This is a continuation of an irregular series which you can find here.  Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.  I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.  They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.  My three comments to them were:

• Prohibitive for life insurers to hold equities
• At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
• The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.  They looked in the rearview mirror and said that we were doing fabulous.  Why change success?

I was outvoted; I was a one-man minority.  There are a lot of people who would have loved to make that change in hindsight, but done is done.  I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.  We may be headed for significant inflation or deflation; it is difficult to tell which.  Bonds offer little competition to equities here.  Commodities and cash may be better, but I am reluctant to be too dogmatic.  If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

• That we can use simple models to forecast future outcomes.
• That average people are capable of avoiding fear and greed when it comes to investing.
• That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
• Over long periods of time, average investors can beat long Treasuries by more than 2%/year.  (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
• That financial markets are expressions of what is going on in the real economy.
• That the real economy tends toward stability
• That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.  And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.  If a large portion of the population wants to convert assets into a stream of income — guess what?  They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.  As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.  What they say is true, but the same is true of other types of defined contribution and defined benefit plans.  When assets underperform, and/or investors make bad choices, guess what?  The pain has to be compensated for somehow:

• 401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
• Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.  Also same as 401(k)…
• Private sector DB plans: employers may contribute more, or they may terminate them.
• Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”  First, risk and return are virtually uncorrelated in practice.  Only when enough people realize that might risk and return become positively correlated.  Second, there are times to increase and decrease risk exposure.  Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.  The time to add to high risk assets is when no one wants to touch a high yield bond.  More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.  Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.  At present, investment opportunities are average-ish.  I would be wary of stretching for yield here, or raising my risk exposure in equities.  Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.  I have a simple formula for how much one could take from an endowment at maximum:

• 10 Year Treasury Yield
• Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
• less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.  At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.  This attempts to marry withdrawals to alternative uses for capital in the market.  You may withdraw more when opportunities are high, and less when they are low.  (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.  Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.  In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.  (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)  The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.  We’ve spent years on the illusions generated by assuming high returns off of financial assets.  Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.  Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

Since the mid-1980s, when a number of cranks argued that the balance sheet of the US needed to be laid bare, including off balance sheet items like Social Security and Medicare, there came a statutory requirement that there would be a Financial Report of the US Government.

Here is fiscal 2010′s report.  Page with more options here.

Now let me give you my summary of the 2010 report.

Note the large drops in net liability for Medicare parts A & B.  This is the effect of the “Affordable Care Act.” (My, what an Orwellian name.)  Yes, Obamacare, in order to get the bill passed, said that there would be reductions made to reimbursements for Medicare.

The benefits from Medicare are statutory, and are not rights, per se.  Yet there are human needs that prompt the estimates, at least on average.

That is why I don’t think that the 2010 report is accurate, and they agree with me in their verbiage:

The extent to which actual future Part A and Part B costs exceed the projected current-law amounts due to changes to the productivity adjustments and physician payments depends on both the specific changes that might be legislated and on whether Congress would pass further provisions to help offset such costs. As noted, these examples only reflect hypothetical changes to provider payment rates.

It is likely that in the coming years Congress will consider, and pass, numerous other legislative proposals affecting Medicare. Many of these will likely be designed to reduce costs in an effort to make the program more affordable. In practice, it is not possible to anticipate what actions Congress might take, either in the near term or over longer periods.

The Medicare Board of Trustees, in their annual report to Congress, references an alternative scenario to illustrate the potential understatement of costs under current law. This alternative scenario assumes that the productivity adjustments are gradually phased out over the 15 years starting in 2020 and that the physician fee reductions are overridden. These examples were developed by management for illustrative purposes only; the calculations have not been audited; and the examples do not attempt to portray likely or recommended future outcomes. Thus, the illustrations are useful only as general indicators of the substantial impacts that could result from future legislation affecting the productivity adjustments and physician payments under Medicare and of the broad range of uncertainty associated with such impacts. The table below contains a comparison of the Medicare 75-year present values of income and expenditures under current law with those under the alternative scenario illustration.

ObamaCare assumes/demands that it can pass through cost reductions to Medicare recipients.  The difficulty is whether doctors and other healthcare providers will accept reduced payments.  What is a reduction in payment may become a reduction in service.  Who cares if you have Medicare, if few doctors are willing to accept it?

