Green shoots and leaves? Or a false spring?

July 14, 2009 at 6:09 pm | Posted in economics, recession, saving | Leave a comment
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The economy is in recession partly because the consumer is fearful.  The consumer is afraid of the high level of debt as well as of falling networth (retirement, real / investment asset prices) and also afraid of job loss. The correct private response to these fears is to cut back spending to deleverage, boost assets/networth by fresh savings / investment and to build a short term savings buffer as unemployment self-insurance. The means of doing this is by cutting back on discretionary spending to generate or increase a cash flow surplus, and put that to work to achieve these private objectives. However, given that private debt is such a large part of income, it will take a long time to realign.

Suppose someone wants to build an additional savings buffer of 6-months of must-spend expenses… pretty reasonable, I’d say, and not something that would fundamentally improve their balance sheet, so they really need to do more… Take an average family with $50k household income. Given that they are probably taking home about 80% of their pay ($40k) after taxes, and spending about 95%+ of their take home, and assume that 75% of their expenses are non-discretionary ($30k), they would need to save $15k to achieve that 6-month goal. Since only 20-25% of their spending is discretionary, even if they cut that to zero (highly unrealistic) it would take 18 months to achieve this objective. Clearly, then, spending alone is not enough. But right now, raising incomes to meet this goal is just as unrealistic, on average!

This $15k savings goal for an average family translates to $1.7 trillion for all US households – $1.7 trillion of reduced consumer spending. I think the true savings goal to restore private fiscal health is way greater than this.  So the stimulus is not enough. No way. Not even close.

The public impact of the collective private actions is this: Everyone is cutting back, and is willing to work longer hours / grow productivity just to keep their job. People are even willing to take pay cuts to avoid layoffs ( you kept the job, but your nominal debt is the same, real debt has increased because nominal and real wages went down). As a collective, that sucks because the economy needs to deleverage even more with a lower income base to do it – debt to income just went up a notch. That means demand for discretionary goods and services is way down, will stay down for a long time, and, when it begins to recover, the incremental demand will be met for a long time from existing employment, so this will be a jobless recovery when it recovers. In the meantime, note that the growth in unemployment is only about 5-6% points so far i.e. unemployment has not risen fast enough to account for higher productivity and the lower demand that has occurred and will continue to impact the economy. This means there is a lot of “dry powder” left in productivity gains for when the recovery does happen.

The economy is 65% consumer, and the rest is enterprise spending to create capacity to meet consumer demand. A lot of export markets are in worse shape than the US.

I think this is a false spring. We may not drop back into the depths of winter, but the real spring lies on the other side of a few bad cold spells – enough to wither the green shoots.

Stay cautious. Stay pessimistic.


Retirement planners overestimate returns

September 16, 2008 at 9:56 am | Posted in retirement, saving, Uncategorized | Leave a comment
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I think there is a risk that retirement advice tends to underestimate what we need in retirement, and how to get there. In particular, I think there is a tendency to be too optimistic about the long-term returns on our investments, and thus save too little. And I think the main problem is that they use an inherently risky assumption about how much our investments can earn to forecast our savings goals, which I think should be fundamentally low-risk. I don’t want the risk that I do all I set out to do to be able to retire comfortably, but fall far short. It is ok to fall short of stretch goals, or luxury, but I must ensure that the necessities are taken of, and there isn’t much risk that my nest egg falls short of that basic level.

So here’s how I would aim for a risk-free retirement.

The risk free rate in the US is basically the 10-year treasury, which currently returns 3.4%, but lets assume it is 4% over the next few decades (If it averages too much more, we are all in trouble on the economy). A look at the markets today basically tells us that anything above this is risky – either there is some default risk (mortgages are just one example, there are plenty of others) or there is uncertainty of returns (the equity markets) or something else.

This is not surprising at all – If any investment, equity, or otherwise, returned a 8% return with the same risk as a US government treasury, the market would sell out of US treasuries and buy that investment – whether it is an S&P 500 index fund or the Orange County, CA residential REIT or Vallejo, CA muni bonds or a silver fund or whatever it may be. In the process, the two returns would begin to converge. In practice they don’t. So the market is telling us that this alternative investment or basket of investments (lets call it X) are riskier than treasuries – risky enough that the market demands a 4% higher return than treasuries.

Now – I want to have a nearly 100% chance of not running out money. Maybe that means 90% for some, 99% for others. But its not 50%. That means that whatever my target retirement date is – 25 or 30 years from now – I want to be just about sure that I have saved the amount I needed to save (more on how much that is later).

Say I want to save $1 million at the very least – 99%+ sure… I could buy US treasuries, or some other “safe” asset. If I assume a 4% return, I can figure out how much I need to save over a 40 year career to get to $1 million – $7560 in year 1, growing at 2% a year. But lets say I actually invest in equities, which have a higher potential. And to put that in context, if the family is making $75000 a year, you need to save just 10% of your income to make it to that $1 million  mark.

If I actually get an 8% compound return, when I was planning for 4%, I have $2.5 million in the bank when I retire. Wow! What a windfall! Maybe I retire early. Maybe I travel a lot or buy a vacation home somewhere. I can live up the good life. But if I really got 4% (remember, that is all that is considered risk free, anything above that – well, lets hope for it, but lets not depend on it), I have $1 million. With whatever is left of social security or other sources, I have enough to pay the bills, and pay for all my medications and maybe assisted living at the end of my life, and a nice vacation every now and then.

So if I assume a 4% return, I end up with something between a comfortable retirement and a luxurious, windfall retirement.

What if I assumed an 8% return like the financial planner suggested? My financial planner would tell me to save $3000 a year instead to get to $1 million. Easier? Yes, so this is what I want to hear – $3000 does it, why bother with $7500??

But – If I do get an 8% return, I have a comfortable retirement. What if I only got 4%? That is equal to the risk free rate, but remember, the market returns could be lower than the risk free rate – just not very likely over a 40 year period. Well, if I got 4%, my nest egg would be only $390,00! I’ll have to work longer, maybe my retirement travels would few and near home, and maybe I might have to think about which of my diabetes or cholesterol medication I could afford to skip this month!

The financial planner knows that saving $3000 is easier than saving $7500. She’d rather get the commission on the $3k than hope you agree to save $7.5k (rather than just go to another guy who tells you $3k is more than enough.

Don’t worry about your assets outliving you – if they do, it means you had fewer caramel lattes than you could have had, or ate out less often than you could afford. Assess the situation when you retire, and decide if you can now try the fancy French restaurant and the holiday cruises.

But if you outlive your assets, you had better have really nice kids with good jobs.

I’d rather plan for my nest egg to be a regular egg and end up with an ostrich egg, than plan for it to be a regular egg and pray it doesn’t end up being a pigeon egg! Its hard to save more, but the next time a planner says you can make 8%, just say, no thanks, lets plan with 4%.

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