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The Fed is printing vast sums of money to lend to borrowers who may not be able to repay. This may lead to very high inflation, which would wipe out the real values of retirees’ fixed nominal pension or annuity payments. Taking out a larger mortgage can hedge this risk since inflation will water down the real value of required mortgage payments. What’s lost from the left pocket can be gained by the right.
The Fed has printed almost $1.5 trillion dollars in the past year to prop up businesses in our depressed economy. The Fed calls this asset purchases, not money creation, because it’s buying IOUs in exchange for the green backs it prints (actually, electronically creates). The Fed says that all that extra money it has printed — 27 percent of the traditional M1 measure of the money supply — will be returned to the Fed when the borrowers make repayment, leaving M1 where it was before COVID struck.
But if the borrowers, primarily banks, large companies, and the US Treasury (to whom it lends indirectly), can’t repay, the extra money will be a permanent 27 percent addition to the nation’s money supply. A ton more money chasing the same amounts, actually declining, thanks to the COVID Depression, amounts, of goods spells higher prices. So the Fed’s well-intended intervention can leave us with 1970s-type stagflation — low economic activity combined with high inflation. The prospects for inflation are actually far greater given that the money multiplier — the degree to which private banks expand the money supply via their lending and the velocity of money, the speed at which money circulates in the economy — remain miles below their pre-Great Recession levels. This, plus the amount of money the Fed has printed since 2008, provides a basis not just for high inflation, but for hyperinflation.
This concern about high inflation down the road may be leading new retirees to shy away from withdrawing their retirement account balances in the form of annuities. Annuities are the perfect hedge against longevity risk since you keep getting your annuity no matter how long you live. And they pay a higher return than regular bonds because when other annuitants die, you get to spend their money and vice versa if you die.
Yet if the annuity you buy is fixed in dollars, i.e., if it’s a nominal annuity, its real value — the amount of actual goods and services it can buy — will decline. Indeed, if inflation is high and persistent enough, nominal annuities can be watered down to the point they are worthless in real terms.
The best way to hedge this risk used to be to purchase not a nominal, but a real annuity — one whose payment would be adjusted upward each year in light of that year’s inflation. Unfortunately, the last remaining issuer of actual as opposed to phony, i.e. graded, inflation-protected annuities — The Principal Insurance, Co. — recently gave up that ghost. Hence, if you want to annuitize your retirement account balances, your monthly payments will be fixed in nominal dollars — dollars whose purchasing power can quickly get watered down by even moderate, say 5 percent, inflation. Yes, you may be able to buy a graded annuity, whose monthly payment rises at a pre-set rate each year. But if that rate is less than inflation, you’ll still lose purchasing power over time.
If you can’t buy an annuity whose payout rises with the price level, is there another way to hedge inflation risk? Stated differently, can you roll your own inflation-indexed annuity? There is. One well-heeled user of my software company’s, MaxiFi Planner software, used the program to provide the following personal example (Note, names are contrived to maintain the user’s confidentiality.)
Bob and Mary retired at age 60 and are now both 65. At retirement, Bob moved his 401(k)s and lump sum pension payout into Rollover and Roth IRAs. Mary has Traditional and Roth IRAs from her working years. The couple’s combined Rollover and Traditional IRA balances are $6 million and their combined Roth IRA balances are $1.5 million. They have regular savings of $500,000 and they own their $1 million home, which carries a 5/1 ARM mortgage balance of $525,000. Their ARM mortgage will step up from 2.5% to 2.75% interest at the end of 2020 so they will need to decide whether to pay off the mortgage, accept the 1-year step up with continuing interest rate exposure, or refinance at the currently low 30-year mortgage rates.
Bob plans to take Social Security benefits at age 70, which will provide $38,500/year. Mary has a $16,000/year teacher’s pension escalating with inflation and she is currently taking individual Social Security benefits of $2,100/year. Mary will claim her excess-spousal Social Security benefit when Bob turns 70, increasing her total Social Security benefits to $3,500/year.
Bob and Mary, who want to be as cautious as possible, set their maximum age of life at 110. MaxiFi Planner finds the annual discretionary spending (all spending in excess of housing costs, Medicare Part B premiums, and federal and state income taxes) that provides the same real living standard per person to Bob and Mary through their 110th birthdays, if they make it that long. They also used the program’s current default assumptions of a 1.5 percent nominal return on assets and a 1.5 percent inflation rate. This zero real long-term safe return is actually higher than the negative roughly 40 basis-point return on 30-year inflation-indexed bonds (Treasury Inflation Protected Securities or TIPS).
