My Mom died last week.  She was 88.  I suppose I’m very lucky to have had her so long.  Don’t feel lucky though.

She was not feeling well, so my sisters checked her into the hospital.  Mom cracked a joke about the handsome doctor who checked on her.  Twenty minutes later she slipped away with her daughters holding her hands.

Here she is near the water where she was happiest.

I have lots of great stories about my Mom, but I’ll hold those for some other time.  One story is worth recounting though.

My Mom and my wife and I were leaving a concert in San Francisco’s Tenderloin district.  The Tenderloin is SF’s ‘red light’ district.  It’s generally fine, but not always.  I was walking ahead with a few people and my Mom and wife were with another group slightly behind us.   I turned back to look and saw my Mom with surrounded by three guys.  That didn’t look good, so I went back.  The three guys ran off and I asked my wife what happened.

She told me the guys pulled a knife and demanded the camera my Mom was carrying.  She grasped the camera tighter, looked at them directly and said, “That’s my son’s camera.”  I told her she could have just given them the camera because I would rather have my Mom than the dang camera.  She looked at me as though I was crazy.  She was holding something of mine and no knife-wielding thug could intimidate her.

She was made of sterner stuff than that.

I miss my Mom

My experience with inflation dates back to the 1970s and early 1980s.  Inflation averaged almost 8% for the entire decade of the ’70s, but it cranked up into double digits in 1979.  Let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.  Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks really remember that home mortgage rates hit 18% back then?  Or, that they never went below 12% from 1979 through 1985?

Is inflation an immediate problem?

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation is now running in the Fed’s sweet spot of 1-2%.  However, given all the monetary stimulus and government spending we have seen, inflation is definitely a threat, but one that has not really manifested itself yet. I do not expect us to get back to the inflationary climate we saw in the 1970s, but none of us knows what lies ahead.

If you believe inflation is on the way, you also need to figure out where in the inflationary process we are.  If, like the early 1970s, you think inflation is underway and the Federal Reserve will not attack it for quite a while, then inflation hedges make some sense.  However, if you think the Fed might be planning to raise interest rates soon in order to counteract inflation, then inflation hedges could be a problem.  Here’s why.

If inflation went quite a bit higher, the Fed would eventually be forced to raise short-term interest rates.  Long-term interest rates would certainly go up and that would be bad for those holding long-term bonds.  Once interest rates begin moving up, then economic activity would probably slow down, bringing us into recession and that would hurt most other assets such as real estate and stocks.

For example, in 1979, the Federal Reserve (under Chairman Paul Volcker) decided to really attack inflation by raising the Fed Funds rate (short-term interest rates).  As you saw in the chart above, interest rates on home mortgages went way up.  As rates went up, economic activity fell off and we entered a recession.  In that environment, most assets fell (real estate, stocks, bonds).  Gold prices lagged the decline in other assets, but they also fell.

Gold — from darling to dog in two years

In fact, gold hit a high point in 1980 of $875 per ounce, but it fell as low as $463 within a few months.  Gold prices went back up into the $700 range, but by 1982, gold prices had fallen to a low of $298 per ounce.  That’s right.  From a high of $875, the price of gold fell to around $300 within a couple of years. Beginning in 1982, inflation fell quickly from the double digit level, but gold prices fell much more quickly as gold had a 60% price decline.

What should I do about inflation?

If you believe high inflation is coming our way, how do you protect your portfolio? This piece from the Wall Street Journal covers some solutions and we add a few more ways to protect your portfolio from the ravages of high inflation.

However, be careful out there, because it is not as easy or straightforward as some would have you think.  The key takeaway I have for you is that you should seek investments that you believe are undervalued and likely to go up in value.  That’s how you keep your portfolio growing:

Inflation-Protection Strategies Offer Investors No Guarantees (Wall Street Journal, October 5, 2009, Jeff D. Opdyke)

Worried investors have been looking for insurance in the form of assets such as mutual funds and exchange-traded funds focused on gold, commodities and Treasury inflation-protected securities, or TIPS. In the past year, interest in TIPS funds in particular has been running at record levels, with some weeks recording more than $400 million in sales.

But many of these investments have never been tested during a bout of meaningful inflation. The last time inflation ramped up significantly was three decades ago. Yet TIPS have been around only since the late 1990s, and commodity funds are of even more recent vintage, as are the gold funds that invest in bullion or track the metal’s market price.

This is a really important point.  Wall Street is great at coming up with new and complex investment opportunities.  However, the track record on Wall Street innovations is not good.

Be cautious with new or untested investments

I think of it just like new operating systems for a computer.  I never rush to upgrade my computer with the latest, groovy operating system because I know there will be bugs.  I wait a few years usually before upgrading so that the bugs will largely be fixed before I make the switch.

I view innovations from Wall Street with even more skepticism than I do new operating systems for my computer.  In general, if it is new — and complex — and it’s from Wall Street, I pass.

