This is a continuation of my previous entry on Social Security.
I have received some comments, via my blog, e-mail and also directly from those know me in real life, questioning whether the rationale expressed in my previous post holds even considering the massive 'baby boomer' retirement. Some wrote saying that the demographic tidal wave that contributed to the economic growth over the past few decades in the U.S. is now going to 'sink' into retirement, implying those who were propping up the U.S. economy over the past few decades will soon be in need of being propped up themselves.
This point appears powerful at first glance, yet it does not seem to hold up to a basic analysis of current data. The millions of baby boomers who are set to retire from this year on out till early 2020s, are not going to drop off the map. Let's examine this from investing and consumption perspectives separately. If one agrees that a retiring boomer needs at least 60% of his/her pre-retirement income, a basic analysis shows that this money is not going to come from Social Security or personal savings. Let's examine the savings scene first.
Based on Federal Reserve statistics on net worth (2004 data), the situation is grim (median and mean data):
Under 35 years old = $14,200 ($73,500)
35-44 years old = $69,400 ($299,200)
45-54 years old = $144,700 ($542,700)
55-64 years old = $248,700 ($843,800)
65-74 years old = $190,100 ($690,900)
Over 75 years old = $163,100 ($528,100)
In analyzing data like the above table for the entire U.S. population, the median values are far more meaningful than the mean values, which inevitably skew up due to the high wealth disparity among every age group in the country. After all, U.S. is the country with the world's largest number of millionaires and billionaires. It is known that the top 10% of the U.S. is estimated to hold over 70% of the country's wealth and even across the world, the richest 2% hold half of all global wealth. So, let's forget the mean and focus on the median values.
About 50% of the people at or nearing retirement have a net worth below the $150-250K median range for the age groups from 45 till over 75. For the sake of simplicity, let's take the midpoint of this range ($200K) and consider, based on recent data, about 46% of this median net worth is in home equity. Taking this portion away (as housing is required even during retirement), the median investable net worth for this group is about $108K. When I plug this figure into an annuity calculator assuming a 6% moderate growth rate for a 30-year payout period, I get a fixed annual payout of $7,400 (not adjusted for inflation). An inflation-adjusted annuity may only start at about $5,200 a year (I got this for a 65-year old male using Vanguard's annuity calculator while making a few other assumptions).
The average personal income (2006 data from Social Security Administration adjusted for inflation till 2008) is about $41,000. Even if an average retiree needs only 60% of this pre-retirement income, the income needs during retirement are $24,600 on a post-tax basis for the first year, which will rise with inflation in subsequent years. The average beneficiary (May 2008 data from Social Security Administration) receives about $990 in monthly benefits or $11,880 in the first year of retirement. So, SSA benefits and the annuity payout (inflation-adjusted) yield about $17,000 in annual income. This still leaves a 30% shortfall compared to the $24,600 expense requirement and likely a 35-40% short-fall when you consider Medicare premiums (which will be deducted from the SSA payment) and maybe a 45% shortfall if one considers taxes (modest but still has some impact) at these income levels. The shortfall grows further if more than 60% of the pre-retirement income is required during retirement. Remember that all of this applies to the median case, so 50% of U.S. residents will fare even worse than this scenario.
What's the implication of all this? Even for the "median" baby boomer case, staying employed during his/her 60s and possibly into 70s is going to be required to maintain a reasonable standard of living. Guess what happens when the boomers continue to work till say, 70, instead of withdrawing from Social Security at 62 when become eligible? Those 8 years of extra employment generates 6.2% of taxes paid into the SSA system (~$2,500 of SS taxes at 2008 median income levels). This is a double-benefit for SSA. Instead of paying out benefits for 8 or more years, the system is now taking in taxes to shore up its fund. Even if some of the boomers opt for Social Security benefits in their 60s, they will need to supplement it with earned income as the median case example shows. Under current rules, every $2 of earned income reduces SS benefits by $1. All this can only mean that the SSA will have more to payout for those in the queue later.
Staying employed into their 60s and possibly into early 70s is the only option I can see for the current generation of 45+ year-olds with the median net worth figures cited above. So, contrary to being a strain, I see this as a strengthening of the Social Security system. I suspect this may be one reason why the trustees keep extending the year when the trust fund is expected to be fully depleted. I remember the first projection as 2030 about a decade ago, then they adjusted it to 2035, then 2038 and now they project 2041. I believe this will continue to be extended as people are forced to extend their employment horizons and delay taking their social security benefits.
Showing posts with label Perspectives. Show all posts
Showing posts with label Perspectives. Show all posts
Jul 17, 2008
Jul 14, 2008
Investment Risk & Market Timing
“O Fortuna! Like the moon everchanging, rising first, then declining.”
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
- Carmina Burana, lyrics from O Fortuna
Risk is a part of our everyday life. When we get out of bed in the morning, there is a risk that you may trip by stepping on something lying on the floor from the night before. If you stepped a few inches on either side, you may be okay. Would you call it a risk that you stepped on a soft piece of foam that literally gave you a ‘spring in your step’? You are off to work on what is normally a 30 minute commute. On some days, the inevitable traffic jam makes your commute an hour long or worse, you may be involved in an accident or mechanical repair that causes you to miss work that day. That is certainly a risk, but is arriving to work within 20 minutes (instead of the normal 30 minutes) a risk? You take a well-deserved vacation to Las Vegas where you wager $50 on blackjack. Your risk is that you might lose all or a portion of the $50. What if lady luck shined on you that day and you made a $50 profit, so you walked away with $100. Is that a risk?
