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A riddle to be solvedThe word Carborundium also looks a lot like Conundrum which is currently a very popular word that means a riddle or a puzzle. That seems like a good segway to a conundrum that the Optimist has about how to hedge the value and the purchasing power of a retirement. Before continuing to pose his conundrum, the Optimist wishes to warn any readers who assumed that this commentary would answer the title question. Although the Optimist may sound like an irritatingly smug person who thinks he knows it all and is much too sure of himself when he talks of silver and gold, the truth is that there are many topics in which he is barely literate. The Optimist hopes that readers will be able to shine light into the dark voids he has about this topic. Why hedge a retirement?A person who either recently has or soon will retire has a vested interest in the equivalent of a substantial amount of equity. It is reasonable to expect the company providing the retirement benefit to handle that equity with care, and to take steps to protect most of the value of the retirement equity from obvious concerns, such as a modestly rising rate of inflation. If one anticipates a possibly substantial and potentially abrupt change in the financial force field which impacts on that equity, however, then it might be reasonable to consider supplementing the protective envelope that surrounds the retirement equity. As with most true hedges, the focus is not on investments which offer additional profit potential, but rather to essentially purchase an insurance policy that returns a portion of the equity that would have been lost due to events which cannot be otherwise controlled. Assume no risk from the source . . . There have been many unfortunate instances in which a company went bankrupt and the employees lost much of the retirement equity they expected to receive. That is a nightmare which not even the Optimist can present a positive perspective about. For this discussion, however, we can contemplate a much brighter prospect. Let’s consider a company that will pay the retirement benefits, and that has zero risk of any problem that might negatively impact the ability of that company to pay all agreed benefits, in full and on time. For example, let’s assume for this discussion that a hypothetical corporation has a monopoly on and manufactures really expensive little widgets which the entire defense establishment adores. Obviously, there will never be a slowdown in that company’s earnings, and it’s promises to pay a defined set of retirement benefits are as safe as anything can be in this troubled world. The Optimist hopes all of his readers work for a comparable corporation. . . . but other risks loom large So why would one waste time and energy worrying about the defined set of retirement benefits which our hypothetical company will certainly pay? The answer is that there are potential risks which are not covered by the company retirement plan. As one simple and relatively slow example, the retirement payments will be indexed to increases in the CPI. Consider the impact if the CPI does not move up as fast as the real cost of living, as the Optimist considers likely. The difference between the higher costs due to more rapid rises in real inflation, minus the lower gain obtained by indexing the retirement benefits to a slower rising CPI, would be a consistent net loss of purchasing power. The inevitable result of a continuous loss of purchasing power is that the piranha of inflation would continuously eat away the muscle and meat from the retirement plan’s skeleton. A helicopter symbolizes a more rapid concern. If on a bright and clear day the sky darkens because the sunshine is blocked by millions of freshly printed hundred dollar bills fluttering aimlessly down from a fleet of helicopters chartered by the Fed, one might reasonably be concerned about the purchasing power of a few hundred dollar bills obtained by cashing a retirement check the following week. Perhaps the most rapid risk could be visualized as a herd of large elephants all trying to exit through a small fire door at the same time. That pachyderm pandemonium is similar to the chaos that would ensue if the USA’s creditor nations all panicked and tried to dump their trillions of dollars and bonds simultaneously. For a few days (would you believe years?!) after that financial meltdown, it might be difficult to exchange a retirement check for anything edible. A note to deflationistsThe Optimist apologizes for presenting a topic which will be of little interest to investors who want to primarily protect against deflation. If the USA is on a path to deflation in the not too distant future, then there is no need to worry about hedging a retirement, or even to consider various investment strategies. A deflationist would need only to convert all assets to cash, or to a super safe T-Bond equivalent, and then wait for precipitously plunging prices of everything to multiply the purchasing power of cash. A retirement or Social Security check each month for a fixed number of fiat dollars would automatically gain purchasing power during a deflationary contraction. There would be no need to do much more investment work than to sing another verse of “Don’t worry - Be happy” as falling prices everywhere magnify the wealth of cash equivalents. The