As an example, consider commodity-oriented exchange-traded funds (ETFs).  They are new and relatively untested, so be cautious.  One critical issue with commodity mutual funds or ETFs is whether or not they actually hold commodities or just a basket of futures contracts for a given commodity.  With precious metals, it is possible to actually hold a commodity such as gold.  However, some commodities such as agricultural products or even oil or gas are less likely to be owned directly by a given fund.  In many cases then, an ETF or mutual fund just holds future contracts or notes redeemable by a bank.

There are some mutual funds such as Pimco Commodity Real Return Fund (PCRDX) that seek to benefit from investments in commodity-related securities.  Here’s how Pimco describes the investment strategy:

PIMCO manages CommodityRealReturn Strategy by combining a position in commodity-linked derivative instruments backed primarily by a portfolio of inflation-indexed securities…Other fixed income instruments may also be used tactically in the portfolio. The commodity-linked derivatives capture the price return of the commodity futures market, while our active management of the fixed income assets seeks to add incremental return above those markets, along with additional inflation hedging…

This type of fund can give you exposure to commodity-related investments, but it is no walk in the park.  We use this fund a bit, but we do so knowing it can be very volatile.  For example, in 2008, it fell over 43%.

Tracking error

Commodity mutual funds or ETFs have the potential to go up in value due to inflation, but they are inherently volatile.  And, as we saw above, they also invest in futures contracts and other so-called derivatives that can lead to unintended consequences as shown by this piece from MarketWatch.  It illustrates the point with examples of a couple of examples of commodity or precious metals ETFs that had results wildly divergent from the actual commodity or metal they are tracking:

…The United States Natural Gas Fund (UNG) , for example, has tumbled 50% this year while natural gas prices are down about 12%…

Natural gas prices go down so you expect the fund to go down, but a loss of 50%? Ouch.

…PowerShares DB Oil Fund’s flexible strategy helps it navigate market conditions…Since the fund’s inception in early 2007, it has gained about 16% while oil prices have risen about 40%…

Nothing wrong with a gain of 16% since 2007, but that return significantly lags the actual increase in oil prices.  As long as you understand what a commodity or precious metal mutual fund or ETF does, then that’s fine.  I suspect many investors in UNG are a bit mystified though.

If you are interested in investing in precious metals, I would simply just own them directly.  That is, buy some gold coins or silver coins and hold them in a safe deposit box.  If you do go that route, you have the coins and there is no muss or fuss. As a second best choice, I would buy an ETF such as the SPDR Gold Trust (GLD), which, by its prospectus, actually buys and holds gold at its custodian in London.

Other ETFs or mutual funds investing in precious metals or commodities may simply be putting together a basket of futures contracts on the commodity in question.  That’s fine if you have faith in the ETF or fund provider, but how exactly those contracts will perform in volatile markets is a bit of a question mark.

The Wall Street Journal continues:

…Though long heralded as a hedge against inflation, gold hasn’t always gone along for the ride when U.S. consumer prices are rising. Consider data from Morningstar Inc.’s Ibbotson Associates research and consulting unit: The correlation of spot gold prices to an Ibbotson-tracked inflation benchmark is just 0.096. (Correlation is perfect at 1; the closer to 0, the less the correlation.)

Certainly, gold has done well in some inflationary periods, like the late 1970s, when the metal spiked above $800 an ounce. Still, investors would do better to view gold as an international currency that hedges against weakening paper currencies, particularly the dollar. For instance, the U.S. dollar index, tracking the greenback’s performance against a basket of currencies, has slipped more than 13% since March, when the index hit its peak so far for this year. Gold prices, meanwhile, are up more about 14% so far this year.

…But there’s another issue: What does your gold fund own?

Exchange-traded funds such as SPDR Gold Shares and related trust products such as Canada’s Central GoldTrust own physical bullion, held in secure bank vaults and regularly audited.

Others don’t own physical gold and instead seek gold exposure through derivatives. PowerShares DB Gold, for instance, tracks an index of gold-futures contracts…

In mutual funds or ETFs that invest through futures contracts on gold or silver, there are a number of risks.  The obvious one is that spot prices for a given precious metal and futures contracts for that metal have very different prices as we saw from the examples above.  In a rising market, the fund would often underperform spot prices.  That can be very disappointing if you bought a fund and the precious metal followed the trajectory you anticipated, yet the fund lagged far behind.

So, there is the issue of the internal structure and strategy of the fund or ETF.  But, there are also other issues.  The Wall Street Journal continues:

…Many commodity-based securities are exchange-traded notes, or ETNs, which pose a different risk. Unlike ETFs, which generally own a pool of hard assets or securities, ETNs own nothing. They are promissory notes issued by a bank, meaning they’re unsecured debt; the return you earn is calculated based on the movement of an underlying commodity index.

“You’re loaning money to a bank, and the bank pays you the return of the underlying index,” Morningstar’s Mr. Burns says…

Hmmm.  Loaning money to a bank.  What could go wrong?

Here are some thoughts on different asset classes of mutual funds and how they might fare during inflationary times:
Money market mutual funds: One very good investment in times of high inflation is cash in a money market funds.  In a money market fund, interest rates are variable, so your money will begin earning higher interest as soon as rates go up. Assuming interest rates go up due to inflation, the return on the money market fund should go up too.

