You Can’t Hide In Fixed Income

Investing timidly may shield you against risk ... but not against inflation.

When is being risk-averse too risky for the sake of your retirement?  After you conclude your career or sell your company, you have a right to be financially cautious.  At the same time, you can risk being a little too cautious - some retirees invest so timidly that their portfolios barely yield any return.

For years, financial institutions pitched CDs, money market funds and interest checking accounts as risk-devoid places to put your dollars.  That sounded good when interest rates were tangible. As the benchmark interest rate is now negligible, these conservative options offer minimal potential to grow your money.

America saw 3.0% inflation in 2011; the annualized inflation rate was down to 2.7% in March. Today, the yield on many CDs, money market funds and interest checking accounts can’t even keep up with that.  Moreover, the Consumer Price Index doesn’t tell the whole story of inflation pressures – retail gasoline prices rose 9.9% during 2011, for example.1,2

With the federal funds rate at 0%-0.25%, a short-term CD might earn 0.5% interest today.  On average, those who put money in long-term CDs at the end of 2007 (the start of the Great Recession) saw the income off those CDs dwindle by two-thirds by the end of 2011.3

Retirees shouldn’t give up on growth investing.  In the 1990s and 2000s, the common philosophy was to invest for growth in your thirties and forties and then focus on wealth preservation as you neared retirement.  (Of course, another common belief back then was that you could pencil in stock market gains of 10% per year.)

After the stock market malaise of the 2000s, attitudes changed – out of necessity.  Many people in their fifties, sixties and seventies still need to accumulate wealth for retirement even as they need to withdraw retirement savings.

Because of that reality, many retirees can’t refrain from growth investing.  They need their portfolios to yield at least 3% and preferably much more.  If their portfolios bring home an inadequate yield, they risk losing purchasing power as consumer prices increase at a faster rate than their incomes.

Do you really want to live on yesterday’s money?  Could you live today on the income you earned in 2004 or 1996? You wouldn’t dare try, right?  Well, this is the essentially the dilemma many retirees find themselves in: they realize that a) their CDs and money market accounts are yielding almost nothing, b) they are withdrawing more than they are earning, c) their retirement fund is shrinking, d) they must live on less.

In recent U.S. history, inflation has averaged 2-4%.  What if that holds true for the next 20 years?4

For the sake of argument, let’s say that consumer prices rise 4% annually for the next 20 years.  That doesn’t sound so bad – you can probably live with that.  Or can you? 

At 4% inflation for 20 years, today’s dollar will be worth 44 cents in 2032.  Today’s $1,000 king or queen bed will cost about $2,200 in 2032.  Today’s $23,000 sedan will run more than $50,000.4

Beyond prices for durable goods, think of the cost of health care.  Think of the income taxes you pay.  When you add those factors into the mix, growth investing looks absolutely essential.  There is certainly a role for fixed income investments in a diversified portfolio – you just don’t want to tilt your portfolio wholly away from risk.

Accepting some risk may lead to greater reward.  As many equities can potentially achieve greater returns than fixed income investments, they may prove less vulnerable to inflation.  This is especially worth remembering given the history of the CPI and how jumps in the inflation rate come without much warning.

From 1900-1970, inflation averaged about 2.5% in America.  Starting in 1970, the annualized inflation rate began spiking toward 6% and by 1979 it was at 13.3%; it didn’t moderate until 1982, when it fell to 3.8%.  U.S. consumer prices rose by an average of 7.4% annually in the 1970s and 5.1% annually in the 1980s compared to 2.2% in the 1950s and 2.5% in the 1960s.4,5

All this should tell you one thing: you can’t hide in fixed income.  Inflation has a powerful cumulative affect no matter how conservatively or aggressively you invest – so you might as well strive to keep pace with it or outpace it altogether.

The Latest on Social Security

Benefits increase for 2012. Ideas for reform are numerous.

Social Security gets its first COLA since 2009.  As moderate inflation has made a comeback, the federal government has decided to boost Social Security benefits by 3.6% for 2012.  This means an average increase of $39 per month for 55 million Social Security recipients ($467 for all of 2012).  Also, more than 8 million Americans who get Supplemental Security Income will get $18 more per month ($216 for 2012).1

There are two things to note in the fine print.

·         A COLA increase in Social Security means that Medicare premiums can also increase.  Much of the 2012 COLA adjustment could effectively be eaten up this way, as Medicare premiums are automatically deducted from Social Security checks.  (2012 Medicare Part B premiums should be announced before the end of October.)1,2

·         Businesses should note that the Social Security wage base will rise to $110,100 for 2012.  Currently, the federal government levies payroll tax on the first $106,800 of income; next year, that ceiling rises by $3,300.  This means about 10 million more high-earning Americans will be subject to the payroll tax, which could vary anywhere from 3.1% to 6.2% in 2012 depending on legislative action (or inaction).1,2

Will the “super committee” of 12 make cuts to the program?  It’s uncertain; the deadline for the long-term budget reform plan from Congress falls on November 23, and the bipartisan and Joint Select Committee on Deficit Reduction (a.k.a. the “supercommittee”) has been meeting more or less in secret, with AARP and other lobbyists pressuring them not to cut Social Security and Medicare.5