What do the above examples have to do with investing? Well, quite a lot because they are in stark contrast to how the financial world measures risk. The financial world defines risk in terms of variance (or standard deviation) from an “expected” return. If a broad equity index like S&P 500 is expected to return 8% a year with a standard deviation of 14%, that means, roughly two-thirds of the time, the annual return will fall between -6% and 22% and you can be 95% confident that the returns in any given year will be between -20% and 36%. That variance is collectively called “risk” or “beta” in the parlance of finance professionals. Since the market itself is used as a benchmark, the market beta is, by definition, 1.0. Any given stock’s or a segment’s (like small-cap stocks) variance is measured similarly and its variance divided by the total market’s variance gives us a beta value for that stock or segment. For example, the historical beta of U.S. small-cap stocks is about 1.2, which means it is 20% more volatile than the S&P 500 index. So, if you thought the swings on the S&P 500 returns are wide enough to give us an upset stomach, a 1.2 beta implies that the swings on either side are 9.5% larger (recall that standard deviation is the square root of variance).
You and I as investors don’t experience risk as the financial world defines it, do we? The downside is the only risk for us, the upside is the reward. Any return above the “expected” return is a reward for us and arguably, any returns that beat ‘safe’ cash investments may also be acceptable to some, so a large portion of the variance range of returns may not be ‘risky’ from an investor’s perspective. Naturally, the presence of an upside guarantees the presence of a downside. Herein lies the paradox for many investors who gauge the risk of an investment using beta. I submit that beta is inappropriate as a risk metric for most practical investors. If a highly volatile investment has gone down substantially (take the equity markets as of this writing as an example), does it mean that the markets are now more risky? Using beta as a risk metric would say that the market is just as risky when it was going up as when it is going down. However, the downside risk (the only risk that matters to investors) has actually decreased when the markets have declined significantly. India’s equity market lost nearly 35% in value so far this year, and China’s equity market has wiped out over half of the investor’s wealth so far this year. So, are China and India more risky or even equally risky to invest in now compared to last year? I would argue that that they are far less risky to invest today compared to last year for any long-term investor.
The same scenario applies in United States. Using Vanguard’s Total Stock Index ETF (VTI) as a proxy for the broader U.S. market, its current price of 61.5 suggests an earnings yield (the inverse of P/E ratio) of 7.93%. As of July 11, a 10-year Treasury Bond is yielding 3.96% and the 30-year bond is yielding 4.52%. Are stocks more risky now than bonds? Absolutely not! The stocks are priced very attractively for a long-term investor compared to other investments. Look back and do the analysis of the periods where the earnings yield on stocks was nearly twice that of bonds. In the following years, the stock market delivered substantial returns to the investor.
Yet, the financial press is screaming with headlines of risk in equity markets and with the dire status of financial institutions, equities seem to be the last place people want to invest. Wall Street Journal reports that of last week, investors have yanked about $39 billion from U.S. mutual funds and over $6 billion from ETFs – precisely the wrong moves to make when the market is priced so attractively. If you have additional money to invest and have a long investment horizon, now may be the time to buy equities or at least continue your periodic investments. Even if there is no additional money to invest, staying the course during times like these preserves the upside potential when the markets do turn around.
To those who seek the refuge of investment ‘professionals’ during times like these for trying to identify ways to eke out market-beating returns, I am reminded of this classic quote from William Bernstein (emphasis mine):
“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
It is tempting to think that if only we could sell out of equities just prior to or just after a bear market started and re-enter at the early stage of the next bull market….doing so would escape the 20% or so decline that even a diversified portfolio may endure in a bear market. It is important to remember how difficult it is to do that and get it even reasonably right. Even in strong bull markets, there are months with negative returns and conversely in bear markets, months with positive returns. To those who feel they can forecast market movements with any reasonable degree of accuracy, consider the following words from various experts at the end of the last major bear market. I have annotated actual market performance below these quotes in parentheses.
“I suspect 2003 will end up being the fourth consecutive down year for the first time since 1932.” – Jeremy Grantham, January 2003. [U.S. and many international markets delivered the best return in 2003 in hindsight over the last 8 years, with S&P 500 delivering 24.82% return including dividends]
“I do not believe a long term investor will make money in this market because it is a secular bear market.” – Felix Zeulauf, Barron’s, January 27, 2003 [From January 2003 till May 2008, which includes more than 6 months of the current bear market, the S&P 500 delivered a 10.71% annualized return including dividends]
“Soaring energy costs, the threat of terrorism, and a stagnant job market have sent consumers’ spirits plunging to levels normally seen only in recessions….consumer confidence level fell to 64 in February, lowest level since 1993.” - Wall Street Journal, February 26, 2003, page A3.
“Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds – including a hefty $3.7 billion just last week…” - Wall Street Journal, March 11, 2003, page C1.
[From March 1, 2003 till May 31, 2008, the S&P 500 delivered 12.23% annualized return with dividends reinvested.]
“These stocks are still way ahead of themselves. I am not sure we have seen the bottom. I think we could see new, lower lows.” - John Rutledge, Evergreen Investments, Wall Street Journal, June 16, 2003, page C1.