Short-term & intermediate-term bond funds:  If you have some fixed income investments, as a first step for an inflation conscious investor, I would shorten the maturity of any bonds or bond funds you own and only use short-term and intermediate-term bond funds primarily.  You could also put some assets in a fund that invests in Treasury Inflation Protection securities as mentioned above.

U.S. stock mutual funds: Stocks can do OK in a moderate inflationary environment, in particular stocks of companies that have pricing power.  However, if inflation really takes off, eventually the Federal Reserve would have to raise interest rates and that would result in a recession in all likelihood.

International stock mutual funds:  The points made above about U.S. stock funds apply generally to international stock funds too.  In addition, there is the currency issues.  That is, most international funds hold stocks in currencies other than the U.S. dollar.  As such, if inflation has a negative impact on the dollar, then those funds should benefit.  The flip side is true also though.  That is, if the dollar strengthens, then most international funds would suffer a bit due to their non-dollar exposure.

Real estate mutual funds:  Real estate has been struggling for a couple of years now.  Residential real estate started falling first and now commercial real estate is taking a big hit.  Assuming you are a long-term investor and assuming you are worried about inflation, real estate funds are worth a look.  It may be premature at this point because real estate is still weak, but historically real estate has done pretty well during inflationary times.  I would wait a bit on this though.

In closing, I’ll make a couple of points.  First, there is no guarantee that we will go through a high inflationary period.  There is pretty solid evidence that inflation will be moving up at some point, but that does not mean we will get back to the type of inflation we saw in the 1970s.  Also, as you know, disinflation, not to mention, deflation, is still a possibility although probably a much lower one than inflation.  But, if the economy fails to re-ignite, we could drift into another recession in a year or two and that would mean most inflation-centric investments might suffer.

When it comes to investing, I believe a diversified portfolio works best because the future is not knowable.  That is, do not bet all your assets on one specific scenario such as high inflation.  You can certainly do things to lessen the impact of inflation on your portfolio, but do not put all your assets in one narrow strategy.

Full Disclosure:  Kurt Brouwer owns shares of Pimco Commodity RealReturn Fund (PCRDX)

The U.S. economy expanded at a 3.5% annual pace in the third quarter, as massive government stimulus helped drag the economy out of the longest and deepest recession since the 1930s, the Commerce Department estimated Thursday.

This is an estimate and will almost certainly get revised.

Along with improvements in key monthly figures on output and sales, the rise in real gross domestic product means the Great Recession is likely over in a technical sense, even as further job losses occur. A formal call on the end of the recession isn’t expected for months

…It was the first increase in real gross domestic product in a year and it was the strongest growth in two years, the government said. Before growing in the June-to-September quarter, the U.S. economy had shrunk for four straight quarters for the first time since the Great Depression.

…In the past year, the economy has contracted 2.3%. The economy shrank 0.7% annualized in the second quarter and 6.4% in the first quarter. The figures are seasonally adjusted and adjusted for price changes.

…Third-quarter growth was due to higher consumer spending, a slowdown in the reduction of inventories, an increase in residential investments, and robust government spending…

How much of the growth was due to stimulus and other forms of robust government spending? The Bureau of Economic Analysis report referenced above can be found here.  It gives us a bit more detail on the elements of GDP growth:

…Motor vehicle output added 1.66 percentage points to the third-quarter change in real GDP after adding 0.19 percentage point to the second-quarter change…

Yikes.  That is, of the 3.5% growth, fully 1.66% came from motor vehicle output and that, of course, was goosed mightily by Cash for Clunkers.  If vehicle output had come in at the same level as the second quarter, then GDP growth would have been only been 2.03% (3.5 - 1.66 + .19 = 2.03).

This chart illustrates what I meant by vehicle sales were goosed by Cash for Clunkers:

Source: Clusterstock

The little sign in the chart indicating a car going off a cliff presumably is suggestive of a likely decline in vehicle sales now that Cash for Clunkers is over.  I would be shocked if we did not see a big dropoff in vehicle sales.

So, the good news is that the economy has sped up and we are seeing modest economic growth.  The bad news is that growth is still heavily dependent on various government spending programs which are unsustainable.

This Bloomberg piece notes a Senate Committee report that paints an unflattering picture of this burgeoning group of funds:

Kohl Says Target-Date Funds May Present Conflicts of Interest (Bloomberg, October 28, 2009, Jeff Plungis and Margaret Collins)

Target-date mutual funds suffer from high fees, limited choices and potential conflicts of interest, a Senate committee was told today.

Ouch.  I suspect this report is causing a few migraines in the marketing departments at the large mutual fund companies.

Employers who offer workers the funds as part of their 401(k)s retirement plans typically can’t choose the investment mix, according to a staff report delivered to the Senate Special Committee on Aging at a Washington hearing. Companies often are limited to the administrator’s own mutual-fund offerings, the report said.

