That Rebate Check Could Ruin Your Retirement Part 2 (2008-05-19)

That Rebate Check Could Ruin Your Retirement Part 2

(2008-05-19) by David John Marotta

Last week's article explained the wrong-headed decisions behind the current tax-stimulus package, its deleterious effects on an already fragile economy, and how consumers delude themselves in the ways they spend the money. This week I explain the effects of the rebate checks on the savings for retirement. Anyone who spends more than 4% of their rebate will actually lose ground saving toward their retirement.

Retirement is the ability to continue your current standard of living solely through the growth of your investment assets. Raising your standard of living is the fastest way to fall behind your retirement goals. Every time you increase your spending by $1, you need $23 more in your investments when you retire.

So if you spend even half of your $1,800 rebate check and put the other half in savings, you fall $19,800 further behind in your retirement. Spending the extra $900 means you are expecting to continue living a lifestyle $900 greater than the lifestyle you have been living. To support that lifestyle, you will need 23 times that amount, or $20,700 more, in the bank at your retirement. But because you are only putting $900 more in your retirement, you fall $19,800 behind.

The problem worsens with every dollar of rebate you spend. Spend the entire $1,800 and you fall $41,400 behind on your retirement savings. Get tricked by the windfall effect I discussed last week, and you will increase several smaller purchases and spend 2.5 times your rebate check. Spending $4,500 more means you have fallen $103,500 behind in saving for your retirement.

Even back at only spending half of your check, you've spent $900 and only saved enough to do that again next year. You've saved like there's only one tomorrow. To support a constant lifestyle increase and not simply a two-year binge, you can only spend about 4% of the $1,800, or $72.

At this point, I can hear your objections: "But I'd just be spending the $900 this year. I'm not really increasing my lifestyle."

Unfortunately, lifestyle is tricky to calculate. It is easy to ratchet up but nearly impossible to trim down. Just try cutting your spending by $900 this month and adding that amount to your investments if you think it's easy to economize. Whatever your standard of living, there are people living $900 below you who are considering using their rebate check to add the one thing they believe they are missing from your lifestyle.

You can't spend money apart from your lifestyle because that's the definition of lifestyle. If you add an additional $900 to your lifestyle, you will have to cut back by the same amount next year just to get back on track toward your retirement.

Most people spend money they will only receive once and are more cautious about spending additional salary. However, the exact opposite should be true. Money you are given once cannot support an increase in your lifestyle. You have to amortize the money over your entire lifetime and spend only about 4% in any one year. But additional salary can be counted on every year. Therefore you can spend between 70% and 80% of salary increases and still stay on track by always saving between 15% and 30% of your income each year.

A much better idea is to think of the rebate check is as a matching contribution. Imagine the government is making you the following deal: "We will give you a check only if you put it in savings and match it with your own money, cutting your lifestyle this year by that amount."

If you take the government's deal and cut your lifestyle by $1,800 and add that plus the rebate check to your retirement savings, then you really grow rich. First, you have added $3,600 more toward your retirement. But more importantly, by cutting your lifestyle by $1,800, you now need $41,400 less to make retirement a possibility! With one small matching funds incentive by the government, you are a total of $45,000 closer to financial independence.

Staying on course toward retirement is as much about moderating your lifestyle as it is about saving and investing. If you need 23 times your standard of living at age 65, you need about 10 times at age 50, 5 times at age 40, and 1.7 times at age 30. Investments can double quickly, but you must have something saved while you are young to get the process started. Delay saving for several years and you will cut in half your lifestyle in retirement.

Compare what you spend with what you have saved to see if you are on the money toward meeting your retirement goals. And consider that tax rebate gimmick for what it is: another cheap attempt at stopping you from achieving financial independence.

Here's a program I could support as president: Offer to pay people matching funds toward their retirement in accounts they would own and control. We wouldn't even have to call it "privatized Social Security."

from http://www.emarotta.com/article.php?ID=284

Tax Rebates Are a Losing Proposition Part 1 (2008-05-12)

Tax Rebates Are a Losing Proposition Part 1

(2008-05-12) by David John Marotta

Beginning this month until July, the government will issue over $100 billion in tax-stimulus checks, the equivalent of about 1% of annual consumer spending and some 70% of the country's $14 trillion gross domestic product (GDP). The assumption is that we can spend our way out of a recession by boosting third-quarter GDP growth over 4%.