“Several important signals suggest that prices have at least topped out for the time being, and at worst are primed to back down….classic signs of a market top…” – Charles Biderman, President of a market-research firm, Wall Street Journal, June 26, 2003, page D1.
[From June 2003 till May 2008, the S&P 500 delivered 9.30% annualized return with dividends].
“Even some bears now acknowledge that, when they warned people to stay away from stocks one year ago they were wrong. But they insist that now, after the market’s big gains, it is too late to buy.” - Wall Street Journal, October 13, 2003, page D1. [For the period from October 2003 (after the big gain in 2003) till May 2008 which includes 7 months of the current bear market, S&P 500 delivered 8.7% annualized return].
Predictions, anyone? :-)
Apr 25, 2008
Can we count on Social Security?
This is a perennially popular topic among Americans, and as I recently completed the “vesting” requirement of 40 quarters, a germane one for me. Our beloved Encyclopedia Americana (aka Wikipedia) explains vesting as follows:
In law, vesting is to give an immediately secured right of present or future enjoyment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest.
Powerful words, but do they apply to our Social Security rights? If Social Security is an “intergenerational contract”, as a former U.S. President put it, why can’t I count on reaping benefits from it as I have fulfilled (and continue to fulfill) my obligations to serve the previous generation of beneficiaries? From what I have heard, financial planners run the gamut on this issue. There are those who count 100% on promised Social Security benefits to those who completely write it off for younger clients. Before we try to project a meaningful estimate of what we can get, if any, from Social Security, we have to start with obvious limitations of this exercise.
First, any commentary on social security’s solvency requires some level of assumptions on the U.S. political enterprise and economic growth. Divining the will of politicians is about as certain as predicting the tropical hurricanes twenty years hence. However, much as the future of individual stocks is uncertain but the collective stock market’s future is reliably tied to corporate earnings as a whole, I will make a bold assumption here. While individual politicians will be as unpredictable as individual stocks, the collective political will – over the long term – will reflect the interests of the population. At least, that’s the premise of democracy, with all its attendant privileges and real life absurdities.
I will start with my prediction that vested workers at or above the age of 50 in 2008 will receive their Social Security benefits as promised. The basis for this assumption is that when they become eligible to receive benefits in about 12 years, the current system has enough resources to sustain them for the rest of their retired lives. Moreover, reducing their monthly benefit check after they start receiving it is political suicide for any U.S. administration so, I think it is highly unlikely. Even strong welfare states like France and Germany with a more burdensome system than the U.S. have not cut benefits. So at worse, annual raises may be frozen in the distant future but still, on a nominal basis, those 50 and higher can count on both the vested social security benefits and annual COLA increments. In considering any future scenario, we should not forget that already elderly Americans form a formidable vote bank (and generally, are more likely to vote). Also, this “AARP segment” (i.e. over 50 group) of the population is only going to rise for the next 40 years in the U.S.
The categories of interest are those in 40s, 30s and 20s. Even with the trust fund declining and as current estimates put it, the system starts to draw on their surplus from 2020 or so, by the time the 40-something group reaches mid-60s, most of their projected benefits can be counted for at least half of their retired lives (assuming they live up to mid-90s). In making this assumption, I am considering that the surplus does not fully deplete until 2042 as SSA actuaries estimate using reasonable assumptions. By this time, the youngest of this group – the 40 year olds - will be 74 years old. Beyond that, going by the ‘political reality’ assumption we made earlier that no cut in benefits will be made to those already receiving benefits, at worse, this group will sail through the rest of their retirement years at the nominal value of their benefits, though inflation will reduce the real value of their benefit check every year. It is appropriate to point out here that monthly benefits I cite in this post are all in today’s dollars (estimated from the online calculator in SSA’s website)
For people in their 30s, the situation is more complex. Many people, especially professional immigrants, reach their minimum vesting eligibility in this age group, having worked for at least 10 years by this time. Those who started to work in their lives earlier (say younger than 20), would reach eligibility before their 30th birthday, but they are not a group that can I relate to so, I will exclude them from my analysis. The ‘political reality’ assumption we made earlier for 40s and 50s starts to become less reliable for the 30s set because the distant political will is even more uncertain, unless U.S. becomes a welfare state like much of Europe is (who knows, that may happen too!). However, another political reality assumption is called for here. For those at the lower end of the vesting spectrum, i.e. those whose presently estimated benefits are in the range of say, $400-$1000 a month, there is a definite political ramification to cut benefits compared to those who are slated to receive higher benefits (over $1000 a month and more likely those at $2000 or higher). Now, if you think that is unfair, let me remind you that no matter what is done (or not done) to the ailing Social Security system, some constituency will always get the shaft. In making this assumption, I also considered that Social Security’s primary goal is to prevent elderly Americans who have earned the right to be vested from falling into abject poverty. It is not meant to provide a ‘cushy’ retired life. Also, those whose benefits are less than $1000 a month most likely have earned relatively low wages throughout their working career or possibly have significant periods of unemployment or have fallen out of the SSA net in some other fashion. Imagine a U.S. politician demanding a benefit cut for this constituency. He may never get re-elected or worse, he may not even reach home safely that evening. AARP may offer a supari on him or at least, they will join forces with every human rights group worth its 3-letter acronym to protest. So, I see this set as a reasonably protected segment of beneficiaries.