Public Statement

I would be much happier if we placed healthcare to be an ordinary matter, not something where the government intervenes to assure coverage.  When Medicare was created in the ’60s, the costs of assuring coverage was low, but the government did not accrue the assets to pay for the future coverage.  Then again, neither did the budding health insurance business, which relied on estimates of uninsured health care usage to price products, and was surprised to find that usage rises when one is insured.  (Just as many health insurers in the present day underpriced high deductible policies for HSAs, assuming that utilization would go down a lot.  Instead, it went down a little.

Today, we face a shortfall in most municipalities, where there is not enough to pay benefits, absent an increase in taxes from the municipalities.  The taxes will be a continuing burden for municipalities.

Beyond Municipalities

The government can assume that there will be less cost from Medicare.  That bogus concept allowed the “Affordable Care Act” to pass.  But will Congress have the guts to stand behind their actions when oldsters complain?  I doubt it, so I think costs will be considerably higher here.

How much higher?  Well, deep in the report on pages 129-131 they suggest an alternative scenario:

This alternative scenario assumes that the productivity adjustments are gradually phased out over the 15 years starting in 2020 and that the physician fee reductions are overridden.

The result is a $12.3 trillion increase in the net present value.  Now it would have been nice, and the actuaries could have done it, if they would have broken out separately:

• The effect of the productivity phase-out
• The effect of overriding the physician fee reductions.
• And even, just showing what the difference would have been if they had run the calculation using last year’s assumptions.

That last one is the key omission.  As it is, I can’t tell but can only guess at how much higher the liabilities of the government are, going from 2009 to 2010.  Compared to using the 2009 assumptions, the 2010 liability figure is understated by $12.3 trillion minimum.  My guess on the 2010 liability has the present value of expenses for Medicare parts A & B running ahead at 7% from 2009 to 2010, which is similar to many prior years in the recent decade, if not on the low side.

To see the total liabilities rise by $4.5 trillion in fiscal 2010 isn’t unreasonable, when one sees that the net debt has gone up by $2.0 trillion, and add in the natural drift of underfunded entitlement plans in a slow economy, where unemployment is high.  Not counted in the estimate is the payroll tax holiday, which is a ridiculous policy because employers do not respond to temporary measures, and Social Security is already in bad shape.

So, there is little reason for cheer in this financial report.  In closing, here are a few charts using my estimate for 2010:

Until next time, fare well, good readers.

This is a post about economics, but it will probably sound more political than most.  Part of being mature is learning to live within boundaries.  No, not everything is possible.  Immature people like Bush II, Obama, JFK, and FDR tell us that we can have our cake and eat it too.  It is not an uncommon positions for assume, particularly when they can use a particularly large cohort of workers as a tool to sap revenue from, while not retaining the funds for retirement benefits.

That said, I can look at the past and be a critic.  That’s easy, there have been real jerks that have milked our society, and retained a good name, though they robbed the future to pay the past.  It is criminal what municipal politicians have done, hiding behind high assumed investment assumptions, supported by brain-dead consultants who assumed markets are magic, and always provide high returns.

But there are enough targets in the present.  The evil party, the Democrats, ignore the long run effects of their deficits, and ignore the entitlements crisis that will engulf the nation.  The stupid party, the Republicans, rolled over for the idiocies of Bush II, and ignored the long term effects of debts and entitlements.

But there is a new force of anger, the t-party.  And that is about all they have, is anger.  They want their taxes reduced, but don’t want large entitlement programs reduced, or defense.  They represent small-minded libertarianism.  I am an economic libertarian, but I recognize that my views mean real pain for many in the short run, though I think those policies will be best for all in the long run.

There was a real loss in our nation when we abandoned the idea that national budgets needed to be balanced.  It brings out the worst in politicians when they think money is free, and they can engage in the basest demagoguery with no cost.  As it is today, we would probably be better off electing our politicians via random selection.

I have no sympathy for the t-party.  If you only have economic interests, and aren’t willing to take stands on broader ethical questions, you do not deserve to be our rulers.  Government is ethical as a rule, and the most important questions are what behaviors we encourage and discourage in our society.

