MountainTops

What Happens When People Ignore The Mixed Economy (An Example From Our Archives)

Monday, June 29th, 2009

Note: Here’s something that we first wrote about in 2001. Read the article, then our follow-up commentary.

One of the mysteries of human behavior is why people don’t do things universally recognized as beneficial.

For example, everyone knows regular exercise is a healthy habit, but every new study seems to indicate Americans are exercising less and weighing more. And even the tobacco industry has finally admitted that cigarettes are a health hazard. Yet people still smoke.

In both of the above examples, some might argue that addictive nature of high-calorie foods and nicotine must be considered as part of the equation. That may be the case, but there are other areas where people just don’t do the things that would be good for them.

Read this excerpt from a letter to the editor in the February 26, 2001 issue of the Wall Street Journal:

“On April 23, 2001, my wife and I will write a check for $461,000 to the U.S. Treasury for estate taxes for her father. One would think this is a painless act since she is now considered by many to be rich.

“How will this amount be met by that date? We are in the process of mortgaging the $220,000 Florida house that has been on the market since October. We have sold all of the liquid assets. Yet we are still going to have to borrow another $100,000 by April and avoid the 25% late penalty.”

A sad story, right? It’s the type of anecdote that makes you angry with the government for taking one last swipe at the hard-earned assets from a lifetime of work.

Wait a minute…

We don’t know all of the details, but this appears to be a sad story that didn’t have to happen.

It’s just a guess, but $461,000 of taxes due means an estate with a ballpark value of $3 million, give or take a few hundred thousand. And if the assets aren’t liquid, there’s possibly property or a business involved. More than likely, then, this was an estate that grew gradually over time. It wasn’t the result of some 20-year-old computer geek cashing in on a dot-com idea.

Which means there was time to plan.

Which means there could have been trusts, and life insurance policies, and gifting plans, and other strategies in place to protect those hard-earned assets. Which means a lot of the estate taxes probably could have been avoided.

Don’t misunderstand. It’s legitimate to decry the tax policy that results in the situation mentioned above. But it doesn’t explain why so many wealthy people don’t take the time to do what they can to minimize the damages. As far as we know, there isn’t an addiction or disease that keeps people from planning. Like we said at the beginning, it’s a mystery.

Why don’t people plan?

Comment: The situation described above is a classic example of the risk of ignoring the certain aspects of the mixed economy. This family apparently did a commendable job of accumulating wealth, probably through diligent work in free-market activity. Now they find the “control” of government taxation removing a sizable chunk of their wealth, and it seems so unfair.

You know what? For most people, the estate tax is unfair. But it’s also characteristic of how the mixed economy works. You can complain, even advocate for changes. But you should prepare for the financial realities.

If you have any knowledge of current economic control issues being discussed by politicians, you know changes to the estate tax rules are again under consideration - and the idea is to increase estate taxes, not reduce them. To remain ignorant of these changes means a lifetime of wealth could be transferred to government entities instead of designated heirs.

“You cannot legislate the poor into freedom by legislating the wealthy out of freedom. What one person receives without working for, another person must work for without receiving. The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friend is about the end of any nation. You cannot multiply wealth by dividing it.”

Dr. Adrian Rogers, 1931 to 2005

Posted in Economics, Financial Planning | No Comments »

Financial Strategies For A Mixed (Up) Economy

Wednesday, June 3rd, 2009

Q: Why did God create economists?
A: In order to make weather forecasters look good.

Economics has long been referred to as the “dismal science.” While the economy might be a frequent topic of general discussion, the people who discuss economics are often perceived as fuzzy thinkers whose commentaries and predictions are unintelligible or irrelevant to the average citizen. After all…

Economists have forecasted nine out of the last five recessions!

Joking aside…a better understanding of economic perspectives could make a significant difference in the way you make financial decisions. Underneath the statistics and unfamiliar terms used by economists are some powerful ideas about how wealth and prosperity are created. In upcoming posts we will illustrate some of these basic economic ideas.

Posted in Economics, Financial Planning, mixed economy | No Comments »

Annual Return Percentages Are Tricky – Especially When They Go Negative

Monday, February 16th, 2009

Some simple calculations with surprising outcomes.

Suppose you have $10,000 on January 1, 2009. You place it in a non-guaranteed financial instrument for two years.

The first year, your account shows a 10 percent gain. The next year you incur a 10 percent loss. For the two-year period, what is your average annual rate of return?