More than 130 million households will receive $600 per adult plus $300 per child with a family of four receiving $1,800. But for taxpayers with an adjusted gross income of $75,000 ($150,000 filing jointly), who paid more than 60% of all taxes, these amounts are either reduced or eliminated. In contrast, many people who never file a tax return or pay any taxes will receive the full amount. The government has created special forms and public relations campaigns specifically to reach this group and encourage them to file and enjoy a rebate of taxes they never paid.

If I am elected president, I won't insult the public like this. Tax rebate stimulus checks are a cheap and inefficient gimmick that will increase the fragility of our economy and impoverish those who receive such checks.

You can't spend your way out of economic trouble as a country any more than you can lift yourself personally by pulling on your shoestrings. Increased spending is an indicator of economic health only when it is preceded by increased production and earnings. Rich people generally spend more, but it certainly is not what makes them rich.

It would be much better if we as a country tried to save and invest our way out of a recession. Imagine if everyone invested their rebate by creating new businesses or building factories. Then we as a nation would produce more. Increased annual production could be sold, which would increase our GDP.

Consuming more goods doesn't really help our economy when half the stuff we buy comes from China anyway. In fact, deferred consumption is the definition of capital and would allow us to use that capital to build more productive companies. It would lower unemployment and reduce inflation.

The tax rebate gimmick is extremely inefficient. The legislation itself added hundreds of pages to this year's tax code. The IRS launched a tax rebate information center offering check amount scenarios, along with information especially directed toward Social Security recipients and veterans. The agency was taking more than 50,000 calls per day over their normal tax-season load. Their automated-response phones handled 1.2 million calls specifically about the rebates, and the IRS reassigned 1,500+ employees just to deal with the inquiries.

To be eligible for the $300 rebate, parents had to apply for a Social Security number for their children. People not normally required to file a tax return had to do so to receive their rebate checks. The IRS Free File Alliance was created to provide free services to people who were filing solely to receive their economic stimulus payment.

None of these compliance costs are free. Someone has to be paying for them. Estimates suggest that compliance costs add an additional 50% to the expense of taxation. Because of the added burden of a unique program such as this, the costs are probably higher.

That means those $1,800 checks will probably cost taxpayers about $3,000 each.

The tax rebate gimmick impacts negatively on our economy. Economic systems change gradually and operate best in stable conditions. Only when goods and services are free to be used wherever they are deemed most valuable does economic growth have the best chance.

But rather than trust in the free markets, President Bush and Congress have tried to boost consumer spending artificially without any reduction of federal spending, thus increasing the money supply and fueling inflation. More dollars chasing static production is the definition of inflation. Many families earning $36,000 a year will receive a $1,800 rebate check representing an additional 5% bonus, only to find that prices on their purchases are 5% higher. Thinking they are better off, they will actually be poorer if receiving the check increases their spending habits by even a penny.

Every time the government bureaucracy engages in centralized spending plans, the economy is weakened. Free markets are the best method of self-rationing scarce resources to where they will do the most good. Every time the government tries to solve an economic problem via fiat, they can only do worse than the efficiencies of the market itself. By trying to strengthen or bail out one section of the economy, they slightly weaken and destabilize all the others.

Finally, the tax rebate gimmick will impoverish those who receive such checks. In polls, most Americans claim they will put the rebate in savings or use it to pay down debt, but behavioral finance research suggests otherwise.

Studies have shown that even the most rational of consumers who receive money spend more as a result. Surprisingly, when they receive relatively small amounts, they justify additional spending by more than 2.5 times the size of the original check. The psychology behind this thinking is so strong, it is safe to assume we are all influenced by it.

We see evidence that the effect is universal when we hear people say they will save the rebate or use it to pay down debt. The fact that they are thinking of the money from the rebate as though it were different from the rest of their budget means they are already engaging in the two-pocket fallacy of money, thinking of money differently simply because of the source.

Perhaps they will pay off some of their debt, but they did that the month before they got the check. Perhaps they will put money into their 401(k), but that happens automatically. Because these rebate checks will continue to be featured in the media for months as they dribble out, they will continue to be in the forefront of our minds. Someone will complain about a delayed check while other coworkers share what they've already purchased. And most Americans will use the idea they have some extra money to justify a purchase they would not otherwise have made, probably more than once.