Bob and Mary are worried their income taxes may increase, so they assumed not just the scheduled 2026 expiry of the Tax Cut and Jobs Act of 2017, they also assumed that their income taxes would permanently increase an additional 10 percent from 2026 on. And they specified that, starting in 2026 that their Social Security benefits will be reduced by 20 percent. Finally, they assumed their Medicare Part B premiums would continue to grow by 3 percent per year in excess of inflation in line with recent history. While all these problems may not arise, Bob and Mary figure that planning for a worst-case scenario is best and, if things turn out better, the only downside will be leaving more to their kids if, as is almost guaranteed, they’ll die before 110.
Back in April, the couple read my Forbes article (which went viral, at least by my measurement of viral) about the potentially major, perfectly safe financial gain to cashing out your 401(k) to pay off your mortgage. But then they started exploring other options namely using some of their IRA money to buy an annuity and to hedge the inflation risk by refinancing with a conventional 30-year mortgage. Yes, inflation would erode the real value of their monthly nominal annuity payments. But it would also erode the real value of their monthly mortgage payments, i.e., the couple would get to pay off their mortgage in watered-down dollars.
Insurance companies have recently been offering joint lifetime income with 20 year-period certain annuities paying $394 each month per $100,000 invested. This type of annuity provides the same fixed nominal monthly income to the couple as long as either spouse is alive. If both pass away before the 20-year guarantee period ends, the remaining payments go to beneficiaries until 20 years is up.
The couple used Maxifi to estimate the lifetime discretionary spending increase arising from buying a $350,000 annuity combined with refinancing their existing $525,000 mortgage for 30 years. The chart below shows, for a wide range of inflation rates, the couple’s lifetime discretionary spending under this and a variety of other scenarios including, as shown in the black curve, maintaining their current adjustable mortgage. The Y (vertical) axis shows, in today’s dollars, the amount of lifetime discretionary spending in units of one thousand dollars. Hence, the number 6500 references $6.5 million dollars.
The first thing to note is that no matter what the couple does, higher inflation means a lower lifetime living standard (i.e., all the curves head south). The reason is that our tax system, particularly the taxation of Social Security benefits, is not indexed to inflation. Second, compared to the solid black line, i.e. Bob’s and Mary’s base case (where they do nothing), paying off their mortgage with retirement account money (my April suggestion) makes them over $30,000 or more regardless of the inflation rate. In short, my “cash out your 401(k) to pay off your mortgage” suggestion is lucrative, solid, and safe against both higher and, as the chart shows, lower inflation.
Next consider how the couple fares if they simply annuitize their IRA to the tune of $350,000. Assuming a 1.5 percent future inflation rate, this move nets the couple $128,000 in extra lifetime discretionary spending. That’s a huge haul. But if annual inflation were to jump to 10 percent and stay there, the couple would be $73,000 worse off with respect to lifetime discretionary spending. So what about their annuitizing, but simultaneously refinancing (by cashing out some IRA assets) for 30 years, with the refinance done at a fixed 3.25 percent rate? At a 1.5 percent inflation rate, this is a $28,000 winner. At a 10 percent interest rate, it’s a $75,000 winner! To summarize, Bob’s and Mary’s refinance cum-annuitzation scheme is roughly as good as mine (cash out 401(k) money and pay off your mortgage) at low inflation rates. At high rates it’s a lot better.
The red curve in the chart is also worth examining. It shows what happens if the couple simply refinances. At a 10 percent inflation rate, the couple would bag $201,000. But the curve’s main point is to show clearly how a fixed nominal mortgage can help you hedge inflation. Yes, inflation erodes our future nominal (fixed) dollar streams of income. But inflation also erodes our future nominal (fixed) dollar streams of required payments. So whether or not you have interest in buying an annuity, do take away this key point — a mortgage protects you against inflation.
To see this most clearly, consider taking out a, say, 30-year mortgage on a paid-off house and investing the proceeds in 30-year TIPS. The TIPS investment would be safe against inflation, whereas the mortgage liability would go down with inflation, i.e. you’d be better off on the transaction the higher the rate of inflation. The problem with this strategy is that TIPS don’t yield much. Indeed, the current 30-year real yield is negative 54 basis points (54 percent of one percent)! So, if inflation doesn’t take off, you end up losing money on the TIPS and having to pay a relatively high interest rate on the mortgage. In short, this represents expensive insurance against inflation. But if you borrowed on your house to invest in a relatively high-yielding and safe annuity, you’d be buying inflation protected at a much cheaper if not negative price.
The bottom line? Mortgages are costly in terms of the interest rate charged (compared with what you can earn by safely investing for the same period as your mortgage lasts) and come with little if any tax breaks. But they have a silver lining. They can protect you against inflation and help you roll your own inflation-protected annuity at a time when the financial industry has stopped selling them.
Larry Kotlikoff
Assumptions: Bob and Mary both live to age 110; Social Security benefits decrease 20% starting in 2026; State and Federal income taxes increase 10% starting in 2026; Medicare premiums increase 3% per year in excess of inflation; returns on regular savings and IRAs just keep pace with inflation; 1.5% inflation rate prior to 2025.