At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 03.09.05

Acting Against Type

The jobs report wasn't an hour old before a reader wrote me pointing out just how wrong my 100,000 job creation prediction had been. The actual report showed an increase of 262,000, well above the "popular" consensus of 225,000. While that seemed like good news, the number hides some basic weakness in the job markets that will eventually need to be vetted.

I'm not so sure that the number released on Friday is the final number. In fact, I expect it to be revised downward rather than in the opposite direction. Employment is still lagging behind the number of new workers that enter the markets each month. It still does not account for disparaged workers. And it still isn't forcing employers to hire more workers, a costly undertaking that is being impeded by a continued rise in health care costs and pensions.

Employers and fixed income investors were happy that wages remain stagnant and inflation looks to be tame. Those two pieces of news assures a steady increase in short term interest rates. Without any sudden jolts forward by the Federal Reserve Board, bond investors can relax. Or should I say, some of them can relax.

Bond investors who believed that short term interest rates were rising as a defensive move against inflation, moving money into Treasury Inflation Protected Securities or TIPS have not be rewarded for their prediction. A tame inflation picture has not had the desired effect on long term rates, creating that Greenspan conundrum. Bond fund managers are especially worried that comparable benchmarks will be difficult to meet if these long bonds don't have a significant increase in yield. Expected to be above 5%, the 30 year bond has not performed as expected pushing these managers to be right on in not only direction, but timing. TIPS have remained flat.

It is important to remember that prices move in the opposite direction to yield. If yields move up, as is anticipated, prices will fall making municipal bonds and TIPS more attractive as the curve moves away from flat. Conundrums aside, patience may be all a fixed income investor for the long term may need.

At Arm's Length: 03.07.05

Seeing Investors in the Absence of Saving

The Investment Company Institute, the mutual fund lobby group conducted a survey last year concerning the state of the Individual Retirement Account or IRA. Created in 1974 as a way to supplement company sponsored pension plans, these plans have grown in size and popularity. Since they were first offered, the program has become the main vehicle for retirement savings for over 40% of the households in this country.

According to the ICI, over $3 trillion is currently invested in IRAs, either traditional or Roth. Both plans are tax deferred. The Roth is made with deposits that have already been taxed and the growth is taxed at retirement; traditional IRAs are tax deductible with the entire amount locked away until age 59 1/2. Both plans assume that the taxable income at retirement will be less.

The surveyors, who looked at 3000 households, found that over two-thirds of those holding IRAs invest in mutual funds with the remaining investments divided somewhat evenly between individual stocks, annuities, and bank deposits.

This plan became essential for employees as companies jettisoned their traditional defined benefit programs in favor of defined contribution plans, the later being self-directed by the employee.

Almost half of those surveyed created traditional IRA plans as a result of a rollover. A rollover can result in a job change, termination or layoff. 70% of the respondents told the ICI that a rollover was the main reason for the plan change. A third responded that they opened the plan because of retirement.

The ICI also discovered in its survey that the median savings in these retirement accounts amounted to $24,000. These plans are preferred by older workers.

So what is the President, the Congress, and Mr. Greenspan missing? Plenty if you look at those numbers.

For openers, the amount of money saved is a mere pittance of the sum needed to retire. If Mr. Bush is allowed to alter Social Security to include private accounts, an idea that might stand alone as a national 401(k) but attached to reform of the most trusted entitlement contract with America, it would fail. Worse, he would still be faced with the same problem. We have created a nation of spenders, not savers and that is not improving. Nor does his proposal automatically solve the problem.

Congress seems to be interested in tax reform more than changing Social Security. When the Fed chairman testified before the House Budget Committee, he offered a suggestion that caught their attention - much the way his side-of-the-mouth endorsement of the President's tax cuts did four years ago.

Greenspan's blessing for the tax cuts of 2001 was meant to be accompanied by a balanced attempt at curtailing spending in order to pay for the lost revenue. Greenspan thought it was a good idea, giving the nod to the President and his policies even as he continued to amass huge deficits. His endorsement of the plan became an endowment plan for the highest tax bracket.

Greenspan has, unfortunately, done it again. The nation's top economist believes that tax reform using consumption tax on spending along with no tax on saving and investments will create a nation of savers where there is none now. By doing so, Mr. Greenspan told the legislators that the possibility of economic stagnation will be avoided.

The chairman knows that to achieve any change in the tax code would create new burdens across the lower half of the tax paying demographic, a group that has historically paid less, if at all. He is apparently okay with this. He also ignored the evidence that this group tends to spend in excess of 93% of their income just to survive, a percentage that decreases as we move up the economic food chain. That spending would be taxed creating a payment that was not previously paid.

Several things need to be taken into consideration long before any changes to the tax code are made. The current savings rate in this country is now 0.1%. Add to that the stagnation of wages and enabling effect of inexpensive money have been detrimental to the saver.

William Gale of the Brookings Institution sees the problem as circular. The lender and the borrower would find themselves in a tax deductible situation that, if tax deductions on interest and taxes on income were eliminated, both parties would walk away without owing a dime. Changes in the tax code that protect both income and the deductibility of interest payments would not force the government into fiscal responsibility any more than it would make the change revenue neutral. The burden of creating tax revenue would simply be shifted to the lower wage workers.

Mr. Greenspan sees other possible effects in his cautious outlook. Workers, he believes, would become more productive because they would want to become shareholders. Capital gains would be considered wealth and this, by default would raise incomes. Unless companies offer shares as part of an new incentive plan, there is little likelihood, these bottom of the income ladder workers would be able to find money to purchase equities because of a new tax advantage.

There is also little evidence that this can happen mid-stream. Mr., Greenspan's idea is a "start from scratch" scenario that would anger realtors and the construction industry, huge lobbying groups who depend on those mortgage deductions to ensure a profitable existence.

Which according to some, is the problem with any tax reform. Special interests would suffer. That home interest deduction, these groups claim, is almost as politically unpopular as trying to change Social Security has turned out to be. Historic entitlements are difficult to eliminate.

The interrelationship between tax reform and Social Security reform is beginning to become more clear to those debating the financial costs of these proposals. Our current deficit looms at $412 billion. Making the 2001 tax cuts permanent - none of which have been proven to stimulate the economy the way they we were told they would - will cost $1.8 trillion over the next ten years. Social Security reform, a plan that so far has been only spoken about and dutifully polled as hugely unpopular - to every one except the President and his band of merry travelers on a 60 day crusade across America - would cost an estimated $1.4 trillion.

Backed into a corner, Mr. Greenspan had only one choice. He needed to support the President even if his ideas are wrong for everyone but the highest tax bracket. He did so mumbling some vague prediction about a fiscal crisis developing on the economic horizon, a vision Congress has largely been unable to see.

While polls, as Karl Rove asserts are not for leaders, surveys such as the one conducted by the ICI are telling in their simplicity. Left to our own devices, we can't save enough to give us long range economic security.

Unfortunately, we continue to count on the myopia of foreign investors. They will not ignore the warning signs for much longer. They are bound to show reluctance to fund Mr. Bush's legacy plans forever. It will be a decision down with a clear conscience and even clearer vision.

The previous week's articles.

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