…Target-date funds, also known as lifecycle funds, move money from riskier investments such as stocks to more conservative alternatives like bonds as an investor approaches retirement. Contributions have grown 98 percent since they were endorsed as a default option for employers by the 2006 Pension Protection Act, according to Morningstar Inc.

…Target-date funds labeled 2000 to 2010 lost an average 23 percent last year with some dropping as much as 41 percent, according to data compiled by Morningstar, the Chicago-based mutual-fund research company. The average 2050 fund declined 39 percent in 2008, while the Standard & Poor’s 500 Index fell 38 percent.

…More than $140 billion has flowed into target-date funds since 2007, and 96 percent of employers that offer automatic enrollment use them, the Senate report said…

Target-date funds certainly could be useful, but they may not make sense as a default option for 401(k) participants.  A default investment option is the one that a retirement plan must put your contributions in if you have not actually made a selection from the plan’s menu of investment choices yourself.

‘Life should  NOT  be a journey to the grave with the intention
of  arriving safely in an attractive and well preserved  body,
but rather  to skid in sideways - Chardonnay in one  hand -

chocolate in  the other - body thoroughly used up,  totally worn out and
screaming ‘WOO  HOO, What a  Ride’ 

 

I’m not sure who actually wrote this, but it does contain a very different perspective on planning for retirement, doesn’t it?  My only quibble has to do with the wine selection.  I always thought chocolate went best with a nice, full-bodied red.

Most of us do not have the perspective of the author of this pithy paragraph though.  In fact, one of the key concerns — perhaps the key concern — people have about retirement is whether or not they will run out of money.

In answer to that question, the answer is almost certainly no.  That is, you won’t run out of money.

Here’s why. Think of your gas tank in your car.  If you were on a long trip and the circumstances were that you were getting low on gas and no gas stations were available, what would you do?  Would you keep driving at high speed knowing that would burn gas quickly or would you cut back to the most efficient speed in order to conserve?  Answer: you’d conserve.

The same is true of conserving your assets in retirement.  If things looked tight, you would cut expenses and reconsider assumptions you had made long before a shortage would come about.  You would make changes, consider new options and, in a variety of ways, you would think outside the box.

Retiring outside the box

As an example of thinking or even retiring outside the box, I was chatting with a client who complained that his retirement expenses were unsustainable given his steady income and savings.

I was kidding a bit, but I said, “You could always move to Guatemala.”

The thinking behind that statement is that many American and Canadian retirees have moved south of the border to expatriate enclaves in Mexico, Guatemala, Costa Rica, Panama and Nicaragua.  Living expenses are generally much, much lower in those places.  The client laughed and told me he had given some thought to living half the year in Mexico.

In other words, though you may think you’re going to retire and maintain all your present circumstances, that may not be the case either because you want a change or because you need to change.

You can have (almost) any thing you want, but not everything you want

In other words, there are definite tradeoffs in planning for retirement.  If your primary goal is just to have the money for a simple, comfortable retirement, then that’s probably fine.  But, if you begin adding on requirements, you may impinge on your primary goal.

Let’s say you are about to retire and you want to figure out how much you can spend each year during retirement.  Before getting into formulas or related concepts such as inflation, in my view, the key question is this:

What do you want?

When I ask that question, people generally have a pretty clearcut plan on certain issues such as:

• I want to leave $_____ to my kids or my church or my charity while providing for a comfortable retirement
• I’m mainly concerned about retirement income and if there is anything left over, it will go to our kids
• I am worried that our retirement needs could become a burden to our children
• I don’t want to leave any money to anyone; so I want to write my last check on my deathbed

The details may vary, but your retirement goal should be clearly stated.  For most people, the primary concern is providing for their own retirement expenses.  Beyond that, they either want to pass on some of their wealth or they don’t.

Once that issue is addressed, the next issue is how much can you spend on yourself — on your lifestyle — during retirement?  The viability of a retirement spending plan rests on three primary components — your spending, your steady income and your savings.

All three of these have to be considered together in order to come up with a coherent answer to the question, will you run out of money in retirement?  Obviously, we cannot know the future, so we are speaking in terms of probabilities, but it is useful to go through this type of analysis:

I. Spending during retirement: Let’s say you are on the cusp of retiring.  First, congratulations are in order.  You made it.  Next, let’s take a look at how you figure out what you’ll spend during retirement.  The best place to start is to figure out how much you spend now.  I know that sounds obvious, but many people don’t really know what they are spending.

We use a Microsoft Excel worksheet to help people go through this exercise so they don’t miss any major spending categories.  One of the biggest spending black holes is your home.  People spend a lot of money on upkeep and maintenance, insurance, property taxes, principal and interest payments and home improvements.  It’s easy to miss something.

Your home: Are you planning to stay where you are?  If so, home expenses may not change much, until you pay off your mortgage.  If you plan to downsize your home, will you buy a condo or rent.  For many retirees, renting is hard to imagine as they have owned a home for decades, but renting makes economic sense for many.

Your state or city?  If you are planning to move, are you considering another state.  If so, the cost of living in that state is important as are all the various taxes (income tax, sales tax, property tax).  There are places around the country — and around the world — where your money may go a lot further than it does where you live now.  Or, you may be considering a move to be close to family or even to bring about a lifestyle change.  A change such as this complicates things, but that’s OK.