I have a further concerns.  Leaders should not be merely facile rhetoricians, but should be genuinely mature.  I cringe listening to the t-party endorsed politicians, because they aren’t mature enough to rule.  If you can’t control what you say, and how you say it, you don’t have enough control over yourself to be one who promotes order in society.

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I wrote the above three weeks ago and sat on it.  After writing it, I said to myself, “This is not one of your better works, are you going to say that?”  After review, I am saying this with full conviction.  Most t-party candidates are not ready for prime time.

Take Sarah Palin as an example. Sarah Palin is a bad joke.  If she is such a good Evangelical Christian woman, why is she not at home taking care of her young children, particularly the one with Down Syndrome.  Or, why was she occupied with Alaska politics at a time when she should have been there for her daughter Bristol, who was about to make some very bad decisions.

Feminism has no place in Christianity.  Men are to lead, not women.  Go home, Sarah.  Homeschool your children, if you can. I would not say this to a woman outside the Church, but since you claim to be one of the disciples of Christ, I say it to you.

I say this as a leader in the Church, ordained by the elders of my presbytery, in a Bible-believing church.  There is no good that comes from neglecting your own home to address the problems of the nation.  Sarah Palin is no Deborah.  Deborah was wise, and Sarah Palin is not.

I fear God more than I care about the political direction of this country.  As the Apostle Paul said, “Shall we do evil, that good may come?”  Paul spoke rhetorically, saying that we should do what is right, regardless of the results.  There is no good that comes from trying to save society, when our own house is not in order.

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I could talk about the other t-party candidates and their idiocies.  Time would fail me.  I am in favor of a brainy libertarianism and Biblical morality, rather than a brain-dead libertarianism, and appeals to general morality.

The most pressing and immediate economic problem is this: we are facing a funding crisis for all of the promises made by governments and corporations regarding retiree employee benefits.  Every day I see more articles about the pain municipalities are going through over funding pensions, with occasional pension strengthening from corporations.

The sins of past governments, making promises that could not easily be fulfilled, or, at least fairly funded in the short run, are coming home to roost.  Funding issues for all levels of government are rising.  It doesn’t matter if you have met the budget this year, however you have done it.  Next year will be worse, because the assets will not throw off enough income to satisfy the liabilities over the intermediate-term, across the whole nation.

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We go to the polls in the US today, but no one dares talk about the funding crisis.  They talk of tax cuts or protecting benefits, while at the same time the economic decay continues, where debt grows, and ability to repay it declines.

It is a sad state of affairs, and indeed, I despair over it.  I love my nation, though I do not support its wars or its economic foolishness.  Unlike what Reagan said, America is not the last best hope of man on Earth, rather it is the God-man Jesus Christ, to whom we must all eventually answer.

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If I have a fault economically, it is that I look to the long-term.  For me, it is Heaven, though on Earth it is what will happen to my great-grandchildren and beyond.  Our policies are slanted to the present, and will force those who are younger to pay far more than they ought to pay, because they will be carrying the profligacy of the Baby Boomers.

No party is seriously looking at the future funding crisis.  There are little hints among the municipalities that are the worst running into problems now.  Those problems will only grow, and spread.  The problems in the unfunded Federal plans will be a plague in their time.

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This is an unusual post for me, prompted partly by the elections, because I don’t think anyone from an economic standpoint is addressing the real problems that we are facing.  Mere politics prevails for now, with fine-sounding but empty words telling the electorate that they will be restored to prosperity.

There are bigger forces in play here.  Consider my old piece, Rethinking Comparable Worth; as it stands, less skilled labor in the US should see wage declines as the rest of the world becomes more competitive.  Unskilled labor is not scarce. Skilled labor is somewhat scarce. Good ideas are scarce.  Real capital is scarce, but financial capital is not scarce.  Commodities vary in scarcity.

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I see this as a time for the US to “grow up,” and see that there are no easy solutions, but that it will take shared sacrifice to preserve our nation.  Taxes will have to rise while benefits are cut.  Keynesians will scream, but the average person in the US will see it as fair, because they know that everything must be paid for; there is no free lunch.

