So what will really happen?

First, the government will have to stabilize the credit markets. This could easily take several years because foreclosures will be spread out in time. Even though home prices may be less than mortgage values, people do not decide to abandon a home on quick notice. They have to carefully consider their alternatives including whether the housing market will recover and the desirability to move to a different location. This is extra tough when people can’t qualify for new mortgage because their credit rating was destroyed by abandoning a mortgage.

It can’t be long before credit card defaults hit the banks really hard thereby aggravating the situation. The top six credit card companies hold $639 billion credit card debt. Then there are $365 billion securities backed by that debt. These are bundled into groups of credit-card receivables and sold to investors, insurers and hedge funds which likely find their way into other derivatives. It’s the mortgage problem all over again because about 30% of credit card debts are from low-credit-score people. Business Week (10/20/08) predicts that this is the next big blowup ahead.

In the meantime, people should develop a better appreciation for the fact that they should be saving. The decline of savings started two decades ago from 9% national savings rate to minus numbers today. Failure to increase savings rates is surprising because of the large number of baby boomers who are starting to reach retirement age and the long-term trend of industry to go from pension plans to savings plans.

As a consequence of saving too little, incurring large debts and losing conventional pensions, people will have to save more—lots more and start quickly.

When the savings rate finally increases to the extent necessary, much of the resulting investment would help the stock market. It would also bring back some of the national debt from overseas, thereby strengthening the dollar and reducing the cost of imports. But this will take years, not days or months and will be softened by slower business growth.

By necessity, many are going to have to retire much later. This is good news if they still have updated skills and the physical capability, but they will face a difficult labor market. On the one hand, demographics show there will be proportionately fewer young people entering the work force. That would bode well for seniors trying to retain jobs. On the other hand businesses will be facing many difficulties. This is likely to be overwhelming for a number of years.

Businesses will have lower volume when consumerism declines—as it must with increased savings! At the same time, employers will also face higher taxes, at least at the state and local level if not at the federal level. Heavy industries will face costly capital improvements for environmental and energy reasons. All of these things put pressure on labor as well as encourage businesses to look abroad for less expensive sources of materials and components–if not total assembly. Lower market volumes mean less need for commercial real estate, so there will be trimming there as well.

Another new impediment is put on businesses that offer pensions when the stock market falls and shows definite signs of slower growth. As an example, suppose that a pension trust’s securities fall 10%. Then the company has to either come up with 10% more funds (think of a huge number) to add to the trust. If the forecasted growth rate for their securities in the trust drops only 1% point, they will need about 15% additional assets in the trust. Firms like General Motors and Ford are already reeling from pension promises that are beyond their capability to fund. This is also likely true for government pension promises—only more so because most government pensions have cost-of-living-adjustments which require higher reserves than fixed pensions of private enterprise.

Another consideration is that the cost of government itself will go up. More regulation and health insurance administration will add significant government employment. Many government employees enjoy automatic cost-of-living adjustments to their paychecks. And government employees on the average make more than the average employee in the private sector. If the business share of higher government costs goes up, the product costs go up thereby aggravating inflation.

Some people think that higher corporate taxes reduce will reduce personal taxes. Not so, higher corporate taxes are simply passed on as higher product costs so that everyone pays—just as with a national sales tax.

The net result of reduced consumerism, increased savings and higher taxes will take some time to evolve before business earnings stabilize at a lower level. When that happens, stock price-to-earnings ratios likely will seek lower values than the historical norms for decades. That’s because of at least two factors: (1) People have got to make up a large part of the savings shortages of the last two decades or face poverty in retirement, and that will take many years of cumulative effort. (2) The outlook for growth will be tempered by the consequences of an aging population that has a much different budget distribution than that of the youth. Consumerism is a disease of youth. Lower price-to-earnings ratios combined with lower earnings do not bode well for the stock market for a very long time.

An aging population brings lower national income, more government outlays for entitlements, and a disproportionate increase in the need for services, particularly medical related services. The service industry does not have as great a multiplication factor for support jobs as does manufacturing. Further, it means a significant increase in the number of retired people to the number of workers. In a couple of decades the number of retirees will be one retiree for every two workers compared to one retiree for every three workers today. By itself, that means a 50% increase in individual workers’ burdens and even more with more people on government welfare.