Answer: - .05 percent. That’s “negative one-half percent.” It might seem counter-intuitive at first, but a 10 percent gain followed by a 10 percent loss results in an overall loss. Here are the numbers (Fig. 1):

FIG. 1

By the way, it doesn’t matter if the loss comes first or last in the two-year sequence - either way, the result is the same. The loss always takes more than the gain adds. (See Fig. 2)

FIG. 2

What’s going on?

The simple formula for finding an average is to add all the results, then divide the total by the number of results represented. For example: 5 people, ages 23, 45, 34, 57 and 26. To find the average age of the group, add their ages (23+45+34+57+26=185), then divide by the number of people (185/5). The average age of this group is 37.

But as the illustrations from FIGS. 1 and 2 show, calculating annual percentage returns over a long period of time - especially when some annual returns are negative - is not so simple. Losses have a disproportionate impact on total returns, and this imbalance increases as the percentages increase. Take this variation on the above example:

The first year, your account shows a 100 percent gain. The next year you incur a 50 percent loss. For the two-year period, what is your average annual rate of return?

Answer: 0 percent! Check out the numbers:

When reviewing the historical performance of a non-guaranteed financial instrument, don’t just evaluate the year-by-year numbers. Instead, try to get an accurate annualized return. If you don’t know how to do this yourself, contact someone who understands percentages and has a computer program that can calculate the real returns for your specific situation.

Posted in Financial Planning, Investing | No Comments »

Is It Time to Get Off the Train? (Stock Market?)

Sunday, February 1st, 2009

Suppose you have several transportation options for getting to work every day. One of the options is a new, high-speed train system.

According to its schedule, the trains can get you to work faster than driving in your own car or taking the bus. Driving your own car might be a little cheaper, but when you take the train, you don’t have to hassle with all the “ownership costs,” such as fuel, insurance and finding a parking space. You just pay for a ticket and ride. It sounds like a no-brainer. You start riding the train.

It turns out there’s a bit of difference between the projected performance of the train and reality. More often than not you get to work on time, but the trains rarely run according to schedule. (There are some days when you get to work early because the train is running so fast.)

Besides the slightly erratic schedule, there’s another nagging problem: Sometimes a train jumps the track. You’ve never been on a train that’s derailed, and so far, nobody has been hurt, but reports on the incidents are unsettling.

When the high-speed train was first introduced, some were hesitant to ride because of safety concerns. Both train company management and government overseers assured potential riders of the soundness of the system. “No system is entirely fool-proof” they said, “but we have every reason to believe the high-speed system will deliver as promised. Riders will reach their destinations faster, and at less cost.” You want to believe them, but some commentators are hinting that perhaps the risks are greater than reported.

Over the course of the next year, train service gets more unpredictable. One week, you’re late arriving to work four of five days. Frustrated by the uneven performance, several of your commuter acquaintances give up riding the train, and decide to start driving their own cars to work.

Then, one day, you are on a train that derails. Amid the noise, lurching cars, confusion, and jarring stop, there’s a sick feeling in your stomach. In the quiet that follows the shock, everyone does some self-assessment, checking for injuries and missing personal items. Fortunately, there are no major injuries.

During the two hours it takes to get everyone off the train and clear the track, there’s a goofy sort of camaraderie with your fellow passengers. You joke about the experience, wondering if appearing on the evening news will be enough to get you excused from showing up for work. You lament that it’s too bad the damage wasn’t greater, because there could have been a nice settlement and movie deal in works. But instead of heading on to work when a new train comes down the track, you just go home. You’re having second thoughts about continuing to ride the train.

Of course, the next day you go to the station. Most of your commuter buddies are there, too. “Hey,” one of them says with a laugh, “let’s hope lightning doesn’t strike twice, because how else are we gonna get to work?” Nothing happens on the way in - no delays, no surprises, everything is on time - but you are edgy the whole trip. Same thing happens on the way home.

As you step off the train and begin the short walk home, you ask yourself, “what’s it going to take for me to stop riding the train?”

LET’S RE-WRITE THIS ARTICLE:

Suppose you have several (accumulation) options for getting to (your retirement goals). One of options is a new, high-speed (stock-market investment program).

According to its (projections), the (stock market) can get you to (retirement goals) faster than (building your own business, real estate) or (anything else). Driving your own car might be a little cheaper, but when you (use the stock market), you don’t have to hassle with all the “ownership costs,” such as (employees, rent, insurance and finding a parking space). You just (buy some shares) and (go along for the) ride. It sounds like a no-brainer. You start (investing in the stock market).

