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An Investors View of Social Security

March 8th, 2010 No comments

There is quite a lot of controversy and politics concerning Social Security. In this post, I take on some issues concerning Social Security (SS) with a balanced take and from an investor point of view.

Myth or Truth: Is SS an Investment?

The supporters of SS generally claim that the program is an insurance policy and not an investment. Critics would generally agree it’s not an investment. Therefore, participants should not expect a ‘return on investment’ in the same way one would on a stock/bond portfolio or even a savings account. The structure of the program suggests that it in fact has components of an investment when it concerns the determination and funding of the retirement benefits.

Here’s how it works, with an indicator to each point as to whether or not it qualifies as an investment:

  1. You earn credits each year that eventually count towards your retirement benefit. These credits are based upon your earnings, not your taxes paid. So, increases in the payroll tax rate that have occurred do not offer a higher benefit because it’s not based upon a direct link to taxes paid. (Investors normally like to calculate an investment return based upon actual money contributed). Not an investment.
  2. To determine your initial retirement benefit, your historical earnings are brought forward using the historical growth rate of average wages. Wages tend to increase faster than inflation so this calculation offers a real rate of return. It’s an investment.
  3. Once in retirement, your benefit level increases each year at the inflation rate. This is unique, nearly all investments do not have this feature.
  4. An investment has a few basic features, including an asset value that can be measured and a legal right to ownership by the holder. SS benefits do not have an asset value and citizens do not have any legal ownership to an asset or benefits for that matter. Not an investment.

Myth or Truth: Is the SS Trust Fund Real?

Payroll taxes collected are immediately used to pay benefits for current retirees. For the past 25 years or more, the payroll taxes collected have been greater than benefits paid. This surplus has been invested in a Trust Fund that contains special issue Treasury Bonds that SS can use to pay for future benefits. Supporters of SS point out that the trust fund contains real assets that can be used to pay future benefits. Detractors note that the Trust Fund is a fiction because its claim against the Treasury is simply the money it owes itself, which does nothing to insure future benefits. Who is right?

It depends upon your point of view.

All sorts of people and institutions all over the world lend the U.S Treasury money. If you believe that lending the U.S. government is a worthwhile investment (meaning that they can spend the money efficiently to create future economic growth and opportunities), then the money that is lent through the Trust Fund could improve the ability to pay future SS benefits by higher taxes collected from future economic growth. If you do not believe that this a worthwhile investment, then you likely believe that this spending won’t improve future growth and therefore the Trust Fund may seem like a fiction.

Regardless of where you come across on this question, it is more important to realize that the existence of the Trust Fund (whether real or fictional) does not tie directly to your benefits. Congress can decide to change benefit levels independent of the Trust Fund; its existence does not insure your benefits. Far more important is the near and long term expected cash flow of the U.S Treasury.

Myth or Truth: Will You Get SS Benefits At All?

Most people can probably agree that it is unlikely you won’t get any benefit. The program is too large and has a large enough of a support base that would prevent the program from being dismantled.

The real question is how much will you pay in taxes during your working years and how much will future retirement benefits be reduced. Getting any benefit does not mean it will be a benefit at the same level of past generations. It is safe to say that taxes will likely go up and benefits will be reduced in the future to bring the system into balance.

A very rough estimate for SS retirement benefits for middle income workers is to multiply your income from your final working years by .25. This means that you will likely get about 25% of your working income in retirement benefits. There are rules that can further reduce your benefits (e.g., if you work prior to normal retirement age your benefits can be reduced).

It is prudent to add in a margin of safety to your expected benefits, depending on how far in the future you expect to get benefits. People who are perhaps less than 10 years away from retirement age will likely get their expected benefits in full. If you have more than 10 years to go, I would apply a discount of 25% or more.

What to do with your Cash Balance Account

March 6th, 2010 No comments

Do you have a Cash Balance Account (CBA)? A CBA is an account hybrid between a pension and a tax deferred savings account. Most employers today do not offer traditional pensions anymore they offer some version of a tax deferred contribution account (401K, SEP IRA, Roth 401K, and others).

About 10 years ago, I left an employer who previously had offered both a traditional pension as well as a 401K account. The creation of the CBA enabled the employer to hand off the pension obligation to me.

There are some upsides and downside to this kind of arrangement depending on your point of view.