Other easy items to miss are expenses that come once a year (such as many types of insurance) or expenses that occur irregularly, such as replacing a car or a furnace or a roof. Once you have a good handle on how much your spend now, you can estimate what you will spend in retirement.  In order to look forward in terms of spending, you have to make some decisions:

There are rules of thumb for adjusting your working level of income to see how much you will need in retirement, but I have not found them terribly useful.  I think it’s much better to track your current spending and then go through and make adjustments to deal with your contemplated lifestyle changes during retirement.

One of the best ways to estimate retirement expenses is to talk with those who are already retired.  This is not a huge revelation, but I have found that many folks are reluctant to ask family members or friends or others about what life in retirement is like or to find out how their spending compares to spending before they retired.  Most retired folks that I know are happy to help others and share their knowledge.  So, if you have questions, just ask.

II. Steady Income: Figuring this out is generally the most straightforward part of the process.

Social Security: Most people will have Social Security income during retirement and the Social Security administration sends out a specific statement for your personal Social Security benefit at retirement.  The only big decision for Social Security is whether or not to take it immediately or to wait until full retirement age.  This chart from the Social Security administration illustrates how your initial monthly benefit can change depending on your age when you start taking Social Security.

Source: Social Security Administration

As you can see, assuming a retiree has a full benefit of $1,000 per month at age 66, the actual benefit could be higher or lower depending on what age the retiree actually elects to start taking the benefit.  Many articles I have seen recommend waiting until age 66 to get the full benefit.   That may not necessarily be the best choice for many people because you have to give up four years of Social Security benefits to get the higher amount.  The reason it may not make sense for you to wait until full retirement age is that the crossover point could be about 12 years.  That is, it takes 12 years at the higher benefit amount to make up the amount you missed by not taking benefits at 62.

For example, using the numbers in the chart above, at age 62, you would get $750 per month for four years for a total of $36,000.  On the other hand, if you wait until age 66 for full benefits, you would get an extra $3,000 per year ($250 per month).  Without getting too fancy, in actual dollars it would take 12 years to make up the money you missed by waiting.

If you plan to work until 66, it probably makes sense to wait to take benefits until that age.  However, many people may want to take benefits at 62 just to bring in some income.  That method will give you more money until the crossover point is reached in about 12 years.

Many folks will have some part-time or full-time employment income during the early years of retirement and that could impact your decision on when to take Social Security benefits among other things.  For more on this issue, you can go to the Social SecurityAdministration’s Retirement Benefit site.

Other pension benefits:  If you are lucky enough to have an outside pension plan from your employer, then that is an additional source of income during retirement.  In addition to the pension income, you may also be eligible for additional benefits such as retiree health insurance.  One very important question to consider with an outside pension is whether to take the monthly income option or to take a lump sum distribution, assuming that option is available to you.  If you are at all concerned about the level of funding for your pension, taking a lump sum may make sense.

III.  What assets do you have?

This refers to your investments, whether IRAs, 401(k)s or personal savings or investments.  We typically include retirement assets if you have them in an account in your name.  We include monthly pension income above under Steady Income.  Looking at your assets means you would also potentially include other assets such as your home or a business or anything else you have that is valuable.  You may want to remain in your home now, but it is still a resource if you have some equity in it.

If there is a gap between your spending (Section I) and your steady outside income (Section II), then your portfolio has to be tapped to make up the difference, if you cannot cut expenses that is.

People often ask what is a reasonable return for retirement assets and that is hard to forecast because returns vary dramatically from year to year and from one type of asset to another.  If you have your investments in a diversified portfolio, then you could consider historical rates of return, that is the long-term average return for each type of investment.  We look at those historical returns and then make adjustments according to our view of conditions in the future.

What kind of spending assumption should I make?

What we often do is look at a 4-5% withdrawal rate from your portfolio.  That is, if someone has a long-term portfolio, then he or she should be able to withdraw 4% per year from that portfolio without drawing it down to zero over the course of a normal retirement.  The way the math works on this is to assume a return from a diversified portfolio of say 8%.  Then, from that 8% return, deduct your inflation assumption.  Say, that’s 3% and the remainder, 5%.  Assume some income taxes, albeit at a fairly low rate, and 4% is left that can be spent without dipping into your principal on an inflation-adjusted basis.  In this scenario, you would be able to pull out 4% per year and also to keep your principal intact even with the ravages of 3% inflation.

However, you may not be as concerned with inflation as you get older depending on your initial goal.  For example, if you plan to write your last check when you check out, then keeping your principal intact will not matter much to you.  Or, if your primary concern is your own retirement span and whatever is left over, if anything, could go to your children or a charity, then again keeping up with inflation may not concern you too much.

In these cases, you could spend quite a bit more than 4% because you don’t mind dipping into principal and because you don’t care if the portfolio value does not keep pace with inflation.