Into the above protected segment falls a small sub-group, namely high-earning professional immigrants who return to their home countries after minimum vesting in the Social Security system. For those with or just over the minimum 40 credits of vesting, their estimated monthly benefits are likely to fall in the $400-$800 range, below my arbitrary ‘at risk’ criterion of $1000+ per month. While it may be unfair to group the truly disadvantaged people with these high-earning professionals who just decided to work outside the SSA system, I believe eliminating this relatively small sub-group from the large protected segment is impractical and at best, is of questionable value to SSA’s sustainability. There are bigger fish to fry elsewhere! Similarly, limiting these benefits to U.S. citizens and disenfranchising vested foreign nationals has marginal value to SSA’s sustainability and such a move may have some ‘image problem’ for the U.S. as a leading free market democracy whose equal opportunity law covers ‘national origin’. Therefore, I believe this sub-group will see most of their social security benefits intact and at worst, will receive at least 73% of projected benefits from 2042 as SSA currently estimates.
The highest risk group is clearly the 20s. They are unlikely to be vested today and given the long line of people ahead of them in the beneficiary queue, are unlikely to see nearly as much benefit even after vesting when they reach their 60s. Even for this group, going by the ‘pay as you go’ philosophy of social security, there will be some benefit if the projected 2:1 ratio of workers to beneficiaries continues beyond 2050. Note that even if the projected ratio becomes 1:1 (i.e. one worker supporting one retiree), at the current payroll SS tax rate of 12.4% and annual average wage of at least $36,651 (2006 SSA data), an average beneficiary will get a $340 a month in present dollars (assuming a ~10% frictional cost allowance for administration and other systemic costs) adjusted at wage inflation rates in perpetuity.
All the above scenarios assume a future U.S. GDP annual growth of at least 2.5% as considered by SSA’s own trustees, which is lower than the 3.4% that the U.S. has seen over the last 50 years. This assumption is significant because had the U.S. grown at 2.5% instead of 3.4% over the last 50 years, the U.S. economy would be nearly 40% smaller than it is today. So, the future projection does consider a significantly bleaker economic growth picture for the U.S.
In law, vesting is to give an immediately secured right of present or future enjoyment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest.
Powerful words, but do they apply to our Social Security rights? If Social Security is an “intergenerational contract”, as a former U.S. President put it, why can’t I count on reaping benefits from it as I have fulfilled (and continue to fulfill) my obligations to serve the previous generation of beneficiaries? From what I have heard, financial planners run the gamut on this issue. There are those who count 100% on promised Social Security benefits to those who completely write it off for younger clients. Before we try to project a meaningful estimate of what we can get, if any, from Social Security, we have to start with obvious limitations of this exercise.
First, any commentary on social security’s solvency requires some level of assumptions on the U.S. political enterprise and economic growth. Divining the will of politicians is about as certain as predicting the tropical hurricanes twenty years hence. However, much as the future of individual stocks is uncertain but the collective stock market’s future is reliably tied to corporate earnings as a whole, I will make a bold assumption here. While individual politicians will be as unpredictable as individual stocks, the collective political will – over the long term – will reflect the interests of the population. At least, that’s the premise of democracy, with all its attendant privileges and real life absurdities.
I will start with my prediction that vested workers at or above the age of 50 in 2008 will receive their Social Security benefits as promised. The basis for this assumption is that when they become eligible to receive benefits in about 12 years, the current system has enough resources to sustain them for the rest of their retired lives. Moreover, reducing their monthly benefit check after they start receiving it is political suicide for any U.S. administration so, I think it is highly unlikely. Even strong welfare states like France and Germany with a more burdensome system than the U.S. have not cut benefits. So at worse, annual raises may be frozen in the distant future but still, on a nominal basis, those 50 and higher can count on both the vested social security benefits and annual COLA increments. In considering any future scenario, we should not forget that already elderly Americans form a formidable vote bank (and generally, are more likely to vote). Also, this “AARP segment” (i.e. over 50 group) of the population is only going to rise for the next 40 years in the U.S.