It turns out there’s a bit of difference between the projected performance of the (stock market) and reality. More often than not you (make progress on your retirement goals), but the (stock market) rarely (performs) runs according to schedule. (There are some days when you get ahead because the stock market is booming.)

Besides the slightly erratic schedule, there’s another nagging problem: Sometimes (one of the investments) jumps the track. You’ve never been (in a stock) that’s (tanked), and so far, nobody has (lost everything), but reports on the incidents are unsettling.

When the (stock-market investing) was first introduced (as something for the average American), some were hesitant to (participate) because of safety concerns. Both (investment) company management and government overseers assured potential riders of the soundness of the system. “No system is entirely fool-proof” they said, “but we have every reason to believe the (stock market) will deliver as promised. (Investors) will reach their destinations faster, and at less cost.” You want to believe them, but some commentators are hinting that perhaps the risks are greater than reported.

Over the course of the next year, (the stock market) gets more unpredictable. One week, you (lose 10 percent of your account value) in five days. Frustrated by the uneven performance, several of your (investor) acquaintances give up (playing the stock market), and decide to start (managing their assets themselves).

Then, one day, you are (in a stock) that (bottoms out). Amid the (business page headlines, 24-hour TV news coverage and meltdown), there’s a sick feeling in your stomach. In the quiet that follows the shock, everyone does some self-assessment, checking (the magnitude of their losses). Fortunately, the (stock rebounds over the next few months).

During the two (days, weeks, months) it takes to (see if the stock will settle down), there’s a goofy sort of camaraderie with your fellow (investors). You joke about the experience, wondering if appearing on the evening news will be enough to get (a bailout from the government). You lament that it’s too bad the damage wasn’t greater, because there could have been a nice settlement and movie deal in works. But instead of (buying another stock), you (pass). You’re having second thoughts about continuing to (stay in the market).

Of course, the next day you go to your broker’s (web site). Most of your (investor) buddies are there, too. “Hey,” one of them says with a laugh, “let’s hope lightning doesn’t strike twice, because how else are we gonna (be able to retire?)” Nothing happens (in the market that day) - no delays, no surprises, everything is (quiet) - but you are edgy the whole (week). Same thing happens the (rest of the month).

As you (log) off the Internet and begin the short walk home, you ask yourself, “what’s it going to take for me to stop (investing in the stock market)?”

Posted in Financial Planning, Investing, financial crisis | No Comments »

Following The GRA Trail: From 401(K)S To…?

Wednesday, September 17th, 2008

It was a short sentence buried in the middle of a small article in an inside section of the November 3, 2008, Wall Street Journal:

“Some experts are already calling the 401(k) a failed experiment.”

The article, Financial Crisis Highlights Shortcomings of 401(k) Plans, focused on several problematic aspects of 401(k)s: people aren’t saving enough, allocation options are either limited or complex, high fees cut into returns, and too many invest in company stock.

But who are these “experts” calling the 401(k) a failure?

An e-mail to writer of the article, Eleanor Laise, generated no response. Thus, it was time to investigate via the Internet.

When “401(k) a failed experiment” was typed into Google, it found the “expert.” Her name is Teresa Ghilarducci. Ms. Ghilarducci is a professor of economic policy analysis at the New School for Social Research in New York, and her statement that the 401(k) was “a failed experiment” was made in an October 7, 2008 Congressional hearing.

This hearing was called in light of the recent financial crisis and its negative impact on the account values of many participants in retirement plans. In the proceedings, several members of Congress made rumblings about needing to change the way Americans prepare for retirement. California Representative George Miller, the chair of the House Committee on Education and Labor stated his desire for the hearing was to “conduct much-needed oversight on behalf of the American people.”

Ms. Ghilarducci was called to speak before the committee primarily because of a paper she published in November 2007, titled “Guaranteed Retirement Accounts.” In her report, Ms. Ghilarducci highlighted the following flaws with 401(k)s:

The tax breaks are “skewed to the wealthy because it is easier for them to save,” because the higher one’s income (and marginal tax bracket), the greater the deduction for making deductible deposits. Low-income people, some who pay no income tax, don’t have the “extra” to save, and don’t have the same incentives. This format, according to Ghilarducci, “exacerbates income and wealth inequalities.”

Further, Ghilarducci is of the opinion that individuals are ill-suited to handle investment risk, as “humans often lack the foresight, discipline, and investing skills required to sustain a savings plan.” In light of these shortcomings, Ghilarducci concludes “Governments, and to a lesser extent employers, are better suited to bear longevity, financial, default and inflation risks than individual workers.”

