01 June 2009

The S&P and Me

Image via Calculated Risk.

A Lifetime Of Investment Returns Lost

The first time I put money into the stock market was April 1996, when a first 401(k) payment came out of my paycheck from Younge & Hockensmith, P.C. in Grand Junction, Colorado. Like most young men starting out in life at that time, I invested it in a diversified equity mutual fund portfolio.

The accounts involved have gotten more complicated over time. Some prior employer accounts have been rolled into IRAs (not all consolidated with each other), and one has been left to sit around in the prior employer's plan, until I have time to get around to the rollover paperwork. But, with one exception (an accounting error in my favor of a couple hundred dollars from a long closed retirement account that I cashed), I have always rolled over my old retirement funds on a tax free basis, sometimes followed by Roth IRA conversions.

Every new account at new employers has had more or less similar investments. And, basically, every time I have sold mutual funds held for retirement, it has simply been to purchase new ones with a similar goal at a different company, and the choice has been entirely motivated by administrative convenience. In short, the S&P 500 is a reasonably fair summary of the investment returns I've had over the years as a buy and hold investor.

As the chart above shows, earlier this year, the S&P 500 dropped to the level it was at when the first funds went into my 401(k). My thirteen year return on that investment was basically zero. Even worse, I've actually lost investment principal through this years S&P 500 bottom in all the money I've saved for retirement since then. The S&P 500 is up almost 40% since its bottom, and most of us are hoping that this isn't simply a dead cat bounce (disclaimer: no cats were harmed in the preparation of this blog post).

The Case For Retirement Savings

This isn't to say that saving for retirement has been an entirely bad idea. Some of those salary deferrals generated matching funds that amounted to pay in exchange for participating in the plan. The income that investments would have been purchased out of, had I used after tax dollars to do so, has remained untaxed, except for modest amounts that I have converted to Roth IRAs in years when my marginal tax rate was low. And, the nudge to save that the tax status provides has worked. I have assiduously refused to raid the nest egg for consumption in good times and bad -- without tax sheltered savings, the money almost certainly would have been spent on something that I no longer remember now.

About Social Security

Social Security provides a retirement no more generous (which is to say just barely better than poverty) than it did when I started saving for retirement. And, there is much more talk of cutting back on Social Security than making it more generous. Already, normal Social Security retirement age for people born when I was has been moved back from age sixty-five to age sixty-eight. Social Security is not an entire retirement, but simply writing it off, as it is fashionable for those my age to do, isn't honest either. Social Security benefits are economically equivalent in safety and amount to hundreds of thousands of dollars of retirement savings in the form of safe treasury bonds, and I am certainly not ready to overlook hundreds of thousands of dollars.

Thankfully, Congress resisted the temptation to invest the Social Security trust fund in the stock market or private accounts with stock market investments, so I am at least no worse off than I was when I started in the Social Security part of my retirement. The investment retirements for middle class people on their Social Security contributions looked pretty dismal compared to the stock market in the boom years when these proposals were in vogue, but these days, the internal return on investment for Social Security contributions looks quite competitive with investments of equal amounts in 401(k) accounts over my work history.

Against Defined Benefit Pension Plans

I also have not been won over to the virtues of defined benefit pension plans. I have been typical in my generation in my career moves. I have not spent a lifetime working for one employer, and I know the way the actuarial benefits work out in defined benefit pension plans well enough to know that they favor long term employees over those who work for an employer for shorter periods of tie. The marginal benefits of being involved in a defined benefit pension plan surge in the final years as you reach the threshold for normal benefits under the plan; and then turn work much beyond normal retirement age into a nearly non-profit proposition. I've also seen too many companies, big reliable prosperous companies, fall into bankruptcy and abandon their pensions without sufficient funding, during my adult life to feel comfortable betting my retirement on one company's continued economic well being. The pension benefit guarantee corporation mitigates that risk, but not completely.

At any rate, defined benefit pension plans have simply not been an option for me. I have spent my entire career at firms that do not offer them, even though some have been large firms and some have been in business for many decades. They are not found even at large law firms and many Fortune 500 companies these days. Smaller employers almost never had them, except as asset protection and tax dodges designed to exploit irregularities in funding formulas. I would never recommend a defined benefit pension plan to a client that doesn't have one already, because the economic risks are too great to the employer because funding and plan benefit obligations ebb and flow with the investment performance of defined benefit pension plan assets, and because they rarely create useful golden handcuff incentives for the employer, except in the case of employees who have already proven themselves to be absolutely loyal.

While it may happen due to pressures from unions who have a large stake in the reorganized entities, it doesn't make good business sense for either General Motors or Chrysler to have defined benefit pension plans going forward after their respective bankruptcies. Notably, I can't recall any of the airlines that had defined benefit pension plans going into bankruptcy lately, reinstating them after bankruptcy.

Doubting Equity Investments

My faith in the equity markets has been shaken.

For most of my career, financial planners and the lawyers and accountants who work with them, have assumes that equity markets would return 7-8% per annum total return in finitum, in the long run, although obviously not every single year. Financial professionals have assumed that the opportunity costs of being too cautious outweigh the risk of investment losses for investors with all but the shortest time horizons. But, the people who made the models that these financial professionals formed their doctrine upon have been historically blind.