The categories of interest are those in 40s, 30s and 20s. Even with the trust fund declining and as current estimates put it, the system starts to draw on their surplus from 2020 or so, by the time the 40-something group reaches mid-60s, most of their projected benefits can be counted for at least half of their retired lives (assuming they live up to mid-90s). In making this assumption, I am considering that the surplus does not fully deplete until 2042 as SSA actuaries estimate using reasonable assumptions. By this time, the youngest of this group – the 40 year olds - will be 74 years old. Beyond that, going by the ‘political reality’ assumption we made earlier that no cut in benefits will be made to those already receiving benefits, at worse, this group will sail through the rest of their retirement years at the nominal value of their benefits, though inflation will reduce the real value of their benefit check every year. It is appropriate to point out here that monthly benefits I cite in this post are all in today’s dollars (estimated from the online calculator in SSA’s website)
For people in their 30s, the situation is more complex. Many people, especially professional immigrants, reach their minimum vesting eligibility in this age group, having worked for at least 10 years by this time. Those who started to work in their lives earlier (say younger than 20), would reach eligibility before their 30th birthday, but they are not a group that can I relate to so, I will exclude them from my analysis. The ‘political reality’ assumption we made earlier for 40s and 50s starts to become less reliable for the 30s set because the distant political will is even more uncertain, unless U.S. becomes a welfare state like much of Europe is (who knows, that may happen too!). However, another political reality assumption is called for here. For those at the lower end of the vesting spectrum, i.e. those whose presently estimated benefits are in the range of say, $400-$1000 a month, there is a definite political ramification to cut benefits compared to those who are slated to receive higher benefits (over $1000 a month and more likely those at $2000 or higher). Now, if you think that is unfair, let me remind you that no matter what is done (or not done) to the ailing Social Security system, some constituency will always get the shaft. In making this assumption, I also considered that Social Security’s primary goal is to prevent elderly Americans who have earned the right to be vested from falling into abject poverty. It is not meant to provide a ‘cushy’ retired life. Also, those whose benefits are less than $1000 a month most likely have earned relatively low wages throughout their working career or possibly have significant periods of unemployment or have fallen out of the SSA net in some other fashion. Imagine a U.S. politician demanding a benefit cut for this constituency. He may never get re-elected or worse, he may not even reach home safely that evening. AARP may offer a supari on him or at least, they will join forces with every human rights group worth its 3-letter acronym to protest. So, I see this set as a reasonably protected segment of beneficiaries.
Into the above protected segment falls a small sub-group, namely high-earning professional immigrants who return to their home countries after minimum vesting in the Social Security system. For those with or just over the minimum 40 credits of vesting, their estimated monthly benefits are likely to fall in the $400-$800 range, below my arbitrary ‘at risk’ criterion of $1000+ per month. While it may be unfair to group the truly disadvantaged people with these high-earning professionals who just decided to work outside the SSA system, I believe eliminating this relatively small sub-group from the large protected segment is impractical and at best, is of questionable value to SSA’s sustainability. There are bigger fish to fry elsewhere! Similarly, limiting these benefits to U.S. citizens and disenfranchising vested foreign nationals has marginal value to SSA’s sustainability and such a move may have some ‘image problem’ for the U.S. as a leading free market democracy whose equal opportunity law covers ‘national origin’. Therefore, I believe this sub-group will see most of their social security benefits intact and at worst, will receive at least 73% of projected benefits from 2042 as SSA currently estimates.
The highest risk group is clearly the 20s. They are unlikely to be vested today and given the long line of people ahead of them in the beneficiary queue, are unlikely to see nearly as much benefit even after vesting when they reach their 60s. Even for this group, going by the ‘pay as you go’ philosophy of social security, there will be some benefit if the projected 2:1 ratio of workers to beneficiaries continues beyond 2050. Note that even if the projected ratio becomes 1:1 (i.e. one worker supporting one retiree), at the current payroll SS tax rate of 12.4% and annual average wage of at least $36,651 (2006 SSA data), an average beneficiary will get a $340 a month in present dollars (assuming a ~10% frictional cost allowance for administration and other systemic costs) adjusted at wage inflation rates in perpetuity.
All the above scenarios assume a future U.S. GDP annual growth of at least 2.5% as considered by SSA’s own trustees, which is lower than the 3.4% that the U.S. has seen over the last 50 years. This assumption is significant because had the U.S. grown at 2.5% instead of 3.4% over the last 50 years, the U.S. economy would be nearly 40% smaller than it is today. So, the future projection does consider a significantly bleaker economic growth picture for the U.S.
Apr 14, 2008
Painkiller for Few but Headaches for Many?
It hurts me to post this entry. Some of my well-admired qualities about U.S. economy, its hard work and die-hard optimism, the reason why I aspired to come to the U.S. more than 15 years ago as a student to earn a Ph.D. in engineering, suffered a serious setback during the course of recent events.
The last 4-5 months were painful as the process of "deleveraging" began in our capital markets. Sub-prime was how it started but it has spread to 'prime' and other areas of credit markets, affecting most recently, even a bellweather corporation like GE. Much of this is normal part of business cycle and it is healthy (possibly even cathartic) for the economy to self-reflect once in a while and shake off the excesses, in this case, in the housing market. The country emerges from this process (as it did from several such declines in the past) with a stronger and more efficient economy poised to embark on another long period of growth. But the deep credit crunch was caused by the excesses of too much and too easy credit in the last few years, so the severity of pain could have been mitigated but the pain itself could not possibly be avoided.
Enter the politicians or as a recent book called them the homopoliticus. From Japan to Jamaica, from Uruguay to United States, they are often one of a kind species. A wide range of policy makers and influential officials, ranging from the Federal Reserve to Presidential-hopefuls are stampeding one another to bail out the very individuals, banks and other Wall Street institutions that contributed to the recent boom-and-bust cycle. Responsible homeowners, investors and institutions are left wondering why they are suffering the pain for the excesses caused by a few. What do I tell my son, that America is a land of no consequences? That you can engage in fiscally irresponsible behavior all you want and when the going gets tough, Uncle Sam will bail you out?