  • First, it moves the management of the pension risk from the employer to the employee (not unlike a 401K).
  • The CBA severs the pension obligation from the balance sheet of the employer. So, the pension is not tied to the future success of the employer the way many traditional pensions are because it is funded independently in a separate account.
  • The CBA offers the opportunity for the employee to roll the money over to an IRA providing additional investing opportunities.
  • The CBA provides more transparency about pension value and the investment rate of return.

If you have one of these accounts these are some of your options.

Do Nothing

The CBA can be left in the original account that was setup with the employer. Over the past 10 years this has been a good strategy for me because it has earned a fixed positive return that has performed better than other retirement accounts I have. Even when retirement starts the money can still stay there and I can start to draw a pension from it without moving it.

Roll Over to an IRA

Because the CBA has a cash value, it can be rolled over to an IRA, either one you already have or in a new account. Whenever you roll over an account be cautious about how this is done. What you want to do is have the administrator cut the check to the new IRA and not to you. This will prevent the rollover from being viewed as an early distribution from the IRS. (If this does happen, it can be fixed, but it is an unnecessary hassle).

Roll Over to a 401(k)

It may be possible to roll the money over to an existing account (401(k), SEP IRA, etc.) that you have with your employer. Check with your account administrator as to whether or not they will accept the rollover. In general this option may not offer the range of investment opportunities that a roll over to an IRA would.

Draw from the CSA

If you decide to retire early, or even if you don’t, you can start drawing a pension at anytime (it does still keep the benefits of a pension account) . There is an advantage here over an IRA, which are not by default setup to draw a pension (particularly for early retirement). You can do the same thing in an IRA but you need to file paperwork to do this – I will cover this option in a future article.

The downside to this option is that you need to keep the money in the CSA, which will typically offer a lower return on investment than other options you would have in an IRA (stocks, bonds).

Why Cash is a Poor Investment

February 28th, 2010 No comments

In these turbulent financial times, cash has become a safe haven. However, over the long term cash is not a good investment.

What is Cash?

When we think of cash, we normally think of the physical currency (bills and coins) that we use daily. From the U.S. Government point of view, a more accurate term to use is not cash but money supply. Only a fraction of the money supply is represented by physical currency. Just think of your house: when you bought it or sold it there wasn’t a barrel full of cash exchanged, it was represented by blips on a computer screen account or on a paper contract. The money supply represents the sum of all the money in circulation as well as the money represented as deposits in banks and credit unions.

It’s Not Absolute

One of the first things that I learned about cash when I started investing is that cash is not an absolute measure of anything. We tend to think of cash as a steady barometer that tells us the relative valuation of things. For example, if you search for furniture at multiple stores one of the ways to determine the relative valuation is to compare the cost in dollars; the dollar is used as one means to compare value.

Over the short term cash is a good method of valuing things. Over the long term, the value of currency and money supply are constantly changing making valuation harder to predict.

In financial markets, the value of cash (or the dollar) is itself subject to relative valuation by other things, most notably other currencies. If you travel overseas, you have probably seen that the cost of goods and services is impacted by the conversion rate of dollars to other currencies.

Also, within the U.S., the Federal Reserve manipulates the money supply periodically based upon economic policy goals. Right now, the Federal Reserve is increasing the money supply to spur economic growth since this will lower the cost of borrowing by banks. Over time, the money supply generally increases faster than economic growth causing inflation. This reduces the buying power of your cash.

How Cash Makes Money

If you deposit money at a bank, you earn interest. The way that the bank or credit union earns money on your deposits in money market funds is by lending your deposits out to credit worthy businesses for short terms, typically less than one year. This type of credit is very safe relative to other types of lending since loans made out for short term periods to credit worthy borrowers rarely default.

Since the money supply is not tied to anything, the interest rate is largely determined by Federal Reserve policy and not any real economic asset. So, if you look at the interest you could earn on money market funds over the last 10 years, it would have looked something like this:

  • 2000: 6.2%
  • 2002: 1.7%
  • 2006: 5.0%
  • 2008: 3.0%
  • 2009: 2.5%

If you needed that interest to pay your bills, this would turn out to be a poor investment since the rate of return is unpredictable.