To rectify these problems, Ghilarducci proposes a new program: the Guaranteed Retirement Account (GRA). Designed as a universal retirement plan administered by the Social Security Administration (or similar governmental unit), this program would:

• Require all workers to have 5 percent of their annual pay deducted from their paychecks and deposited to the GRA account, unless they were participants in an similar employer-sponsored defined-benefit pension plan.
• Provide a flat $600 tax credit for every worker, instead of a deduction based on the amount deposited.
• Guarantee fixed returns at 3 percent annually by investing only in conservative investments. (If actual investment performance exceeded 3 percent, the administrators could elect to exceed this minimum.)
• Convert all existing 401(k) plans to GRAs
• Distribute benefits in the form of a monthly income in retirement. No distributions would be allowed prior to retirement, and lump-sum distributions after retirement would be limited to $10,000 or 10% of the account balance, whichever is higher.
• Limit transfers upon death to heirs to 50 percent of the account balance if death occurs before retirement, and 50 percent minus benefits received if death occurs after retirement age.

These recommendations, if implemented, would represent a significant change in retirement planning for Americans. The Federal government and/or employers would assume most of the responsibility for providing retirement incomes, while forfeiting the opportunity for individuals to achieve greater returns through riskier investment options.

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How Likely Is It That GRA’s Will Soon Become Part Of The Financial Landscape?

Thursday, September 11th, 2008

The press secretary for the Congressional committee initially released a statement that committee members “were listening to all ideas.” And another committee member said he found the GRA proposal “intriguing” and “part of the discussion.” But when pressed on a national news program, Miller backtracked, saying he would not be in favor of “killing the 401(k).”

From a historical perspective, the Clinton administration floated a proposal over 10 years ago to preemptively impose a 15 percent tax assessment on retirement accounts, assuming the government would be better served to collect some of the tax immediately instead of waiting for individuals to retire. The proposal never made it past the trial-balloon discussion.

On the opposite end of the spectrum, the government of Argentina announced plans in September to nationalize all its citizens’ retirement accounts, and implement a program which in some ways mimics the GRA idea.

Here’s the reality: Because the key features of government-authorized retirement accounts are controlled by legislators - and influenced by politics - changes are inevitable. But while inevitable, changes are very difficult to predict. For a long-term financial objective like retirement, this prospect of constant change makes relying exclusively on government programs a risky option, particularly for those who desire more than a guaranteed minimum in retirement.

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Life Insurance Sidesteps Moral Hazards

Thursday, September 4th, 2008

Among the most compelling daily storylines in this financial crisis are the details of the “bailout;” - i.e., who needs (and who will receive) a financial rescue from the Federal government? For politicians and economists, it’s a heated debate as to who is or is not worthy of government assistance. And for some institutions and businesses, receiving immediate financial assistance will be a make-or-break decision.

But even if the specifics don’t directly impact your life, the issues arising from the bailout should provide some interesting financial insight for the individual.

One of the insights is gaining a better understanding the concept of “moral hazard.”

MORAL HAZARD DEFINED

A Moral hazard occurs when a party is insulated from risk, and this “protection” encourages them to behave differently. If an individual or institution can avoid the full consequences of their actions, there is a tendency to act less prudently than they otherwise might. This existence of a moral hazard makes it more likely that negative consequences will result.

MORAL HAZARDS IN THE CURRENT FINANCIAL CRISIS

In regard to current events, the moral hazard issue has surfaced several times. Some commentators have said mortgage lenders over-indulged in risky sub-prime lending because the federal government enabled them to do so by providing assurances that it approved of the efforts to make home ownership more affordable, and was willing to provide some financial back-up in case some sub-prime borrowers defaulted. If this assessment is correct (and many would say it is, particularly in regard to government-sponsored lenders like Fannie Mae and Freddie Mac), the arrangement created a moral hazard. Believing they were covered even if the borrowers defaulted, lenders were more likely to take on bad risks, and more likely to incur losses.

Likewise, Treasury Secretary Henry Paulson has expressed some concern that extending an offer of a government bailout to too many companies would establish a bad precedent. Believing they could always turn to government in case things go awry, businesses in the future might be less diligent in managing their financial affairs.

MORAL HAZARDS ARE EVERYWHERE

Theoretically, there is the presence of a moral hazard in any type of guarantee or insurance. Martha White, writing in a September 19, 2008 Slate article, says “if I

have health insurance, I’m more likely to sky-dive. If I have fire insurance, I’m more likely to burn sandalwood candles in my bedroom.” In the workplace, the guarantee of an hourly wage may create a moral hazard because employees will not work harder than what’s required to hold their position. (”What’s the point in working harder? I’m getting paid the same whether I do five jobs in a day or ten.”)