When I last blogged about the craziness of the Washington DC real estate market after I first moved into this area, I thought I was making a responsible decision by not buying at the peak while feeling sorry for those who were stretching way beyond their means to buy obscenly priced homes. While I probably did the right thing, I did not imagine that even as a bystander, I would pay a price one day. As a renter, I did not suffer any home value deterioration as prices in our area suffered double digit declines and are going down further. However, the impact was still felt by my portfolio, which suffered along with the rest of the U.S. equity market over the past few months. Of course, homeowers suffered a 'double whammy' with the declining home values and equity markets. Many who bought a house in 2005 or later are facing an 'upside down' mortgage and some of them, though eminently credit-worthy, have locked in bloated monthly payments on their 30-year mortgages as the massive premium they paid haunts them for years to come.
Financial responsibility seems to be increasingly rare in America and unreasonable profligacy is ever-present, egged on by the populist political cries and mindless bailout policies. What happened to the America that rewarded hard work and responsibility while refusing to become a 'welfare state' like much of Europe is? The pain of the credit cruch is now unfairly borne by responsible individuals and well-managed institutions, in the form of serious erosions in their wealth and currency values, and whose only fault is to live in the same neighborhood or city as the profligate few.
The last 4-5 months were painful as the process of "deleveraging" began in our capital markets. Sub-prime was how it started but it has spread to 'prime' and other areas of credit markets, affecting most recently, even a bellweather corporation like GE. Much of this is normal part of business cycle and it is healthy (possibly even cathartic) for the economy to self-reflect once in a while and shake off the excesses, in this case, in the housing market. The country emerges from this process (as it did from several such declines in the past) with a stronger and more efficient economy poised to embark on another long period of growth. But the deep credit crunch was caused by the excesses of too much and too easy credit in the last few years, so the severity of pain could have been mitigated but the pain itself could not possibly be avoided.
Enter the politicians or as a recent book called them the homopoliticus. From Japan to Jamaica, from Uruguay to United States, they are often one of a kind species. A wide range of policy makers and influential officials, ranging from the Federal Reserve to Presidential-hopefuls are stampeding one another to bail out the very individuals, banks and other Wall Street institutions that contributed to the recent boom-and-bust cycle. Responsible homeowners, investors and institutions are left wondering why they are suffering the pain for the excesses caused by a few. What do I tell my son, that America is a land of no consequences? That you can engage in fiscally irresponsible behavior all you want and when the going gets tough, Uncle Sam will bail you out?
When I last blogged about the craziness of the Washington DC real estate market after I first moved into this area, I thought I was making a responsible decision by not buying at the peak while feeling sorry for those who were stretching way beyond their means to buy obscenly priced homes. While I probably did the right thing, I did not imagine that even as a bystander, I would pay a price one day. As a renter, I did not suffer any home value deterioration as prices in our area suffered double digit declines and are going down further. However, the impact was still felt by my portfolio, which suffered along with the rest of the U.S. equity market over the past few months. Of course, homeowers suffered a 'double whammy' with the declining home values and equity markets. Many who bought a house in 2005 or later are facing an 'upside down' mortgage and some of them, though eminently credit-worthy, have locked in bloated monthly payments on their 30-year mortgages as the massive premium they paid haunts them for years to come.
Financial responsibility seems to be increasingly rare in America and unreasonable profligacy is ever-present, egged on by the populist political cries and mindless bailout policies. What happened to the America that rewarded hard work and responsibility while refusing to become a 'welfare state' like much of Europe is? The pain of the credit cruch is now unfairly borne by responsible individuals and well-managed institutions, in the form of serious erosions in their wealth and currency values, and whose only fault is to live in the same neighborhood or city as the profligate few.
Jan 4, 2008
Emerging Markets Fever
I am back after a long hiatus from blogging as family responsibilities kept getting in the way ;-) First, Happy New Year to all of you! Phew, what a year 2007 was for the markets and I am happy to put it behind me. No, it was not particularly bad (even the anemic U.S. markets ended positive for the year) but the roller-coaster ride put the "V" in Volatility back! The 4-year run in the raging bull market in international equities is still going strong. The Vanguard Emerging Markets Index fund (VEIEX) delivered a blistering 37.5% for the year. Even the developed country markets outside U.S. (notably, excluding Japan) delivered double digit returns in 2007. Meanwhile, the U.S. total stock market (VTSMX) delivered a paltry but positive 5.5% for the year, about the same as what a good money market fund would have yielded, without of course, any of the market risks.
What does this mean for 2008? Continue to invest in the winners and dump the losers? The emerging market story has never been stronger. Most of the emerging market countries are in the best shape ever. They have cleaned up their financial act, have a lot of currency reserves, stimulated domestic growth and are experiencing real improvements in the quality of life of their citizenry. Many leading emerging market companies are making bold forays into developed markets with mega-sized acquisitions of marquee names in business. Yet, after 5 years of impressive gains, most emerging market stocks are now trading at valuations far higher than many established developed market stocks. The "BRIC" countries (Brazil, Russia, India, China) are the hottest segment within the emerging markets and their stocks have had unbelievable runs in 2007. Many of these markets have transparency issues, notably poor disclosure requirements. Historically, investors have rewarded markets with greater transparency and accountability with higher P/E ratios because the earnings are more reliable and have fewer unknowns. The P/E ratios of stocks from India and China are now hovering 40-100% higher than those of U.S. stock market, considered the most transparent in the world. Strange, indeed!