The Perfect Absolute Asset

If cash is devalued over time due to inflation, is there a better place to put it that is safe and has the intrinsic value of a real asset?

Before currency existed people used hard assets such as gold and silver as cash. Even today, you will see some financial analysts recommend that you keep some portion of your portfolio in gold or silver. Because gold is a ‘real’ tangible asset that you can touch, it is uncomplicated compared to other assets like stocks and bonds and always has intrinsic value unlike the currencies of many nations of the past. But even gold is not perfect since its price changes due to supply/demand by commercial and consumer use. Also, like anything else that can be traded easily in a marketplace is can be overbought and oversold due to speculation just like other assets.

Another option is to put your cash in special U.S. Treasury bonds called TIPS which provide protection against inflation. You may not earn much on these but at least you can be assured that inflation won’t devalue your cash.

Why Invest in Public Stocks/Bonds?

February 26th, 2010 No comments

In a previous post, Investing Basics, it was discussed what investments are and how they should be valued. When talking about investments in personal finance, what this usually means is investments that are publicly available. What ‘publicly available’ means:

  1. The investment is offered to the general public. It is possible to buy private stocks and bonds  but they are not available to the general public.
  2. Registration with the Securities and Exchange Commission (SEC) an agency of the U.S. Federal Government. The company must abide by some rules for communicating information. This includes documents such as quarterly reporting and annual reports.
  3. The investment was offered for sale through a public offering. Sometimes this can be a spinoff of an existing company or typically a new offering where a portion of the company is sold.
  4. The investment is available to buy through a network of brokerages using standardized mechanisms to name them, trade them and transfer them.

There are great businesses that never go to the public markets as well as horrible ones that make it to the public stock markets. However, there are a lot of advantages to buying public investments. These advantages primarily can be categorized as ‘soft criteria’ because they do not refer to the financial or fundamental aspects of the business, but facilitate in increasing confidence and ease of transacting.

Here are some of the advantages which can be categorized as ‘soft criteria’.

Transparency

When a company or other investment vehicle registers to become a public company, it must open up its books for regulators and investors. This information includes all its financial information, its near term outlook and usually an assessment of the risks that are inherent in its business and future prospects. Additionally, the financial statements must be audited by an accredited third party auditor.

These documents are available for viewing at the SEC as well as at the website of the business (for a stock) or investment company (perhaps if it’s a bond).

Maturity

Businesses that you would want to invest in (excluding very small companies on small exchanges) have some level of maturity as a private company before they go public. A track record of success as a private company can lead to demands by investors and others to go public.

Liquidity

A listing on the public markets provides liquidity, which means the ability to trade the investment easily and efficiently based upon a frequently updated fair assessment of its value by the marketplace. If, e.g., you owned an oil well, this investment is less liquid because the marketplace for it is smaller and it may be difficult to accurately assess its value over the short term.

The lack of liquidity in the credit markets has increased costs and prevents financial institutions from conducting their normal business activities (even if that activity is sound and credit worthy).

Sustainable Business Model

As an investor, one of your goals is to make money year after year. Public investments will have  sustainable business models that has been proven as a private company as well as when the company is public. There needs to be some business advantage that enables sustainabilty, this could be a unique technology, providing a better quality product, or providing a useful service in an efficient manner.

And, Most Importantly, Earnings

A developing business usually doesn’t earn a profit in the beginning because it is consuming all of its capital and revenues on building the business. It is during the early phases of the business where the risks are highest. Its business model may not be sustainable or viable, or it may not be able to find the right market, or earn a decent return on its invested capital.

Fortunately, investments that in the public markets will already have earnings (or I should say, the ones that you want to invest in)  so these risks are reduced. This doesn’t mean that every company will succeed or earn money all the time of course (some fail), but the fact that the business made it to the public market indicates a higher potential to sustainably earn money.

Categories: Investing Tags: ,

You Don’t Need to Invest In Stocks

February 20th, 2010 No comments

One of the first posts on the site was this one, which talked about the definition of an investment. There are many different things you can invest in, in addition to stocks. The criteria you should use to determine your investments should be based upon how well they fit your financial plan goals, or in some cases no goals (I sometimes invest in things that may be speculative or just for fun). You may not need or want to invest in stocks. Here are some considerations as well as a case study that demonstrates one option to a typical stock portfolio.
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