Monday, February 25, 2013

The Race to Zero

The Race to Zero

Bert Whitehead, M.B.A., J.D. ©2013

The government is printing too much money!

We have all heard the clamor raised by concerns that U.S. monetary policy (called "Quantitative Easing") will trigger inflation by causing 'too many dollars to chase too few goods and services.' The U.S. Treasury is issuing U.S. Government bonds at a faster rate than our economic growth. These surplus bonds are purchased by the Federal Reserve Bank, creating money that can be lent to businesses, etc. and so presumably help the economy expand.

There have been a couple problems with this strategy. First, the banks (and corporations) already have too much cash so they are not borrowing it from the Fed as expected. Next, we are still cleaning up the last mess when mortgages were made to virtually anyone. Since the excess money being issued is not being lent out or circulating, it keeps interest rates low. It also depresses the value of the dollar in the international market, since dollars are so plentiful. The good news is that this helps make our exports cheaper for other countries and keeps Americans working.

Ironically, other countries have caught on to this strategy, although not always as aggressively as the U.S. The European Union has been inflating its money supply as a tactic to avoid collapse of the weaker members (Spain, Italy, Portugal, etc.) and to make their exports cheaper. China has had a bout of inflation triggered by a growing labor movement and skyrocketing urban real estate prices. It has been printing more Yuan to reduce its value and make its exports cheaper. And even though Japan is still largely in a deflationary spiral, they have decided that printing more Yen will make their exports more competitive. Even Switzerland, the bastion of conservative economics with the strongest currency in the world, has started printing more Swiss Francs because no one in other countries can afford to buy Swiss watches.

This bloated international money supply is the result of the battle for increasing exports. Lowering interest rates through global expansion of the money supply is ultimately expanding the next inflation bubble. These low rates may give some countries an export advantage, perhaps for another decade or even longer. How can this bubble persist without creating inflation now? There are three factors which can temper inflationary pressures for awhile:

1. Increasing global trade brings down production costs. Just as water seeks the lowest level, free trade enables producers to move to lower cost environments. It also pushes prices down globally which moderates inflation.

2. Technology has brought unparalleled increases in worker productivity worldwide which keeps prices down. Computers, robots, and other smart technologies lower the costs of production dramatically.

3. Consumer savings has increased significantly worldwide as a result of the economic volatility of the past decade. When people feel vulnerable they react by spending less and saving more. This is particularly evident in Japan where people save 6-9% of their income, spurred by their aging demographics and concern that the government's safety net may not be effective when they retire. This savings takes money out of the consumer economy and reduces the amount of money that chases the available goods and services.

Most economists recognize that eventually inflation will catch up with us. But no one knows when or how. Will a smaller, poorer nation default on its debt, or will large investors be scared away from bond auctions as markets lose faith in governments' ability to repay debt? Whether it will be triggered by a 'black swan' event like a war or a natural disaster or simply the gradual erosion of investor confidence, it will likely ignite a global domino effect of hyper-inflation that could engulf most developed countries.

We know it will happen, but we can’t know when. It is critical to prepare by adhering to the one take-away lesson from the history of inflation: you must emphasize safety in bond investments.

This is not easy to accept when you consider that it is likely that interest rates will remain low or continue to drop for another decade, just as they have been dropping in Japan for over 20 years. While a 2% return now on 10-year U.S. Treasury bonds seems skimpy now, it could well be 1% in a few years (which is the current yield on Japan's 10-year sovereign debt). People are saying that interest rates can't possibly go any lower, but they have insisted on that since 1994 when 10-year Treasury rates were at 7%!

It is tempting to be dissatisfied with today’s apparent race to zero interest rates. It impels many of us to want to grasp for higher returns. But higher returns always entail higher risks and it is folly to try to offset lower yields by taking more risks. High yield bonds offer dramatically higher returns than a safe haven, like treasuries, but the risk cuts both ways: when interest rates begin to rise, the value of high yield bonds drops. This is also true of Treasuries, but at least you can be assured of getting your money back at maturity, unlike junk bonds. In addition, when the music stops, holders of junk bonds face significant risk of default. In Functional Asset Allocation theory, which is the centerpiece of our financial planning theory, the function of bonds and cash in your portfolio is to assure consistent cash flow, so it is critical that this part of the portfolio be absolutely safe.

Before you stretch for a higher yield, keep in mind there is a strong likelihood that we very possibly will see continuing low interest rates for a long time. Meanwhile the "Race to Zero" is the harbinger of the next bubble to burst.

(Cf. My blog dated Sept. 4, 2012: Finding "Real Returns" in the Bond Market.)
Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.

Sunday, February 10, 2013

What's a "Safe Portfolio Withdrawal Rate?"