Do you have a lotta money?  Lotsa, lotsa money?  And is it liquid?  More than $5 million?  If so, I have a book that could help you, The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

There are risks that the rich want to avoid, or at least minimize:

• Losses from lawsuits
• Estate taxes
• Income taxes
• Lack of flight capital, if things go really bad
• Inflation, or loss of purchasing power
• Fear of US degeneration: Do you want leave the US, renounce your citizenship, and minimize/eliminate your tax liability in the process?  It can be done, at least at present.

The first chapter describes the rise and decline of America.  It is a bit harsh, but for one following demographic trends, it is accurate.  So, why should you keep money in America, if things are so bad?  (Uh, stable politics, relative freedom…)

The second chapter introduces international investing, because diversifying internationally offers greater possibilities for profit and capital preservation, given the greater tendency of the US to inflate the currency.  To the authors, it is a panacea, and I find it somewhat unrealistic.

The third chapter goes into wills and trusts. How do you want to distribute your money after you die?  How much control do you want until then?

The fourth chapter describes insurance policies that minimize taxation, while allowing for limited asset diversification. The strategies are pretty basic, I have seen better.

The fifth chapter goes into tax havens.  Where can you minimize taxes and other costs best? I found this to be pretty boilerplate; if you pay attention, the tax havens are well-known, with their relative liabilities.

The final chapter tries to tie it all together, but it is all generalities, with little additional substance.

This book would be useful to someone who has prospered dramatically and has never considered wealth preservation.  It gives a taste of all of the tools, but does not give enough to execute the tools on their own.  You will have to hire bright  experts to protect your wealth, but at least you will know what they are  doing, and will be able to spot phonies.

Quibbles

I dislike Agora because of the doom-and-gloom outlook that they possess, but this book does not share in that flaw to any large degree.  All of that said, all strategies that use insurance products are very expensive, and there is no proof that you can obtain above average returns on the assets.  The authors talk a good same, but they offer little proof of superior performance.

Who would benefit from this book:

Only the very wealthy could benefit from this book, and many of them have wealth advisers already, who can help them with tax avoidance and estate protection.  But this gives a good introduction to the topic so that a person could be wiser in hiring an adviser.  He would know what the issues are.

If you want to, you can buy it here: The Insured Portfolio: Your Gateway to Stress-Free Global Investments (Agora Series).

Full disclosure: I asked the publisher for a copy, and they sent one to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Two notes before I begin: I will be in New York City next Wednesday, and maybe Tuesday or Thursday.  I will be meeting with potential investors.  If you would like to hear what I am up to, e-mail me, and maybe we can get together.

Also, if you have a moment, have a look at my friend Cody’s website that deals with applications for mobile devices.  He seems to have found an interesting new niche.

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When I was a kid, I remember reading a story about a business that started a letter delivery service in a major American city, I think it was Philadelphia.  They undercut the US Postal Service by about 20% or so, and they began to attract a decent amount of volume, such that government came and shut them down, because USPS has a monopoly on delivering non-urgent mail.

Unfortunately for USPS, it has a much larger lower cost competitor: the Internet, which is eating into its high margin businesses, forcing prices up as it tries to maintain its subsidy to activities that lose money.

The Internet improves and destroys.  The economics of newspapers has been destroyed by the internet.  Should we be surprised that the economics of a similar business, the Post Office, is suffering similar troubles?  Delivering paper mailings to addresses seems to be populated by junk mailers and a variety of businesses that could deliver via e-mail.  I get few personal letters for my family, and many of those could go via e-mail.

This is a system that is looking for a kick to get it to move from an unstable equilibrium, perpetually asking for price increases, and service decreases, to a stable equilibrium where people receive almost all mail traffic over the internet.  So, what if we replaced the postal service two years from now?

If there were two years of lead time, older folks would be forced to adapt to e-mail, and advertisers would find new means contacting clients.  Some clever businesses would buy up post office sites, perhaps UPS and Fedex, and augment their businesses.

It would be likely that the cost of purely local mail delivery would go down in densely populated areas, but that delivery outside of major urban areas would be considerably more expensive, and would depend on the location of both the sender and the receiver.