Another alternative we have seen is that retired folks take out more than 4% in years when investment returns are good, but they cut way back on withdrawals from the portfolio in down years.  That can work if you are disciplined.

Living longer & margin for error

One point to bear in mind also is longevity.  The good news is that life expectancy is going up and people are living much longer.  Initially, most recipients of Social Security did not last all that far beyond 65.  Now, people are routinely living well into their 80s or 90s.  That is one reason why Social Security funding is a problem.  But, it is also a problem we need to consider as part of a retirement plan.  How long are you planning to live?  Or, what life expectancy would you like to assume.  A reasonably healthy couple, each of whom are at age 65, will likely be around for quite a while, and one member of the couple could easily live 20 years or more.  Therefore, retirement planning needs to account for a potentially long life span.

I believe you also need to have a cushion in your planning to account for the possibility of getting lower investment returns or other factors such as higher inflation or a long, long life.

Summing it all up

When you begin thinking about these issues, the temptation is to go right to one of the retirement calculators you can find online (see here or here or here for examples).  That’s fine.  Do it.

But then, you actually have to sit down and do your own personal math.  Track your expenses.  Make adjustments based on what you hear from retired family or friends.  Add in your steady income from Social Security or other sources.  And, finally, make a conservative assumption of what you can take from your portfolio to make up any difference between spending and steady income.

As you can see, this is a very personal decision as your goals could be quite different from those of family members or friends.  If your situation is complicated or if you want a more rigorous retirement analysis, you would need to go to your CPA or financial advisor for help.

Have fun and if you have an interesting tale let me know.

This charts shows results the percentage of companies that are revising earnings upward (or downward).  The chart tracks the S&P 1500, which is a broader index than the S&P 500.  The S&P 1500 covers about 85% of the U.S. stock market.

In this chart, the blue line shows the price movement of the index on the left axis and the red line shows the percentage of companies (right axis) that were either raising or lowering earnings estimates at a given point in time.  Currently, the red line indicates that a number of companies are now revising estimates upward (above zero on the right axis).

Last year and even early this year, most companies were revising earnings estimates downward in line with the slumping economy.  Eventually, that trend began to reverse and the number of companies posting reduced estimates began to diminish.  The improved outlook for earnings coincided with the low point stocks hit back in March.

Source: Bespoke

Corporations are revising their earnings estimates upwards as we can see from the chart.  Yet, they are also beating those upwardly-revised estimates.  This is what needs to happen for a while if stocks are to go on a sustained upward path.  As the folks at Bespoke put it:

…Upside estimates have been outpacing downside estimates for a few months now, and companies have still been able to beat estimates at a high rate, which we believe is a major reason for the rise in the overall market…

This chart, also from Bespoke, shows the percentage of corporations beating their earnings estimate and puts this period in the context of the recent past:

Source: Bespoke 

Bespoke continues:

In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market…

The key issue here is the long-term trend.  Are corporate earnings just bouncing back from last year or are they embarking on a new, sustained uptrend?  We will keep watching this and let you know.

…Neither the Republicans nor the Democrats can claim any glory when it comes to spending control.  Politicians seldom get criticized for spending our money, so they keep right on doing it.  We can assign blame to different players and parties, but that still begs the question: ‘What the heck do we do?’

…We cannot run such massive deficits indefinitely on that much there is agreement.  But, where is the plan for how we bring spending and revenues more closely into balance?  If there is one, I have not seen it.

In response, one of my readers asked this in a comment:

So how do we go about fixing the deficit?

Answer #1: Balance the budget. 

One obvious answer would be to argue for balancing Federal spending and revenues.  There is one problem though, which is that we have only had something like 12 years out of the past 78 (since 1930) in which we had a balanced budget or a budget surplus.  So, being a practical sort, I am suggesting that a balanced budget is a pipe dream.

As you can see from the chart below, Federal spending (red line) and receipts (blue line) have been out of balance for long periods.  The pattern seems to be that deficit widens during recessions (gray bars) and narrows during times of economic expansions.  However, the trend for many years — with the exception of the late 1990s — has been to be in deficit. That is, Federal spending has almost always outpaced tax revenues.

Source: St. Louis Federal Reserve

As you can see, Federal spending and revenues seldom balance. Here is the same chart covering the period 1970 - 2008:

Source: St. Louis Federal Reserve

Must we balance the budget?

It would seem that we seldom actually balance the budget and we primarily operate in a deficit.  So, that begs the question: do we need to balance the budget?  In terms of a family or a business, the answer is unquestionably yes because the family or the business would eventually go bankrupt when it ran out of cash to spend.  Some families or businesses could last longer than others, but eventually the reckoning would come.

But, the Federal government is different because it is a permanent entity unlike a family or a business.  And, it can issue debt that is backed by the government’s ability to tax us in order to pay off the debt.  So, to answer the question, does the Federal government need to balance its budget, the answer is not necessarily.  It might be better for monetary reasons to do so, but it’s not absolutely necessary.

If we don’t have to balance the budget, what should we do?