How might Social Security address its long-term shortfall? Proposals abound, from simple fixes to radical reforms. ·         President Obama’s fiscal commission has suggested raising the FICA cap.  In this proposal, the payroll tax cap would gradually increase between now and 2050 so that 90% of wages earned in America would be subject to Social Security tax by the middle of the century.  (This is how it used to be.)  Under this plan, the taxable maximum would be $190,000 by 2020.2

·         Rep. Paul Ryan (R-WI), Chair of the House Budget Committee, has authored the GOP’s “Path to Prosperity” plan, the so-called “Ryan roadmap” that would encourage workers under age 55 to direct some of their payroll taxes into personal retirement accounts.  Rep. Ryan’s proposal would also index initial Social Security benefits for most retirees to price growth instead of average wage growth and set the age for Social Security eligibility at 67.3,4,5

·         The conservative Heritage Foundation suggests a 5-year strategy in its Saving the American Dream proposal, which calls a reduction in Social Security benefits for the richest 9% of retirees, a $10,000 tax exemption for all who work past the federal retirement age, and the near-term elimination of taxation of Social Security income.6

·         Republican presidential candidate Herman Cain has proposed replacing Social Security with the “Chilean model”.  In the early 1980s, Chile’s government ended its retirement entitlement program and put retirement planning solely in the hands of individuals, who maintain personal retirement investment accounts and set their own contribution levels and retirement dates.  Investor’s Business Daily notes that on average, the program has yielded better than 9.2% compounded annual returns over 30 years.7

·         Twelve fixes were suggested in a 2010 report issued by the U.S. Senate Special Committee on Aging, among them:

o   A 3% cut in benefits

o   Taking the payroll tax to 7.3%

o   Hiking the full retirement age to 68 or older

o   Increasing the Social Security averaging period that determines SSI

o   Reducing the typical yearly COLA by 1% or .5%

o   Reducing spousal benefits

o   Investing some of Social Security’s trust funds in equities

o   Directing some estate tax revenues into Social Security’s trust fund

Perhaps a fix lies somewhere within these proposals; unmodified or altered, alone or in combination.

How much retirement income do you have these days?  With Social Security’s future still a question mark, you may be thinking about where your retirement income will come from in the years ahead.  If you would like to discuss this further, it may be worthwhile before 2012 arrives.  We always look forward to serving you.


1 - [10/19/11] 

2 - [10/19/11]    

3 - [10/21/11]               

4 - [9/26/11]

5 - [10/21/10]            

6 - [10/21/11]   

7 - [10/12/11]            

8 - [5/18/10]  

LTC Cost Increases Pummel Both Insurers and the Insured

Here’s why, and what it means for you

MetLife, which has been selling long-term care insurance for 25 years, announced that it would no longer sell LTC policies after 2010. The decision does not affect current policyholders.

Meanwhile, John Hancock has announced price increases of 40% for many of its existing LTC policies.  (Affected policyholders will be notified over the next two years when their increases will occur.)

The turmoil is caused by the fact that long-term care is a relatively new aspect of society, and the

insurance industry is discovering that selling policies profitably is much more challenging than it expected.

To understand why, first understand that today’s sellers of long-term care insurance began by selling life insurance — and they’ve been doing that for hundreds of years. The industry has literally centuries of data telling it how many people can be expected to die in a given year, what the ages of those people are likely to be, and how likely it is for someone who buys insurance to actually retain that policy until they die (thus requiring insurers to pay the death benefit).

That last statistic, known as the persistency rate, plays a huge role in helping insurers determine what to charge for life insurance policies. Obviously, if you cancel a policy before you die, the insurance company gets to keep all the premiums you paid over the years without ever having to pay out benefits. This helps insurers keep prices lower for the people who keep their policies until death, while helping the insurance companies earn a profit. (And as much as we all love to hate insurance companies, the truth is that we must allow them to earn a profit; otherwise, they won’t offer insurance at all.)

Unfortunately for insurance companies, they don’t have centuries of data about long-term care. Not only have they underestimated how quickly costs would rise, forcing them to pay more than they expected when claims are submitted, they wildly underestimated the persistency rates. While as many as 95% of life insurance buyers cancel their policies before they die, most LTC policy holders never drop their coverage. As a result, insurance companies are paying far more in LTC benefits than they predicted. Combine all that with low interest rates, which make it difficult for insurance companies to profitably invest premiums, and it’s easy to see why many insurers are raising rates while others are simply quitting the business altogether.

So what does all this mean for you?

It means you need long-term care insurance even more than you thought you did. The experience of the insurance companies is clearly demonstrating that far more people are incurring LTC expenses than anyone predicted, and that means you can expect to incur the costs as well. That means your choice is to pay for the cost yourself or buy a policy so the insurer will pay for it. If you already have a long-term care policy, you need to keep it. If the premium rises, you need to pay it.

Do not cancel the policy or select an option that decreases your benefits instead of increasing the cost.

And if you don’t yet own an LTC policy, I urge you to consider buying one before they quit offering them. And don’t fret about price increases: While the premiums may increase, the cost will be a fraction of what you’d pay for care on your own. And buy it sooner than later, because the cost is based on your age at the time you purchase it (the younger you are, the cheaper it is annually). Also, as you get older you’re likely to develop a health condition that will prevent you from qualifying for a policy.