Bankers on the lending side have been able to avoid some of this long term risk analysis, because while they call their longest term popular loans until the last few years a thirty year mortgage and the thirty year bond, the average thirty year mortgage is refinanced or paid off due to a real estate sale in about ten years (which is why mortgage rates track ten year government bond prices), and few people stay on the risk of a thirty year corporate bond investment for the entire thirty years; they are readily traed in the bond markets and often they are refinanced or repaid early (using escrows against long term treasury bonds where pre-payment isn't expressly permitted).

For someone with a five or ten year time horizon, looking at the post-World War II, post-Great Depression, or 20th century history of market performance makes sense. For someone in their twenties or thirties, planning for savings that will need to sustain the into their seventies or eighties or nineties, one needs to look back further to Shay's Rebellion, the Panic of 1819, the Civil War, and the Panics of 1873 and 1893, in addition to the Roaring 20s an the Great Depression where most people's knowledge of economic history begins. If you have a forty to seventy year time horizon, the odds that you will be hit by a big bust sometime or other is quite great, and that big bust could strike at any point during that time frame. There have been at least eight or nine very deep economic downturns in U.S. history, depending upon how you count them, to date, and economies in Europe and Japan have also seen economic downturns on a regular although not entirely predictable basis (Japan's Great Depression, for example, started two or three years before ours, depending upon what measure you count the beginning with), since the industrial revolution.

If I were thirty years older than I am right now, the current bust would be devastating. Not only would I be seeing my nest egg demolished, I would have almost no working years to build it back up before I would otherwise have been ready to retire. In the real event, I have lost money like almost everybody else in my generation, but I also have a reasonable prospect of winning it back with future investment returns, and saving more for retirement, before it really matters. My losses at this point are merely paper losses.

Isn't Now The Time To Get In?

The road forward isn't obvious either. The consensus is that this particular financial downturn will be over in a matter of years, if not months. No one doubts that there will be recessions between now and the time that I reach retirement age. But, if economic downturns are, as optimistic economists sometimes like to call them, "corrections," rather than truly random fluctuations, then the notion that a historic bear market has become less probable in next decade or two is not just a gambler's fallacy, but an economic fact.

There may be no time better to take modest risks of the type I've taken all my life with my retirement funds in the equity markets than now. But, having been burned so badly once, this line of reasoning comes with considerably less blind acceptance than it did the first time that I went down this road. This time, the decision will be more about balancing and quantifying possible upside and downside risk, and possibly taking approaches that hedge those risks (e.g. with a mixed equity and non-equity, or less cyclic portfolio). It will not simply be about balancing expected average returns in the long run against my investment time horizon with conventional wisdom.

Paying Off Debt v. Investing

The other big risk that I am re-evaluating going forward is the notion of having debt and investment assets at the same time. Almost every middle class household of my generation has simultaneously maintained retirement accounts (and often other privileged savings accounts like health savings accounts and education savings accounts) while at the same time having a substantial mortgage, at least some short term credit card debt (for the grace period at least), and sometimes vehicle loans.

When the after tax appreciation rate on your investment assets (quite high in tax privileged accounts) exceeds the after tax interest rate on your debts (quite low for tax deductible mortgage interet or zero percent interest float money during a credit card grace period), this makes economic sense.

But, if investment and real estate asset prices are both fall, as they have during the financial crisis, then in hindsight, paying off debt which produces a meaningful risk free return while simultaneously producing tax free implicit income from the use of assets owned free and clear and reduces household financial risk of catastrophes like foreclosures and repossessions, looks like a very good alternative to investing.

How do you balance upside benefit in times of rising prices versus downside risk in times of falling prices? It is a question that every middle class family needs to answer, and that most people don't have the time address rigorously in an undertaking you could earn a PhD doing properly.

Tax law discourages offsetting investment (which for middle class families happens overwhelmingly in tax preferrenced accounts) against debt (which for middle class families is overwhelmingly tax preferrenced mortgage interest).

Bankruptcy law and state law debtor-creditor exemption rules reinforce the instinct to have offsetting mortgage debt and privileged investment assets. If you have lots of money in an IRA or 401(k) and a large mortgage, homestead exemptions will protect both from non-purchase money/401(k) loan creditor's claims in almost all U.S. states. But, if you have a much smaller IRA or 401(k) and a small mortgage, your creditors will have a claim against the home equity in all but a handful of U.S. states.

While tax law favors offsetting debt and investment positions, and bankruptcy does too, that isn't the end of the story. At some point, in bad times, most people need cash flow more than anything else because they have needs that can't be satisfied any other way. A 401(k) loan, IRA withdrawal or home equity loan can provide cash flow and put off the day of reckoning that brings the visible trappings of a middle class life crashing down for many months, and sometimes things will turn around and this financial damage can be remedied. But, these loans also voluntarily make assets that might otherwise be exempt from creditor's claims available to them.

The data from bankruptcy filings appears to show that most people who file bankruptcy in the post-2005 bankruptcy reform era would have been better off if they'd pulled the trigger and given up much sooner. Perhaps this is a rational product of the increasing importance of a good credit rating. But, perhaps this is just a matter of fear and ignorance producing bad decisions.

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