. If we could focus on the safety of income, then we could make some progress.
The solution for Maria, looking at it from the income angle, may have been an income annuity. Give up access to the principal in exchange for a guaranteed rate of income for life. The income would be safe.
What could go wrong? A few things. Inflation could erode purchasing power, thereby reducing the real value of the lifetime income. I wrote about this in The Great Pension Heist. Another could be the risk she’d be placing in the company issuing her annuity. The payments guaranteed by the insurance company are only as strong as the company’s ability to honor its promises.
Build Safety in Layers
The answer to Maria’s dilemma is not one perfectly safe investment. It is several imperfect tools, each assigned a specific job.
Keep a portion of your money in CDs and cash, perhaps three to five years of planned withdrawals. Use Social Security and, where appropriate, an income annuity to provide dependable lifetime income. Then use a diversified portfolio of stocks and bonds to provide the long-term growth needed to combat inflation.
Each tool has a job. Each addresses one risk while introducing another. Together they can create something none can provide alone: a resilient plan.
Every Get Has a Give
It’s not just in investment management that we must rely on layered approaches, in which specific tools are tasked with specialized jobs that seem to offset each other. We spend a great deal of time and effort on tax allocation, as I explain in “How Tax Allocation Can Help You Keep More of What You Earn.”
Our choices for accumulating, growing, and distributing assets include accounts in which we pay taxes on income and gains as they are realized, accounts in which we defer taxes on income from today to the future, accounts in which we pay taxes now for a promise to pay never again in the future, and even accounts that will potentially never be taxed.
Here, as with investments, there are no solutions, just tradeoffs, balancing taxes today and in the future. Every “get” involves a “give.”
Consider that the best account for taxes—the triple tax-free Health Savings Account—has two large drawbacks. First, it’s only triple tax-free if used for health care (and it can’t be used for most insurance premiums). Second, when you die, it becomes immediately taxable as income if it goes to anyone but a legal spouse.
So it’s fantastic to live with—provided you have some ailments. It’s not so good to pass along.
The Roth Conversion Tradeoff
Roth conversions are a hot topic, and one that we address in great detail for our clients. Everyone wants tax-free income when it’s time to withdraw the money. These same folks, however, also value the tax break when they put the money in. They can’t have both. Which is better?
As in much of financial planning, the answer is: it depends.
Specifically, it depends on the taxes you’ll pay when you earn the income versus when you take it out. The goal is to pay the tax when your marginal tax rate is lowest. There are only two ways to avoid them—don’t earn any money to put in. No income, no income taxes. Die without taking the money. You don’t pay the tax—but someone else will, unless you leave it to a charity.
Sometime Yes. Sometimes No.
I made the acquaintance of a developer in Charlotte, NC in my younger days. His community was embroiled in a political fight over a new tax to fund a local project. I asked whether he was for it or against it. “I have friends who are for it,” he replied in his Southern drawl. “I have friends who are against it. And I always stick with my friends.”
This is how I feel about Roth conversions. For some of my friends, it makes sense, as I show in this video. I’m with them.
For others, it’s a bad deal, as I show here. I’m with them as well.
The facts on the ground matter.
Give Every Tool a Job
We’ve long used a grid in our practice to analyze and deploy tools with an eye to the tradeoffs. I explain it in “Financial Planning Tools Explained: Choosing the Right Strategy for Your Goals.”
What I like most about this grid is the concept of off-label uses, which I borrow from the pharmaceutical industry. This is where we can really add value.
As I explain, your cash reserve at some point in your life may be in an IRA or a cash value life insurance policy, depending on your overall picture. This may in fact beat the bank.
A Roth IRA was created to be a retirement account. But given the rules under which it operates, you may decide to use it for college education or a legacy asset for your loved ones. The job of life insurance is usually to provide a large sum of money for loved ones and dependents if a person dies unexpectedly early. Yet some types of policies properly structured and maintained can also provide for tax-free access to cash for retirement income or capital for substantial purchases.
Each of these could be considered an off-label use.
Get What You Need
We can’t achieve perfect safety in the end. We can, however, use the techniques and tools of the financial planning trade to reduce the risks of poor investment outcomes, pay the most taxes at the lowest rates, and provide money when personal or financial trouble strikes.
Cash provides stability. Guaranteed income pays essential expenses. Investments provide growth. Differently taxed accounts provide flexibility. Insurance transfers risk that would be difficult—or impossible—to absorb personally.
Each tool has a job. Each comes with a tradeoff.
Put them together properly and, to paraphrase the Stones, you may not get everything you want. But you improve your odds of having what you need—when you need it.