The price differences would become similar to the price of a person traveling from one place to another.  Is it hard and costly for you to go from point A to point B?  It would be the same for mail.  Sending a piece of mail from one low density area to another would be expensive.

Now, I don’t think the postal service will go away in two years.  But ten years down the road the answer might be different.  Here are two alternative visions of the future:

• Post Office Shows Where U.S. Is Headed: Kevin Hassett
• Testimony of the current Postmaster General

Now, I think Hassett is mistaken when he says, “We need only write regulations that require firms that compete for postal business to provide universal service.”  The US is a big place, with a lot of sparsely populated areas.  The countries that have privatized are typically more compact, making it possible to have netorks that deliver everywhere at a reasonable cost.  Universal service will come with astronomical pricing for low density deliveries.

But I think the Postmaster General is mistaken when he estimates the total amount of demand over the next ten years.  I think that more and more will go online, with many businesses making people pay extra to receive paper bills, statements, etc.  Paper mail is not only costly to deliver, but costly to create.

People will also evaluate the postal service on convenience as well.  As the number of days for delivery declines to five, and local post offices and local delivery diminish in rural areas, people will begin asking for more to be delivered via e-mail.

One final note: I find it tragic/comical that USPS does with its employee benefit plans what all companies and governments should do: fully fund them.  But now they are looking to raid the funds to support current services, and push back on the  Federal government to absorb more of certain shared costs.  I think it is amazing to call funding 30% of retiree healthcare and 80% of pensions to be “fully funded,” because those are the average levels of many corporations.  Raiding the funds may help today, but ten years out, as postal workers age and retire, this will place even more expense pressure on postage rates.

Eventually the economics of a situation prevails.  The proposed move with the employee benefit plan is desperate.  Eventually a significant change will have to be made to the US Postal Service.  It would probably be better to think about an integrated plan today, than let ten years elapse, and face a larger crisis.

Given the nature of the US, and the short-termism that plagues us today, I suspect that we get the crisis.

Recently I got an e-mail from my friend Kid Dynamite.  He asked me an interesting question about pensions and long-duration bonds:

“back to the concept of century bonds.  I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)

I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income??”

It’s a great question and one that deserves more thought.  To do that, we have to separate the accounting from the economics.

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam.  An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea.  The setting of investment assumptions accepts as a rule that risk margins will be earned without fail.  Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.  The same is true of bonds in the pension trust.  They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.

Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free.  Also, let’s pretend that the pension actually needs bonds as long as a century bond.  Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years.  That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.

What that 6% century bond tells us is that the investment return assumption on an economic basis is too high.  And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.

I know that’s not what GAAP accounting requires.  GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics.  That’s not the way GAAP accounting should work though.  GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.

If you earn more than the risk free investment earnings assumption, good.  Those excess earnings will reduce the pension plan deficit or increase its surplus.

Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically.  My, what large pension deficits we see.  But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.

So, the problem isn’t with the century bond, it’s with the earnings assumption.  Now why does that earnings assumption exist?

• The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
• For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
• The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take.  Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we’re in today.
• There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.

So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting.  The truth is, they are worse off than their stated deficits imply.  For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.

So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.

The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities.  Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan.  That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.

And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit.  Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.

I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.

For what it is worth, I don’t encourage calling me “Dave.”  My wife, my pastor, and some close friends call me that.  I learned to love my given name when I became an adult — David is a wonderful name, and I am glad my parents gave me that name.  It is an informal age, with the benefits and problems thereof.

On with the scenarios:

4) I have had short jobs: helping a young man to decide whether to buy a house or not.  My counsel: not.  So far so good.  Helping an older lady figure a complex tax basis of stock her father left her inside a DRIP.  A pain but a finite process.

5) A friend my age (50s) who runs a successful business asked me for advice ten years ago.  My advice was don’t run with negative working capital; leave some margin for error.  It took him nine years to figure out that I was right, and the business suffered 3-4 near death experiences en route.  Now he is more profitable than ever, and was grateful for my advice.  As a shareholder, I am glad that he listened.