ease of positioning investments for deflation makes it tempting to convert to that belief system, but the Optimist will not yield to the easy side of the force. For the last 70 years, inflation has been the American Way of truth, justice, and financial integrity. The Optimist steadfastly continues to support that proud and time honored heritage. What would a good hedge look like?Those who do not have faith that deflation will soon solve many investment concerns have a conundrum of their own. How should they hedge the impact of events which hopefully have a low probability of occurring, but which could be catastrophic to an unhedged portfolio? Before getting on with possible answers, it might be helpful to review the general characteristics of an effective hedge. Obviously, a good hedge should protect the equity of the investment in focus. It should also be not too expensive, and it should index benefits to inflation. A sometimes overlooked but essential requirement for a good hedge is that there must be a solid guarantee that the agreed benefits really will be paid when the need arises. Consider flood insurance as an example. If you are the proud owner of a house that would cost $200k to construct again, then you have a substantial amount of equity to protect. If the house is located in a 100 year flood plain, then there is a possibility of a once in a lifetime flood which could destroy your house. Although the probability of a catastrophic flood is low, it would be prudent to spend a few dollars as insurance against disaster. However, the cost of the insurance must be carefully considered. It would make no sense to spend $thousands each year to protect against a very low probability of losing $200k, and even $hundreds might be an excessive annual cost. Although $200k may be adequate to reconstruct the house today, inflation could raise that cost to $220k next year and to $250k the year after. The proceeds from the insurance should be indexed to real inflation, not just to the flat line fiction published as the CPI. Finally, one must be very confident that the insurance company will pay the benefits when the need arises. If the company that is collecting the premiums each month has all of its assets and many policy liabilities in the same 100 year flood plain, that company might be too busy talking to its bankruptcy lawyer to return your frantic phone calls. So, how should we hedge a retirement?There seems to be enough background here to let us focus on the title question. No more theory. It is time now for specific nuts and bolts answers! After considering the monochromatic offerings the Optimist can present, however, readers might shout Nuts!, and bolt from this discussion. This is the best the Optimist can do. Buy more silver and gold. That seems to pass most of the “Does it walk like a duck?” test. If the retirement value is lost, or other investments deteriorate, or the house is destroyed, equity will remain in the gold and silver, and that equity would be easily available to use for financial reconstruction. The annual costs of owning silver and gold are relatively low, the value of silver and gold will probably rise faster than inflationary increases in costs, and silver and gold will still be there for you when many companies are fighting for position at the take a number machine outside the bankruptcy courts. Since we are all close friends, and you are very understanding of his weak moments, the Optimist can confess that he did briefly harbor another thought. If the coming bad times will coincide with rising long term interest rates, then a simple hedge would be to sell short a T-Bond future, and to subsequently just roll it forward. As with most simple solutions, however, his one has a potentially fatal flaw. Long term rates might not drop! Despite rising real inflation and a world wide economy that is booming (that description mostly applies to Asia of course), long term rates have persistently declined instead of rising as would be rationally expected. To paraphrase Keynes, market insanity can be an asphalt roller if you let your finances be the pavement. If a financial force beyond comprehension is intent on further depressing long term interest rates, the Optimist cannot recommend getting crushed by the weight of a T-Bond short position. Those readers who have a talent for identifying major trend changes soon after the peak, however, might consider purchasing a T-Bond put with a strike that is far out of the money. The time decay of the option premium could be thought of as similar to the monthly cost of an insurance policy. Just as with an insurance policy, the buyer would hope to lose the full cost of the purchase price because the cataclysmic event which is needed to profit from the policy would be terribly traumatic for everyone. As a certifiable optimist, I am prohibited from dwelling on such thoughts, so I will end my attempts at finding possible solutions to the title question. Readers will tell me where to go!The Optimist suspects that a few readers may occasionally entertain financially pessimistic viewpoints. He hopes those readers will share their perspectives on what would be a great hedge for a really bad situation in the years to come. As always, reader comments are welcome, and selected excerpts will be appended to this discussion.
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