The part of the economy that will continue growing is the government, but it is the least productive part of the service industry. It has virtually no productivity gain. Politicians are reluctant to propose cuts in government payrolls, in part because they are part of it, but also because government workers probably constitute at least 20% of the voting public. Benefits for government workers grow disproportionately as well. Government pensions most often have cost-of-living adjustments, i.e., COLAs, and savings plans too. 80% of private sector employees do not have pensions at all, and virtually none have COLA pensions. The number of government employees with pensions is fast approaching the number of people in the private sector that have pensions. That’s because of the double whammy of the private sector reducing the number of pensions while the government’s size is increasing.

The changes from these effects do not occur in days or months. They take years to evolve. To recoup the lost savings of the past twenty years in the next twenty years would require more than a 20% reduction in consumption. This implies savings rates comparable to that only achieved in World War II when most things you could buy were rationed and little else was available. Further, virtually everyone worked and provided income for the family during the war. Saving was politically correct and even school children saved stamps to accumulate savings bonds.

No, don’t look for any rapid improvement in the stock market. There may be spurts as occasional good news is highlighted to improve the economy, but the long-term effects described above will dominate the economy for several decades. There is no quick fix for our past savings deficiencies, record borrowings, unstoppable government growth, automatic entitlement growth and inevitable demographic creep to an aging population with greater demand for services, not hard products.

At the same time, even though stock prices will seek a lower level and grow more slowly in real terms, stocks may still be one of the better hedges against inflation. Inflation will increase the apparent earnings and business assets. Since we are living in a world of ever increasing prices, everything is relative. Inflation is very hard on fixed-income investments because the real value of the principal goes down. Owning a house with a mortgage may be one of the best investments since the value of equity increases disproportionately as the price escalates with inflation and the relative value of the debt goes down. Of course this assumes that we are willing to sell our houses later on, go into smaller homes and invest the savings in something that’s liquid so we can spend it.

As bleak as the picture is as painted above, it can get worse. One of the ways to solve part of the debt problem is for the government to let inflation increase above what we consider to be acceptable levels today. That has happened to numerous other countries and our own as well. Inflation is particularly hard on retirees who are trying to live on fixed incomes. It’s not so bad for government retirees that get a kick upward every year.

It was very poor public policy to pressure lenders to make loans to people who could not afford them. The resulting boom in housing prices made it seem that a home was a great investment and worth some speculation—even by those who could not afford the payments, much less all of the other costs of home ownership. People started to consider their home as their primary retirement resource even though a house is about as illiquid as an investment can be and has negative interest. Further this policy exacerbated the lack of mobility of our work force and made people look furtively for new jobs only close to their homes.

But some good came from the resulting crash. My view is that this mortgage crisis has kick-started us on a better path in the long run. It’s better in that less consumption eventually will help provide more for the aging population and less of a burden on our children than continuing this economic madness for many more years. We’re all going to be poorer, but less poor than we would be otherwise. We may still live more comfortably than most other nations. Hopefully the troubles we suffer in the meantime will bring more economically savvy politicians into office. Perhaps they will reduce government growth and entitlements that otherwise will be an unbearable tax burden on future generations.

To our children and grand children:

These can be good financial times, not bad times!

The stock market is falling.  It may be bad for many retirees and those that will lose their jobs as brokers or from bankruptcies but not for many people—IF

·         their investments have been widely diversified, and

·         they have set a tolerance band for reallocating their investments.

Over my almost fifty years of investing, I have seen markets drop many times.  In my first fifteen years I learned the lessons the hard way—by losing money.  I followed the market.  When it got high, I bought.  When it fell precipitously, I sold.  Ugggh!  I was supposed to do just the opposite.

Eventually, I found a way to do better.  I set upper and lower limits to the amount of stock (including stock funds) that I would hold at various ages.  The formula was simple:  I would not let the stock as a percent of my holdings get below 100 minus my age.  That was the bottom side.  Then I set a limit for the top side, namely, 110 minus my age.  So, at age 40 (about when I first started this) my stock allocations were between 60% and 70% of my investments.