William Bernstein in his 2002 classic The Four Pillars of Investing makes an interesting case backed by decades of market data that the best long term returns from equity markets are often not delivered by the hottest growth economies but by those weaker growth economies that do slightly better than what is expected of them. In other words, if China's GDP is expected to grow at 11% annually over the next five years and it actually delivered a 11% growth, as impressive as this is, the returns from its equities will not be nearly as high as say equity returns from a developed market expected to grow at say, 2% annually for the next five years, and it actually delivers a 3% annual growth. In other words, the best returns are captured where there are unexpected positive surprises. It is not the absolute growth numbers per se but the upside surprise that is rewarded in the markets.
With euphoria running as strong as it is in China and India, if growth hiccups even a little bit, say they achieve "only" 10% actual GDP growth, when the expectation has been 11%, the flight of capital from its equity markets will be so dramatic that it may take years for the stock markets in these countries to recover. With increasing foreign ownership in these emerging markets, it is easier than ever for capital to take flight.
Does this mean we should take the profits made so far from emerging markets and run? No. There is no substitute for a well-designed asset allocation plan that has a specified range of allocation for all types of diversified assets according to one's risk tolerance. If your allocation calls for a 10% holding in emerging market stocks and the past couple of years of stellar growth has increased it to 12%, consider if you are okay with this increase or re-balance with other asset classes to reach the 10% level again. Better yet, if you are contributing periodically to your investments, consider investing in other asset classes and temporarily stop allocations to emerging market stocks till they balance to your level of risk tolerance. The latter may be the slower method but it has no tax consequences if your assets are in a taxable account.
Nassim Taleb's theory of "black swans" says that all extraordinary movements in the market are as a result of random, unpredictable events that no amount of current market knowledge can predict. While I don't completely agree with the black swan theory (as it implies no individual can use any specialized knowledge to profitably trade in the markets or nobody has skills to identify and exploit emerging opportunities - Mr. Buffet and others would certainly disagree), there is certainly some element of truth in it especially when most market participants agree on one thing - chances are no big returns can be made in it for the long term. When everybody bets on a horse to win the race, there is nowhere to go but down for that horse. Sure it can win the race, but then everybody "knew it already". However, if it came even second, many will lose money as the odds are for it to win. On the other hand, if a horse nobody expects to win comes in even third in the race, those "idiots" who bet on it will walk away with huge winnings.
Since everybody in the investment world and popular media is crowing about China and India, I find it hard to imagine that this rampant optimism has not been priced already into these markets. There is a reason why underdogs win more often than champions. Because nobody expects them to!
What does this mean for 2008? Continue to invest in the winners and dump the losers? The emerging market story has never been stronger. Most of the emerging market countries are in the best shape ever. They have cleaned up their financial act, have a lot of currency reserves, stimulated domestic growth and are experiencing real improvements in the quality of life of their citizenry. Many leading emerging market companies are making bold forays into developed markets with mega-sized acquisitions of marquee names in business. Yet, after 5 years of impressive gains, most emerging market stocks are now trading at valuations far higher than many established developed market stocks. The "BRIC" countries (Brazil, Russia, India, China) are the hottest segment within the emerging markets and their stocks have had unbelievable runs in 2007. Many of these markets have transparency issues, notably poor disclosure requirements. Historically, investors have rewarded markets with greater transparency and accountability with higher P/E ratios because the earnings are more reliable and have fewer unknowns. The P/E ratios of stocks from India and China are now hovering 40-100% higher than those of U.S. stock market, considered the most transparent in the world. Strange, indeed!
William Bernstein in his 2002 classic The Four Pillars of Investing makes an interesting case backed by decades of market data that the best long term returns from equity markets are often not delivered by the hottest growth economies but by those weaker growth economies that do slightly better than what is expected of them. In other words, if China's GDP is expected to grow at 11% annually over the next five years and it actually delivered a 11% growth, as impressive as this is, the returns from its equities will not be nearly as high as say equity returns from a developed market expected to grow at say, 2% annually for the next five years, and it actually delivers a 3% annual growth. In other words, the best returns are captured where there are unexpected positive surprises. It is not the absolute growth numbers per se but the upside surprise that is rewarded in the markets.
With euphoria running as strong as it is in China and India, if growth hiccups even a little bit, say they achieve "only" 10% actual GDP growth, when the expectation has been 11%, the flight of capital from its equity markets will be so dramatic that it may take years for the stock markets in these countries to recover. With increasing foreign ownership in these emerging markets, it is easier than ever for capital to take flight.
Does this mean we should take the profits made so far from emerging markets and run? No. There is no substitute for a well-designed asset allocation plan that has a specified range of allocation for all types of diversified assets according to one's risk tolerance. If your allocation calls for a 10% holding in emerging market stocks and the past couple of years of stellar growth has increased it to 12%, consider if you are okay with this increase or re-balance with other asset classes to reach the 10% level again. Better yet, if you are contributing periodically to your investments, consider investing in other asset classes and temporarily stop allocations to emerging market stocks till they balance to your level of risk tolerance. The latter may be the slower method but it has no tax consequences if your assets are in a taxable account.
Nassim Taleb's theory of "black swans" says that all extraordinary movements in the market are as a result of random, unpredictable events that no amount of current market knowledge can predict. While I don't completely agree with the black swan theory (as it implies no individual can use any specialized knowledge to profitably trade in the markets or nobody has skills to identify and exploit emerging opportunities - Mr. Buffet and others would certainly disagree), there is certainly some element of truth in it especially when most market participants agree on one thing - chances are no big returns can be made in it for the long term. When everybody bets on a horse to win the race, there is nowhere to go but down for that horse. Sure it can win the race, but then everybody "knew it already". However, if it came even second, many will lose money as the odds are for it to win. On the other hand, if a horse nobody expects to win comes in even third in the race, those "idiots" who bet on it will walk away with huge winnings.