The presence of moral hazard may also introduce the potential for fraud.

Someone receiving income from a disability insurance claim may be inclined to prolong their disability instead of getting back to work. Both a healthcare provider and a patient may have a motivation to recode a procedure in order to receive insurance reimbursement, as opposed to negotiation a lesser payment from the patient. Because sub-prime lending was profitable (and supposedly risk-free for lenders), there are some indications that verification standards were either loosened or overlooked in order to execute the loans.

USING MORAL HAZARD AS A CRITERIA IN FINANCIAL DECISION-MAKING

For individuals, one of the methods for assessing financial risk might be to determine the moral hazards associated with placing money with a particular institution.

For example, if a mutual fund manager is paid for the size of assets under management, there is certainly an incentive to grow the portfolio by generating higher returns. But this same arrangement also creates an incentive to aggressively market to attract more shareholders; even if the investment results are sub-standard, the manager can earn more money by collecting more deposits. Is this compensation arrangement a moral hazard for existing shareholders? Perhaps, because a manager in down market may decide to focus on attracting new shareholders as opposed to managing the portfolio for the benefit of existing shareholders.

When a mutual fund offers a guarantee that all liquidation requests will be honored immediately, it may force the fund management to sell profitable investments in order to provide the necessary cash. This guarantee of immediate liquidation may create a moral hazard for the remaining shareholders - those who remain invested may now hold shares of lesser value. On a smaller, but much more dramatic scale, this liquidation issue is a major concern for hedge-fund managers and shareholders.

Neither of the above-mentioned issues alone are enough to eliminate mutual funds from consideration as an investment option. But having an idea of the moral hazards associated with a particular investment might be a way to better evaluate the financial risks.

For a long time, mortgage-backed securities were considered a conservative “safe” investment option. However, had more people understood the nature of some of the mortgages lenders were selling to investors, and why these mortgages were initiated, perhaps they would have been evaluated better.

THE UNIQUE STRUCTURE OF CASH VALUE LIFE INSURANCE

Unlike almost any other type of insurance or guarantee, there is minimal moral hazard associated with the establishment of a whole life insurance contract. This is primarily because the guarantees involve life and death - literally.

In general, individuals have a strong motivation to live as long as possible. Likewise, insurance companies have a strong incentive for their policyholders to live as long as possible, because the more premiums they collect before paying a claim, the more profitable they are. Thus, insurance company has a vested interest in correctly evaluating the health of potential policyholders, and encouraging people to live as long as possible.

And while it is not unusual for fraudulent claims to occur with other types of insurance, making a fraudulent death claim is quite difficult. Determining whether someone is alive or dead is a lot more clear-cut than being disabled, or meeting a deductible on an auto accident. Of greater significance, almost no one considers dying “worth it” just to collect the insurance.

But both the insurance company and the individual also know dying is a certainty. In order to collect the insurance benefit, the individual knows he/she must keep the policy in force. The insurance company knows that in order to meet their eventual obligation, they must provide on-going incentives for the policyholder to continue paying premiums. The desires of both parties to sustain the contract are resolved through the cash value features. Over time, policyholders acquire more than an insurance benefit, and the insurance company acquires an on-going stream of capital to weather the fluctuations in claims and market events. This profitability allows the company to charge competitive rates and offer competitive dividends, especially in mutual companies where the policyowners are shareholders.

Considering this alignment of interests and limited exposure to moral hazard, it is no surprise that life insurance companies have, as a group, remained stable and profitable in the midst of a global financial crisis. In his 2006 book Money, Bank Credit, & Economic Cycles, Spanish economist Jesús Huerta de Soto looks at three centuries of capitalism and concludes that life insurance is “a form of perfected savings.” He adds:

“The institution of life insurance has gradually and spontaneously taken shape in the market over the last two hundred years. It is based on a series of technical, actuarial, financial and juridical principles of business behavior which have enabled it to perform its mission perfectly and survive economic crises and recessions which other institutions, especially banking, have been unable to overcome.”

Recent financial events have revealed the potential for great harm when moral hazards are ignored by savers and investors. Among its many intangible benefits, cash value life insurance also presents a limited moral hazard for both policyowners and insurance companies.

Posted in Financial Planning, Investing, Life Insurance | No Comments »