After a while I added real estate investments to my portfolio.  I count the equity (price less debt) as a “stock” because, after all, stock is equity as well.  I did not count the equity in my home as an investment because I reasoned that I would always need a home.  Besides, my home was quite modest.

Now, at 75, my equity limits are much lower:  between 25% and 35% of my investments using the very same formula.  The remainder of my holdings are in bonds and money markets.  Using these limits over all of these years has given me a portfolio return that is higher than if I had steadfastly held to an equity limit of 105 minus my age.  That’s because I bought stock when prices were low and sold them when prices were high.  I described the performance differences in my book, “Getting Started in a Financially Secure Retirement.”

Not long ago I was on a radio talk show in New England.  I talked about my allocation limits.  The talk show host said I was old fashioned and dismissed my conservatism.  He felt, as do many, that even retirees should have much larger stock allocations.  I thought to myself, “He’ll learn!”

I can’t see the future any better than anyone else, so my conservative bent could be wrong.  I base my stance now on something very simple indeed.  That’s the deplorable decline in savings rates over the past 20 years and the almost inevitable changes in demographics.  These embody the effects of overdone consumerism, excessive debt and the forthcoming reduction in the ratio of workers to those who will be retired or trying to retire.

In “Getting Started in a Financially Secure Retirement” I show that it will be impossible for the average person to save enough over the next 20 years to be comparable to what the 9% historical savings rate yielded.  We would have to equal the kind of savings we had in World War II when virtually everything was rationed, there was nothing on the store shelves to buy, everyone worked, and buying savings bonds was the politically correct thing to do.

My simple analysis of necessary savings rates does not count the great reduction in the percentage of workers who will get pensions over the past 20 years.  The only major segment of our society where the pension benefits are increasing is the government sector which not only is increasing as a percent of our labor force but also has cost-of-living-adjusted (COLA) pensions that are backed by a sovereign power with the ability to tax.

On the demographics side, the ratio of workers to those over 65 will go from 3 now to 2 in the next few decades.  Again, the effects are very simple to visualize.  That part of our taxes (the largest part) used to support the elderly will have to increase 50% for working folks.  That by itself will be debilitating for the economy unless government benefits are trimmed with a meat ax.

On the debt side, by the end of this year every man, woman and child will have a federal debt obligation of over $180,000.  This includes only the national debt, Social Security and Medicare.  It does not include mortgage and personal debts nor state debts and unfunded obligations.  A family of four could easily have an equivalent debt approaching $1 million including mortgage and personal debt obligations.  At an average interest rate of 5%, that would be equivalent to an annual cost of $50,000, just to pay the interest without retiring any of the debt.  The median family now earns about $70,000.  That leaves about $20,000 for living expenses, state taxes and retirement savings.

Of course that assumes that income and taxes are evenly distributed.  Since 40% of workers pay no income taxes at all, the burden will be 67% more on those who do pay income tax.

So, what do I think will happen?  I believe that not only will income taxes go way up, so will every other form of taxes go up including ones that haven’t yet been invented.  As has already happened in several places in Europe, the government will also have to reduce benefits.

Further adding to the problem will be increased inflation.  That’s because I believe that the demands for higher wages will increase as will the price for goods both because of higher industrial taxes and higher labor rates.  Productivity growth will slow because of increased demand for U.S. labor content.  Finally, the feds will silently applaud inflation growth because it will, as always, reduce the apparent size of the national debt relative to GDP.

So why then wouldn’t I advocate holding any stock if the economic future is so bleak?  The reason is that stock represents owning something tangible that will increase eventually with inflation.  The same is true of investment real estate.  If you have been following my past recommendations, you might be buying stock now, not selling it.

Do I think that things can get worse?  Absolutely.  That’s why I do things incrementally.  When in doubt I go half way.  That gives me an opportunity to talk about the part that did well and ignore the part that didn’t.  After all, isn’t that way the finance industry promotes its performance achievements?  (Smile!).

Caution:  I can’t see the future any better than anyone else.  But I can testify that (1) if you don’t save anything, you won’t have any savings, (2) that regular savings grow faster because of reverse-dollar-cost-averaging, (3) that diversifying investments helps savings growth over the long-term, and (4) that allocation control really pays.