By: Bert Whitehead, M.B.A., J.D

How much can you withdraw annually from your investment portfolio to be sure you don't outlive your money? If you regularly read investment articles, you know that this issue is often debated. Scenarios are analyzed, and various inflation rates, historical investment rates of return, and life expectancy projections are compared.

While these are key and critical exogenous issues if you are managing billions of dollars in pension investments, if you are a real person it is the endogenous factors that are important when you decide how much money to take from your retirement portfolio. Endogenous factors include living within your means, how much you pay in taxes, and taking appropriate risk for your situation.

Inflation: The Bogey Man. There is no question that the cost of living has risen over the years, and the compounded effect of inflation over time is startling. For real people, however, it is more complex than just measuring the price level across the whole economy. Younger and middle-aged Americans will likely see prices rise substantially over their lifetimes, but while working their wages can also increase, and generally faster than the rate of inflation. And if you consistently save 10% of your earnings, the amount you save increases each year and easily outpaces the inflation rate.

For older retired people, especially those on a 'fixed income,' you would think that inflation would be disastrous. Certainly inflation is a continual struggle for those living at a subsistence level. For the more affluent, however, expenses tend to start dropping when they are in their 70's, and continue dropping more rapidly as they age despite increases in inflation. Older people are less mobile, have 'been there, done that, and have the T-Shirt.' They travel less, are generally less active, and less fashion conscious.

So while the rate of inflation is a big concern for money managers who run gigantic pension plans, in reality it has virtually no impact on personal financial planning.

‘I just want to 'Die Broke!' New clients sometimes say they want to withdraw their retirement portfolio money and spend it all on themselves during their lifetimes. No problem, I say: just let me know your date of death!

The simplest and most effective strategy to make sure you never run out of money is to continually save 10% of your total income. While working, most people do this by contributing to their 401Ks. Even in retirement it is prudent to continue to save 10% of your total income (that is, to live at 90% of your means) which includes pension income, social security, and estimated long-term investment returns. Then you don't have to worry about your life expectancy: if you always save 10% of your income you are by definition always living within your means and you will never run out of money.

True, you could end up spending all of your savings for a catastrophic medical expenses. But in that unlikely event, you will be much better off having saved 10% of your income after retirement than you would be trying to spend down to your life expectancy as a primary investment guide.

Of course there is a selection bias in determining which people hire financial advisors. These people generally have been living within their means and saving the surplus their whole lives. For them, the prospect of saving 10% is more comforting than challenging.

If you are going to worry about returns, make it your tax return! Generally the 'safe withdraw rate' calculated by expert financial analysts today ranges from 3.5% to 4.5% of your investment portfolio annually (depending on inflation and longevity assumptions). For real people, however, the source of the funds is much more critical as this determines how much you will pay in taxes.

After-tax cash savings are obviously preferable to withdrawals from a qualified retirement account and impacts your withdrawal rate significantly. Individuals in their early 60's would likely* have to withdraw $15,000 from an IRA to end up with $10,000 in after-tax dollars to spend. Withdrawals from a Roth IRA aren't taxable, but are generally less advantageous than using after-tax savings because investments inside a Roth compound tax free. Taking capital gains results in 50% less tax than a stream of income from an ordinary annuity with the same basis. Selling high-risk assets with uncertain marketability in an over-leveraged portfolio may be more advisable than blindly taking a 4% withdrawal from ready cash.

These issues are dependent on 'asset location,' which determines how investments are structured to be tax efficient. Clearly this is an endogenous consideration when determining withdrawal rates. The composition of assets is different for everyone.

“Are you leavin’ on a jet plane…?” Finally, hiring a great money manager who develops charts, graphs, and long lists of numbers to demonstrate their investment prowess doesn't recognize the really significant issues you face.

Look at the risk in your portfolio this way. If you are flying from New York to Los Angeles, you could hire a fighter pilot who can demonstrate how fast the jet flies, how quickly he or she can maneuver, their skills are in steeply ascending and descending, and that their record flight is 4.25 hours. However, you also have the option to travel with a trained airline pilot who avoids bad weather systems, knows how to handle the jet streams, and is more concerned about the comfort and safety of your flight. Be aware that the airline pilot will estimate your time of arrival as 5.15 hours, but pads the schedule because the trip usually only takes 4.45 hours. If you can “fly comfortably” by withdrawing dollars from a lower risk portfolio during retirement, doesn’t it make sense to do? Doesn’t a safe withdrawal rate depend in part on having a safe level of risk in your portfolio that is appropriate for you and you alone?

Real people need to evaluate the factors that they can control when considering the optimal safe withdrawal rate. Forget the academic studies and historical reconstructions and pay attention to the factors that really affect your future by living within your means, staying attuned to taxes, and investing with appropriate risk.

*Assumes IRA withdrawals are subject to 28% federal plus 5% state taxes.
Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.