6) A younger friend (30s) who runs a successful small business who asks what he should do with his excess money.  I told him to put it in Vanguard’s Balanced Fund, or the STAR fund, if he really did not need it for his business.  But he is the sort that always wants to do the best, and feels mediocre results are laziness.  I have told him, focus on your business; it is what you are best at.  What you earn on spare cash balances, particularly in this low-return era, will not avail as much as you could by selling more, and providing good service.

7) A friend (50s) a few years older than me has been put to the test.  His employer has offered him a severance package if he leaves of a little more than one year’s income.  His pension, if taken today, will barely cover expenses, but is roughly equal to his salary.  He has no savings, and has helped put 3 of his 5 kids through college, with 2 to go.  I advise that he continues to work, and that he turn down the package, because it is unlikely that he could get work nearly as remunerative.  Risk: his company folds, and he loses the package.

8 ) A friend (50s) who has planned asks whether his plan is wise.  I told him that the asset allocator using DFA is pretty smart, and and the cost is reasonable.  Beating the S&P 500 over 9 years by 4%/year is hot stuff.  My only critique is that it is a 100% equities program, which is fine if you can live with that level of volatility.

9) My pastor came to me in 2007, asking whether he should still be in the money market fund for his defined contribution plan.  I had been waiting for this moment, because he was too cowardly in investing, but it was the wrong moment.  I told him to take the moderate allocation, because moderate and aggressive allocations do the same over time, but the moderate will let you sleep.  He came through 2008 like a trooper, with the losses, and bounced back in 2009.  The mix will do him well over the long run.

His case made me look over the denominational plan.  I concluded that the asset allocations were set one notch too high at each level… technically, the percentages allocated between risky and safe assets might be correct when thinking about lifespan, certainty of future earnings, but does not take into account the fear factor so well, i.e., people changing their strategy in the midst of panic, at the wrong moment.

So I let the pastors know that, and told them to shade their asset allocations to the conservative side last June.  It does not help that we are in a period of debt deflation, which will retard asset appreciation for some time.  It is harder for asset prices to rise, when the buying power from debt is diminishing.

And yet there are more who want my advice but haven’t sent me the documents yet… It reinforces to me that most don’t know what to do with excess money.

Perhaps that is a lesson — most people are technical specialists, and do their jobs well, but many are ill-adapted to managing their excess funds wisely.  Another reason to end Participant-directed defined contribution pension plans, and create trustee-directed plans, or even defined benefit plans.

Yes, this is a paternalistic view, and is at odds with my normal libertarian ways of thinking.  As policy goes, let people be free to have whatever savings/investment plan they like.  But if you care for those that you have some charge over, create a plan that takes the investing out of their hands.  Then make sure that it is prudently invested.

And in the end, remember, though it is almost always better to have more than less, invest in such a way that you, and those that rely on you will make it to your goal comfortably.  Just as valuable is the ability to sleep at night, and know that your plan has enough slack to enable you to take some hits, and come through fine.

I get requests from local friends fairly regularly for aid in understanding their finances.  While coming home from church recently, I mentioned to my wife that many were seeking my opinion in our congregation.  Her response was, “So what else is new?”  Then I began to list it, family by family, and the congregations that were seeking my opinion for their building/endowment funds, and/or borrowing needs.  As I went down the list, my wife’s responses were “Not them!”, and “Them too?!” and “No!”

What can I say? My wife is the best wife I have ever heard of, but even married to me, economics is a distant topic.  Her father was well-off, but humble, and I am well-off, and I try to be humble.  You can be the judge there.

I say to my friends asking advice, “Remember, I am your friend.  I will take no money, but I won’t hold your hand and guide you either.  I will give you very basic advice, and it is up to you to learn and implement it.”  I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

With that, the scenarios:

1) 90-year old widow, who lives with her daughter and son-in-law.  Another son-in-law, given to incaution, is advising putting everything into gold and silver.  What to do?

She has adequate assets to support her through the rest of her life.  Her husband was responsible.  I asked her if she needed more income, and she said no.  I told her, then relax, ignore the other son-in-law (I know him to a degree), but if you want to, invest 3-5% in precious metals.  She didn’t see the need, and I told her that was fine.  She asked me what I would do in her shoes, and I said that it was a very difficult environment to be investing in, and that we could not tell what the government might do in a crisis, so the best thing to do was to stay diversified, and invested in companies which would have continued demand.  But if you don’t need the money, don’t take the risk now.