In fact, studies suggest that average consumers will spend an additional $4,500 in relatively small purchases simply because they received a $1,800 check: an extra $45 eating out, a $90 electronic toy, and a $650 appliance. Children will be given their $300 as though it somehow belongs to them, and husbands and wives will use the money as an excuse to make that purchase their partner considers frivolous. Without even realizing it, past studies suggest consumers will spend 250% of their rebate check.

In polls, American claim they will spend only 18% to 40% of the rebate. But in reality, anyone who spends more than 4% will actually lose ground in saving toward their retirement. Next week's article will explain the realities of this scenario. Until then, don't spend a penny of those rebate checks.

from http://www.emarotta.com/article.php?ID=283

Subprime Lending (2008-05-05)

Subprime Lending

(2008-05-05) by David John Marotta

The subprime mortgage meltdown has cost the world 15% of its market capitalization, about $9 trillion. The primary culprit who caused all of this financial loss, pain and suffering is not the mortgage companies. Neither is it the overextended borrowers. It is our own federal regulations interfering with the free market.

For over half a century, only 45% of Americans owned their own home. Then home ownership rose in the postwar period, settling at about 64% in the early 1990s.

In 1994, President Clinton had the good intention of raising home ownership to 67.5% by 2000. He sponsored the revision of the Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. The banks complied and increased their lending to these families by 80%, more than twice any other group.

The sentiment was noble but ill advised. Community groups could now prevent banks from mergers, branch expansions or the creation of new branches simply by protesting to any of four different regulatory agencies. But these traditional activities of banks are necessary to stay responsive to the dynamics of the marketplace. To maintain this ability, banks paid millions to these community groups. In theory, they were supporting mortgage education efforts and fair lending practices. In reality, they were carrying a block of poor loans on their books simply as the price of doing business.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as a positive and encouraging trend. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had gotten $3.8 billion in loan commitments in the city of Boston alone.

Faced with excessive regulatory interference, banks risked additional loan defaults rather than face financial penalties and blocked business. But in a situation characterized by excessive regulation, we all pay the price.

The unintended consequences of good intentions can do more economic harm than all the mean-spirited greed within capitalism.

Part of the good intention was forcing banks to be good neighbors by making altruistic loans that discriminated in favor of underprivileged communities. Any attempts by banks to set higher rates, terms or conditions on people with questionable credit was labeled "predatory lending" and used to hold lenders hostage. This form of price controls held the price on questionable loans artificially low.

Normally, price encourages consumers to self-ration and to use less of a limited resource such as capital and put it where it is likely to do the greatest good. Price controls cause shortages because lenders protect their losses by extending fewer risky loans. But this time, regulations forced them to continue making the loans.

Price controls and lower interest rates caused a surge in the demand for mortgage loans. In response, banks raised the requirements to qualify for a traditional loan and wrote more adjustable-rate mortgages (ARMs). Even ignoring their poor credit rating, questionable borrowers could only qualify for an ARM, and they could barely afford the low teaser.

Clinton's goal was met in 2000 and then surpassed, boosting U.S. home ownership by 2005 to 68.9%. Ownership for minorities grew by 24.1% between 1993 and 2005, nearly three times the rate of for non-minorities.

Another good intention driving the legislation was that home ownership correlates to building wealth, stability and community support. If only we could get struggling people to own their own home, they too could share in the American dream. But we build wealth by deciding consciously to delay purchases such as a home, not to overextend ourselves financially to reach our goals.

The idea was that purchasing a home is an investment. But the home you own is not an investment. An investment pays you money. Rental property is an investment. The house you live in is a liability, which increases proportionately with its size. The fastest way to own a house is to rent as small as possible and save and invest the difference. Low-income households have limited resources, and home ownership drains too high a percentage of their income. In fact, studies show that low-income home owners save less than renters and have less of an emergency fund.

The belief was that home owners build equity in their homes by making regular payments that include both interest and principal. For most families, paying a mortgage is a forced form of savings. But this assumes home owners have the cash flow that allows them to build equity in their houses. Encourage those unaccustomed or unable to save to become home owners, and they are apt to refinance and take any growing equity out of their house to fund other expenses.