Answer #2:  Keep the deficit in an acceptable, long-term range:

We have not balanced the budget very often, so an exact balance may not be necessary, but we should try to keep deficit spending in a range of $200 billion or less in times of economic expansion and $400 billion or so in times of recession.  Over time, that range would expand a bit to keep pace with inflation.

As you can see from this chart of the deficit/surplus, keeping the deficit in a reasonable range is something we have done quite well, until recently.  In normal times, keeping spending and receipts within shouting distance is doable, with a bit of fiscal restraint from our leadership.  The blue line indicates a deficit when it is below zero and a surplus above zero:

Source: St. Louis Federal Reserve

Tax revenues plummet while spending soared

Recently, the long-term pattern of manageable budget deficits has changed — for the worse.  Spending under the Republican Congress (until the 20006 elections) was largely unrestrained.  Fortunately, beginning in 2003, the economy recovered and tax revenues recovered along with the economy so that the deficits were not bad.  But, then the economy began falling into recession and tax revenues fell off while spending picked up.  Then, with the the financial panic of 2008, economic activity cratered and tax revenues plummeted at the very time that spending went up dramatically.

Now that the recession is winding down, government spending should get cut back and tax revenues should pick up.  Unfortunately, there is no sign that spending is being cut.  In fact, Congress has shown no ability to cut spending or even to stop increasing it.  Hence, the red line is shooting north.  And, individuals are making less money and many millions are unemployed, so individual taxes are down.  However, the big revenue killer is corporate income taxes.  Companies have not made much money in a long time and corporate tax receipts are down about more than 50%.  That hurts.

On its Tax Vox Blog, the Tax Policy Center made this point quite well:

…Corporate income tax revenues took the biggest hit, down by more than half from 2008. The deep recession wreaked havoc on corporate profits, leaving a large majority of firms with no tax liability. The consequent $165 billion drop in corporate taxes accounted for nearly 40 percent of the total revenue decline…

Source: Tax Vox Blog

Big deficits as far as the eye can see

Tax Vox continues:

Total federal revenue in 2009 amounted to just 14.9 percent of GDP, the smallest fraction since 1950 and far below the 26 percent of GDP spent by the federal government. That gap will narrow in coming years but CBO projects that it will average more than 4 percent of GDP over the next decade, and that’s only if the 2001-2006 tax cuts expire in 2011 as scheduled. Extending those cuts, even only for President Obama’s broad middle class, will mean deficits as far as the eye can see.

Fiscal restraint 

Congress controls the Federal government’s spending so Congress is the root of the problem.  Or, maybe you could say that we are the problem because we elect representatives who do not focus on fiscal or spending restraint.  This is not a partisan comment because it applies equally to Republicans, Democrats and Independents.  Our representatives in Congress get their clout through passing legislation which means spending government dollars.

In other words, Congress is the solution as well as the problem.  I believe Congress needs some kind of powerful restraint from its bipartisan spending habit.  Ideally, voters would elect fiscally responsible folks to Congress, but that has not happened or it may be that life in Washington brings out the spendthrift in the best of us.  Absent voters, where will the restraint come from?

Divided government & the Clinton years

As you can see, we have been in deficit for most of the past 38 years.  The only time period where we were in surplus was 1997-2000, the last four years of President Clinton’s presidency.  During that period we had divided government, with President Clinton (a Democrat) on one side and Congress (controlled by Republicans) on the other side.

Looking back on that time period, it occurred to me that divided government may have its merits.

See also:

Can our government borrow unlimited sums?

Government: It ain’t broke yet, but just wait

50 Ways the Feds Waste Our Money

Dollars for Dishwashers? Appliance Rebates on the Way (CNBC, August 20, 2009, Christina Cheddar Berk)

…The government’s so-called “Cash for Clunkers” program has been grabbing headlines, but it’s not the only federal program putting money back into consumers’ pockets. A new government program is poised to help appliance manufacturers the same way “Clunkers” gave a jump start to auto manufacturers.

As part of the Obama Administration’s economic stimulus bill, nearly $300 million was set aside to fund a state-run rebate program for consumers purchases of Energy Star-qualified home appliances.

Like the “Clunkers” program, the plan takes aim at energy guzzlers. However, unlike in the popular auto program, consumers will not have to turn in their old appliances in order to buy a more efficient one and qualify for the rebate. However, the exact criteria remain unclear because states are still drafting their individual plans, with the hope of having the programs up and running by the end of this year…

Great line that says so much, ‘…the exact criteria remain unclear…’  It really is impossible to parody Congress anymore.  And, of course, the fact that Cash for Clunkers has been a fiasco will not stop implementation of Dollars for Dishwashers.

Now, we find that even Dollars for Dishwashers was not the end of the government’s effort to subsidize our purchases.  We also have Cash for Golf Carts.

Cash for Golf Carts 

As part of the American Recovery & Reinvestment Act of 2009 (ARRA), there is a stimulating program that is helping golfers buy electric golf carts.  I am not knocking golfers with this post, in fact, I play golf from time to time.  I even spent several years of my wayward youth caddying at a tony country club.

However, I really don’t see why we need to borrow money — that’s what economic stimulus really means at this point — to subsidize golfers who want to buy a cart, do you?