So here we go again. The Wall Street Journal publishes the Fed Reserve’s Wealth chart* which makes it look like our household wealth has been increasing even though savings rates are zilch.

Consider the following:

First and foremost, this includes Bill Gates, Warren Buffett, George Zoros, etc. I personally don’t expect to get any of their wealth.

The chart is not inflation adjusted. That brings the 2007 value down almost to the 1999 value.

Retirement savings do not account for income taxes due.

Then we look at the footnotes from the Federal Reserve. Real estate is adjusted upwards to replacement costs.

And finally, it doesn’t account for the growth of the population.

So, what would an honest chart on wealth look like?

Instead of the total wealth of the country’s households in then year dollars it would be the Median Value of Wealth PER Household in Today’s After-tax Dollar values. (Median Value would eliminate the problem of Gates, Buffett, Zoros, etc.) Then to really make it exciting, it would subtract the per-household-value of national debt and present value of unfunded obligations for Social Security, Medicare and public pensions. Of course, the result would be all negative values on an ever worsening plummet downward. And maybe we wouldn’t be viewed as the richest people on this earth. Maybe the dumbest, but not the wealthiest.

Bud

Dear Mr. Hebeler:

Thank you for your books and spreadsheet in assisting with retirement fund disbursement planning.  Your conservative thoughts are a rudder in the sea of misinformation. 

Here’s my hypothetical question for you:  Inflation and annual expense ratios are onerous costs for wealth accumulation. I can and have populated my asset allocation with low cost admiral shares of Vanguard’s mutual funds so those are minimized.( I like the ability to adjust your investment fees in the “what if” section of the spreadsheet. I’m going to use that feature to show people the real cost of a fund charging 1.5% vs. 0.2% annual fees.) 

Inflation is a whole horse of another color. As you point there is no reason inflation will be constant or that it will remain moderate.  If I go to the Vanguard Retirement Center planner, I can use their Annuity for Life calculator to give me a quote for an immediate annuity.  This says that for each $1,000 I place in the immediate annuity they will provide $4 per month, adjusted for inflation, for the rest of my life, starting at age 50.  That’s $48 annually per $1,000 or 4.8%. And that amount is indexed to inflation. 60% taxable. 

Being a frugal fellow I’ve also saved additional money, half in an IRA and half in post tax investments, that I’d like to not place in an annuity, but maintain in my current portfolio of about 60% stocks and 40 % bonds. This seems to be an intelligent move. It’s a hedge against inflation for my basic living needs and I maintain control of a larger amount of my assets.

Thanks, 

Gary S.

Thank you for asking.  I believe that Vanguard’s inflation-adjusted immediate annuity is a good investment for part of a retiree’s savings.  I think it’s better than getting into the commodities or collectibles markets to offset inflation.  I think that things are so wild now that there is some possibility that we could either go into something like the Great Depression or have hyper inflation–or even a combination of the two.

There are two things to be cautious about:  (1) That you have enough other investments to handle surprises that might require a large amount of immediate cash without borrowing, and (2) the solvency of AIG, Vanguard’s underlying insurer.  AIG is one of the world’s largest insurers, has a good rating, and I believe that Vanguard could step in if AIG got into trouble, but who knows?  (AIG has had a problem recently, but I understand it’s not serious as a % of its total assets.) 

You might also consider using I bonds to accomplish the same thing without the worry about solvency.  Until this January, you could buy $30,000 worth each year per Social Security number, but now the US, fearing another burden from inflation, cut the maximum to $5,000 a year.  However, you can buy $5,000 from a bank and $5,000 from Treasury Direct.  That’s a total of $20,000 for a couple each year.

If you were over 55, I would suggest that you consider using a direct transfer of money from your IRA to buy the immediate annuity.  Then use your taxable account to hold your equity investments.  That will give you a more favorable tax break.

Of course, my own sense of what way the economy will go and what are good investments is just my own opinion–and I could be very wrong.  That’s why I never put all of my eggs in one basket no matter how strongly I feel about such things. 