Since everybody in the investment world and popular media is crowing about China and India, I find it hard to imagine that this rampant optimism has not been priced already into these markets. There is a reason why underdogs win more often than champions. Because nobody expects them to!
Sep 13, 2007
The Right Perspective
Two of my blog readers asked me to write about recent stock market behavior, though I particularly did not feel it to be worthy of comment. However, I am a sucker for requests, so here it goes... In a given month, the stock market is like an emotionally unstable woman unable to decide what she wants to do and often reacts violently at the slightest bit of news, no matter how trivial. This is not a sexist remark but having seen women on their emotional roller coaster, I cannot but compare the similarities with short term stock market behavior. This year is a case in point. After a good start in January, the equity markets tumbled in February, recovered again in Spring, then played dead for a short while, roared in early Summer, fell hard in late July and with the predictability of an emotionally distraught woman, made wild moves in either direction in August only to end the month almost where it started....and in the process, causing millions of heartburn tablets and anti-depressant pills to disappear off store shelves!
Let's take 'stock', shall we? As of Sept. 12, 2007 (the "day after" Sept. 11, 6 years ago, from which point forward the world was never the same), Dow Jones posted an 8.37% YTD return, S&P 500 posted a 5.12% YTD return and the MSCI World ex-US (International stock markets) posted an 8.07% YTD return in dollar terms. Hardly the performance one expects in a year described recently by some media analysts and popular finance reporters as "gut wrenching", "painful" and "illustrates the peril of stock investing".
I purposely chose the Sept. 11 reference because it is important to remember at this time, the truly catastrophic event that transpired in 2001. It is a day with personal significance for me as I lost one of my college classmates, who by a cruel twist of fate, changed his itinerary to be on the American Airlines Flight 11 that crashed into the North Tower of the World Trade Center. Six years later, as I remember his cheerful face, I often wonder if the present generation learned on Sept. 11 a new meaning for the phrase "catastrophic event", much like many families of the previous generation did during Vietnam war or as Japan learned during World War II.
I am not surprised that except for a few lone voices of sanity, the media has, predictably, sensationalized the stock market movements to the extent of routinely making downright silly predictions made by self-serving experts (possibly with short positions in the market), hoping to trigger mass hysteria to sell. I hope you are among the lone voices of sanity, staying the course and reminding yourselves that the recent turmoil is nowhere near any
"catastrophic event" in the stock market, such as the crash of 1929 or more recently, 1987 - both of which, by the way, barely hurt investors who stayed the course over two decades or more. So, have a "zen warrior" mindet to deal with the short term gyrations of the "emotionally unstable" stock market. If it helps, stop looking at your portfolio balances on a daily basis.
Friends, most of you are saving and investing for your own future and that of your loved ones, so please remember to put the wild market movements in perspective. I hope you all look back someday on the 2007 market movements as insignificant in a lifetime of fond memories and meaningful wealth created, a wealth that I hope you share and enjoy with your children, grandchildren or others less fortunate. Peace to all.
Let's take 'stock', shall we? As of Sept. 12, 2007 (the "day after" Sept. 11, 6 years ago, from which point forward the world was never the same), Dow Jones posted an 8.37% YTD return, S&P 500 posted a 5.12% YTD return and the MSCI World ex-US (International stock markets) posted an 8.07% YTD return in dollar terms. Hardly the performance one expects in a year described recently by some media analysts and popular finance reporters as "gut wrenching", "painful" and "illustrates the peril of stock investing".
I purposely chose the Sept. 11 reference because it is important to remember at this time, the truly catastrophic event that transpired in 2001. It is a day with personal significance for me as I lost one of my college classmates, who by a cruel twist of fate, changed his itinerary to be on the American Airlines Flight 11 that crashed into the North Tower of the World Trade Center. Six years later, as I remember his cheerful face, I often wonder if the present generation learned on Sept. 11 a new meaning for the phrase "catastrophic event", much like many families of the previous generation did during Vietnam war or as Japan learned during World War II.
I am not surprised that except for a few lone voices of sanity, the media has, predictably, sensationalized the stock market movements to the extent of routinely making downright silly predictions made by self-serving experts (possibly with short positions in the market), hoping to trigger mass hysteria to sell. I hope you are among the lone voices of sanity, staying the course and reminding yourselves that the recent turmoil is nowhere near any
"catastrophic event" in the stock market, such as the crash of 1929 or more recently, 1987 - both of which, by the way, barely hurt investors who stayed the course over two decades or more. So, have a "zen warrior" mindet to deal with the short term gyrations of the "emotionally unstable" stock market. If it helps, stop looking at your portfolio balances on a daily basis.
Friends, most of you are saving and investing for your own future and that of your loved ones, so please remember to put the wild market movements in perspective. I hope you all look back someday on the 2007 market movements as insignificant in a lifetime of fond memories and meaningful wealth created, a wealth that I hope you share and enjoy with your children, grandchildren or others less fortunate. Peace to all.
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