In fact, that is exactly what happened.

Another good intention was the assumption that mortgages are always good business for banks. Lenders who didn't cheerfully agree were accused of discrimination against minorities by using “old-fashioned” criteria, such as the size of the mortgage payment relative to applicants' income, their credit history or verifying their savings and income. Instead, applicants merely had to demonstrate their ability to manage debt by attending a credit-counseling program.

But these old-fashioned criteria were historically what made loans secure and limited defaults. Forcing banks to lend money to those least likely to repay is not a sound policy.

That the credit debacle took two presidential terms to unravel is simply how economics works. Dropping interest rates and rising house prices masked the default rates as those who would have defaulted simply refinanced a larger loan, milking their homes for 100% of their value like an ATM machine.

Economist professors Stan Liebowitz and Ted Day criticized the program in 1998 in their article "Mortgages, Minorities, and Discrimination" in Economic Inquiry. They wrote, "After the warm and fuzzy glow of 'flexible underwriting standards' has worn off, we may discover that they are nothing more than standards that lead to bad loans. . . . [T]hese policies will have done a disservice to their putative beneficiaries if . . . they are dispossessed from their homes." Unfortunately, no one ever listens to economists.

Everyone was busy praising lenders using relaxed underwriting standards as the paragon of virtue. Although widely understood that approving minority mortgage applications stretched the rules a bit, it was considered good social engineering. Now they are universally criticized by the same crowd that formerly praised them.

Today, the people who advocated lax lending standards are self-righteously critical of lenders for letting this debacle happen. Having forced millions of bad loans, they are now complaining the government is paying a small portion of the losses back to Bear Stearns. Having enacted regulations that ruined the U.S. financial markets, they now claim the credit problems stem from a lack of regulation. Only government uses its power to cause such havoc and then asserts it needs more power.

Bailing out borrowers makes the least sense of all. Although routinely cast as victims, we must remember they substituted attendance at a credit-counseling class for hard collateral in their promise to repay. They purchased homes beyond their means, lived in relative luxury and bilked banks of any building equity by refinancing cash-outs of their homes every time real estate markets appreciated.

Although it isn't their fault for padding their lifestyle by exploiting regulatory mistakes, borrowers don't deserve a penny more. Regulators especially don't deserve a second chance to impose rigid rules on a system that requires dynamic adjustments. Having been hurt so badly by the conspiracy of regulators and irresponsible borrowers, we should at least allow lenders the consolation of foreclosing on the house of cards.

If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully dumb to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive. How can more government regulation help when there is universal ignorance of how the government caused the problem in the first place?

from http://www.emarotta.com/article.php?ID=282

First Quarter Review 2008 (2008-04-28)

First Quarter Review 2008

(2008-04-28) by David John Marotta

The first quarter of 2008 made the difference between well-designed portfolios and poorly designed portfolios obvious. Check your quarterly statement to see which category describes your portfolio.

You may hesitate to change your investment strategy even if you suspect performance is suboptimal. Perhaps you believe your current investment mix went down so much simply because of the markets and will go up when the markets rebound. But this assumption is faulty.

Systemic problems, not market volatility, explain why some portfolios performed extremely poorly in the first quarter. If your asset allocation was unbalanced, you took the brunt of the drop because you are invested primarily in U.S. large-cap stocks. An unbalanced portfolio will continue to be unbalanced and gyrate randomly rather than progressing steadily toward your goals.

Furthermore, if your underlying investments are laden with fees, they will continue to be even after the markets rebound. It may be difficult to see you are paying too much in hidden fees and expenses when the markets are going up. But when they go down, excess fees add insult to injury and exaggerate your losses.

We design portfolios using six asset classes, three for stability and three for appreciation. The three for stability are (1) short money (maturing in less than two years), (2) U.S. bonds and (3) foreign bonds.

1. Short money, such as cash, money market and CDs, continues to be the riskiest investment since 2002. Cash can be dangerous. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same number of dollars doesn't do you any good if they won't buy as much as they used to.

The Federal Reserve lowered the rate of federal funds from 4.25% to 2.25% this quarter. It lowered the discount rate (the rate at which a limited number of institutions can borrow directly from the Fed) from 4.75% to 2.25%.