Bud

If you’ve been paying attention to the news recently you’ve probably heard about this sub-prime mess and credit crunch that is well underway. You may also have picked up on the fact that the central banks have injected billions of dollars of liquidity into the credit markets in an effort to keep them functioning. The Fed Chief Bernanke has opined that the problems in the housing and credit markets are “likely to get worse before they get better”. Treasury Secretary Henry Paulson has proposed bailing out the people who chose to buy houses they could not afford by suggesting that interest rates be frozen on these subprime mortgages for a 5-year period. This is obviously going to create losers, namely the investors who bought investments backed by these risky mortgages and in return were going to be earning a higher return (or no return in the face of defaults). In fact, the government announced today that the freezing of interest rates for a fraction of the 1.2 million people who are eligible for help will indeed occur; thus, the investors who bought investments backed by these mortgages will certainly not be earning the potentially higher returns that they had hoped for. At the same time, due to the rate freeze, the default risk on these investments has decreased as well. The question that needs to be addressed is whether the government is setting an unwelcome precedent with its proposal. After all, this proposal means that the government has introduced a moral hazard for future borrowers or lenders by bailing out folks who have made poor decisions.

But, the buyers of subprime mortgages who could never afford them are not the only ones to blame (and, did they really understand what they were getting into anyway?). There appears to be a fundamental flaw in the system, created by the separation of borrower and lender a few decades back. In the past, local banks used to sell mortgages and other lines of credit to its customers, and they had a true self-interest in making sure those lenders would be able to repay their loans. Now, mortgage companies sell the mortgages to financial institutions, and they repackage them into investment vehicles and sell them to investors. So the risk of default has been transferred to the investors. The problem is that the “middlemen”, the mortgage companies and financial institutions, have an incentive to sell as many as possible because they earn profits without taking on the risk. If defaults occur, which is most likely in the case of subprime mortgages, the investors lose their money. And selling subprime mortgages or investments is the most lucrative. Hence it shouldn’t come as a surprise that the Wall Street Journal recently reported that the number of subprime loans has increased rapidly since 2000 and that a large percentage of those loans went to people who could in fact afford conventional loans with better terms. And who got punished for that? No-one. Yet. So way to go New York Attorney General Andrew Cuomo who just subpoenaed major Wall Street banks to investigate the mortgage business. He is looking at questions related to the disclosure of risks to investors and the level of due diligence done by banks who buy and resell the subprime mortgages.

So what does this all mean for consumers? For one, borrowing on credit has and will become much harder. Lenders, in the face of financial losses, have less money to lend, and have tightened their lending standards and limited credit lines. And it is only getting worse. Data shows that there is $360 billion worth of mortgages due to reset in 2008 to much higher levels, which is more than one-third of the $1 trillion of US subprime loans outstanding. Who knows which banks, after Citigroup, Merrill Lynch, Morgan Stanley and UBS, are the next victims. A Goldman Sachs report suggests that banks and other lenders could cut lending by as much as $2 trillion, creating a possibility for a substantial recession. The Wall Street Journal reports today that delinquencies in the auto-loan market have increased to the highest level in several years, which has forced lenders in some cases to tighten terms for loans. With credit being this tight, you may have to wait a long time to purchase that oh-so-desirable Lexus or you will have to pay much higher rates for borrowing.

Consumers have also and will continue to be hurt by falling housing prices. Studies have shown there to be a direct relationship between a decline in house prices and a drop-off in spending. It is no surprise therefore that data shows that consumers have been cutting back on apparel, autos, and other luxury items. This in turn has hurt those industries.

What can you do to protect yourself? First of all, for those of you who are taking out home equity loans as a way to finance spending, stop now. You are risking losing your home by doing this. Falling house prices are detrimental in this regard, and it is time to start saving. It is time to replenish the lost equity, although this is obviously much harder now. But if you are fairly young, you have time. For those of you who have retirement savings, adjusting your portfolios defensively may be a good idea at this time. Some experts are suggesting overweighting foreign equities and increasing the fixed income portion of your portfolio. If you are close to retirement, the conventional wisdom that you want most of your retirement assets in low risk, fixed income instruments, holds even more so now.