2) 80-year old widow, assets in even better shape.  Her husband was a great guy; an inspiration to me in many ways.  He was a mutual fund collector, and left her a basket of 30+ funds, as well as two homes free and clear.  What to do?  I suggested that she harvest funds that had been doing particularly well and reinvest in funds that had lagged.  I suggested purging certain funds that were likely mismanaged.  I also suggested liquidating one property if she could get an acceptable bid.

3) 50-year old bachelor, never married.  Funds are from TIAA-CREF.  We decided on a 50-50 stock-bond mix three years ago.  Recently we rebalanced to add more equities.  He was disappointed that his portfolio had moved backward.  I said “Welcome to the club.”

I will continue with more in part two, but 2008 blew apart many people’s expectations over what their assets could deliver.  My stylized view of it stems from comments that I got at church.  In 1999, my friends were people into equities, as I was holding back.   In 2002, many said they were exiting equities, and moving to what they understood, residential real estate.  I was adding fresh cash to my positions, and paying off my mortgage. By 2006-2007, they began getting interested in stocks again.  By 2009, both stocks and residential real estate was tarnished, leaving bonds remaining.

Closing then, with three final notes:

a) The low interest rate policy is definitely hurting seniors, and I believe all investors.  We all become worse capital allocators when there is no safe place to put excess funds.  It tempts people to stupid decisions.  If Bernanke wants to do us a favor, let him resign, and put John Taylor or Raghuram Rajan in his place.  Tempting people to dumb investment decisions hurts the economy in the long run, it does not help us.

It may help the banks have a risk-free arb on short government bonds, but that’s not what we should want either.  If they are sound, they should be lending. Raise short rates, and let the banks have a harder time, and give investors a place to put money while they look for better opportunities.

b) Average people, and sadly, many professionals, are hopeless trend-followers.  They have no sense of looking through the windshield, rather they ask what has worked, and do that.  Mimicry can be a help in much of life, e.g., finding where to buy good furniture cheaply, but is harmful with investing where figuratively the devil takes the hindmost.

c) People get caught on eras, and have a hard time letting go of them.  The 70s biased many against inflation, and toward residential real estate. The residential real estate lesson got reinforced in the ’00s.  The equity markets seemed magical from 1975 to 2007, and asset allocators increased their allocations to equities in response.  Now you hear of “bonds only” asset allocations, just as the amount of juice available in most of the bond market is limited.

People got used to refinancing their mortgage every few years, and enjoying the extra cash flow.  The modern era reveals the hidden assumptions on that: that property values would never fall.

The point: markets aren’t magic.  They can only deliver what the real economy does.  Stocks only do well over the long run if profits do well. Valuations come and go.  Bonds make money off the stated interest (coupon) rate less default losses.  Valuations come and go.  Real estate is worth the stream of services that the land and improvements can deliver.  Valuations come and go.

Now, you can play the “come and go” if you are smart, but with the “come and go,” for every winner there is a loser.  But asset allocators need to be more humble in their assumptions for financial planning and not assume that they can earn more than 2% over the 10-year Treasury, or over expected growth in nominal GDP.  The share of income that goes to profits and interest also tends to mean-revert over time, so humility is needed when:

• Illustrating an investment plan for a family
• Setting the discount rate for a defined benefit pension plan
• Setting the spending rate on an endowment
• or even, setting assumptions for the Social Security trust funds.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.  Most small an medium-sized businesses rely on small banks.  Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.  Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.  No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.  Part of it is due to the Fed sucking up a large part of the market.  Part due to the low cost of short term funds.  My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.  In the US, it separates the strong versus the weak states.  In the EU, it separates the strong versus the weak countries.  That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.  As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.  For example, I agree that there could be a lot more extracted from the rich in taxes.  But I don’t think it would succeed.  There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.  I speak as one that has seen this in action.  Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.  Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.  I favor bonds in the short run, stocks in the long run.  Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?  Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.  But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.  They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.  Waltons, Brady Bunch, Eight is Enough, etc.  We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.  Time for sleep.  Just don’t go shorting bonds thinking I told you to do it.