As a result, the dollar continued to slide in value, deteriorating several percentage points in the first quarter. The Euro rose about 3.4% against the dollar. The U.S. Dollar Index, measured against a broader basket of currencies, dropped about 5.3%. Even the Japanese yen rose over 8%. Finally, the price of gold went from $840 an ounce, past $1,000 and back down to $916, ending up over 9%.

This loss of the dollar's purchasing power means that losses in all other categories were compounded. Not only did the U.S. stock market lose value in dollars, but the remaining dollars were worth even less. Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes.

2. The second asset class in stability is U.S. bonds. The Lehman Aggregate Bond Index was up 2.17% in the first quarter. Annualized, that would produce an 8.68% return. Treasury inflation-protected bonds provide some protection against a dropping dollar and appreciated 5.18% in the first quarter.

Having the right balance of stability to appreciation (fixed income to equities, or bonds to stocks) is important for a portfolio's behavior.

Adding bonds to an all-stock portfolio can actually boost returns over the long term. When an all-stock portfolio performs poorly, you just have to wait for it to rebound. But when a portfolio is stable and the stock side bounces down, the natural process of rebalancing sells bonds at their high and adds to stocks at their low. This contrarian move helps the portfolio as a whole rebound more quickly by adding to the stock side when it is down.

Even in a very aggressive portfolio, bonds provide a stable store of value waiting for a market correction. This "dry powder," or cash on the sidelines, can be invested into the markets after a drop to help your portfolio rebound quicker.

3. Foreign bonds, the third asset class in stability, protect you better against the weakening of the dollar. They did very well in developed countries, appreciating nearly 10%. But emerging market bonds were flat. A mix of mostly developed countries and a third in emerging market bonds would have produced a return of around 7%.

The three additional asset classes for appreciation are (4) U.S. stocks, (5) foreign stocks and (6) hard asset stocks. U.S. stocks did the worst.

4. The Dow was down 7.55%, the S&P 500 was down 9.44%, the Russell 2000 lost 9.90% and the NASDAQ lost 14.07%. The average daily volatility in the first quarter was 1.21% compared with a historical average of 0.75%.

Value stocks lost less than growth with small value doing the best, only losing 5.28%. Oddly enough, small growth did the worst, losing 14.40%. Small- and mid-cap stocks have soundly outperformed large cap over the past five years, so your portfolio should tilt toward small and value.

Technology stocks did the worst this quarter. The sectors that lost the least were consumer services and consumer goods.

So U.S. stocks were definitely down. But if your U.S. stock losses were approaching 10%, one of three things is probably wrong with your portfolio: You have all U.S. large cap stocks, you are overly invested in volatile funds or your excessive fees are dragging down your investments. You can view the expense ratio on every fund you own at www.morningstar.com.

5. Many foreign markets fared even worse. Emerging markets were down 11%. Britain's FTSE was down 11%, France's CAC was down 16.3%, and Germany's DAX was down 19%. The EAFE foreign index, however, was only down 8.91%.

The 11 countries we recommend with the most economic freedom fared better than average, only losing 8.23% for the quarter. Overall, your foreign investments should have done slightly better than your U.S. investments. We believe foreign stocks provide better country diversification and also protect your investments against the devaluation of the dollar.

6. The third asset class for appreciation is hard asset stocks, which include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

These stocks exhibit a unique set of characteristics: They have a low correlation with other stocks and bonds and they appreciate with inflation.

Gold and oil both hit record highs in March. They then fell 12% and 11%, respectively, in just three days. Crude ended the quarter up 5.9%, gold was up 10.3% and natural gas was up 30.9%. These commodity prices affect the long-term price of hard asset stocks. With the gyration in prices, hard asset stocks have been much more volatile than normal and lost 4.89% this quarter.

Asset allocation means always having something to complain about, but it also means always having something to be glad about. The S&P 500 was down nearly 10%, but a well-balanced portfolio should be down much less. Don't assume that everything is down the same. Some portfolios just can't overcome having all their assets in large-cap U.S. growth stock funds with excessive expenses. And because they are poorly designed, these portfolios won't rebound as quickly with the markets.

Take the time to compute your first quarter's returns and determine if your investments are designed to meet your goals. It's an excellent opportunity to review your asset allocation and investment selection.

from http://www.emarotta.com/article.php?ID=281