One problem with very large government programs is that there are always unintended consequences.  I suspect the legislators who worked on this program did not really intend to give electric golf cart sales a boost, but who knows what evil lurks in the heart of the vast golf cart lobby? This editorial from the Wall Street Journal describes  program [emphasis added]:

Cash for Clubbers (Wall Street Journal, October 17, 2009)

…Uncle Sam is now paying Americans to buy that great necessity of modern life, the golf cart.

The federal credit provides from $4,200 to $5,500 for the purchase of an electric vehicle, and when it is combined with similar incentive plans in many states the tax credits can pay for nearly the entire cost of a golf cart...which is typically in the range of $8,000 to $10,000. “The purchase of some models could be absolutely free,” Roger Gaddis of Ada Electric Cars in Oklahoma said…

Free.  When it comes to almost any consumer product, if you make it free, you can in fact stimulate demand. That’s not exactly news though.

The golf-cart boom has followed an IRS ruling that golf carts qualify for the electric-car credit as long as they are also road worthy. These qualifying golf carts are essentially the same as normal golf carts save for adding some safety features, such as side and rearview mirrors and three-point seat belts. They typically can go 15 to 25 miles per hour.

…The IRS has also ruled that there’s no limit to how many electric cars an individual can buy, so some enterprising profiteers are stocking up on multiple carts while the federal credit lasts, in order to resell them at a profit later…

Great.

This golf-cart fiasco perfectly illustrates tax policy…politicians dole out credits and loopholes for everything from plug-in cars to fuel efficient appliances, home insulation and vitamins…then insist that to pay for these absurdities they have no choice but to raise tax rates… 

This is kind of funny in a way.  We don’t generally think of golfers who tootle around in golf carts as needy, but they are just responding to incentives, so you can’t really blame them.

However, if you think of this as a wasted and misguided use of our money, then it’s not so funny.  And, if you multiply this sort of idiocy thousands of times in many different industries, then it starts to get infuriating.

Congress & the vast golf cart industrial complex

I doubt if anyone in Congress is in thrall to the vast golf cart industrial complex, but the American Recovery & Reinvestment Act is now funding well-to-do golfers who want a FREE personal golf cart.  I shudder to think of what’s next.

See also:

50 Ways the Feds Waste Our Money

CRASH for Clunkers

Clunking toward health reform

Convicts Cash In On Fed Stimulus

We’re in the best of hands

Clunk

Collateral Damage From Cash for Clunkers

Source: Washington Post

As you can see, the red ink is flowing in Washington DC.

In a way though, this record budget deficit is a little less bad than it could have been.  As you can see from the next chart, also from the Washington Post, earlier this year the deficit was projected to be even larger, more in the range of $1.75 - 1.85 trillion.

Source: Washington Post

But, where do we go from here?  As I read through this piece from the Washington Post, I was not reassured that anyone in Washington DC actually has a handle on this.  Or, at least, the WaPo reporters could not find anyone who really has a plan [emphasis added]:

Record-High Deficit May Dash Big Plans (Washington Post, October 17, 2009, Lori Montgomery and Neil Irwin)

The federal budget deficit soared to a record $1.4 trillion in the fiscal year that ended in September, a chasm of red ink unequaled in the postwar era that threatens to complicate the most ambitious goals of the Obama administration…

…At about 10 percent of the overall economy, the gap between federal spending and tax collections is the largest on record since the end of World War II, and bigger in nominal terms than the past four years of deficits combined. Next year is unlikely to be much better, budget analysts say. And Obama’s current policies would drive the budget gap into the trillion-dollar range for much of the next decade.

This is the type of record we really don’t want.  And, I think we need to get past the partisan sniping.  Neither the Republicans nor the Democrats can claim any glory when it comes to spending control.  Politicians seldom get criticized for spending our money, so they keep right on doing it.  We can assign blame to different players and parties, but that still begs the question: ‘What the heck do we do?’

The WaPo article continues:

…A combination of factors combined to produce the $1.4 trillion gap. A deep recession caused tax revenue to plummet by more than $400 billion this year, while the government’s economic rescue efforts swelled federal spending. In all, the government spent $3.5 trillion in fiscal 2009, while taking in only $2.1 trillion in taxes, the Treasury Department said. Among the outlays: $113 billion in stimulus cash, $154 billion for the bank bailout and nearly $96 billion in capital payments to Fannie Mae and Freddie Mac, the troubled mortgage insurance giants that the government took over last year.

…”In the short term the deficit is not our primary problem,” said Heather Boushey, a senior economist at the left-leaning Center for American Progress. “The unemployment rate is near 10 percent, and the key thing is to get the economy growing, which will increase tax revenues. But in the long term we do need to think about the deficit problem and do something about it.”

Economists universally agree that the nation cannot run such massive deficits indefinitely. The question now facing Obama, budget experts said, is how to bring spending and revenue more closely into balance in the years ahead, after the economy fully recovers…

We cannot run such massive deficits indefinitely on that much there is agreement.  But, where is the plan for how we bring spending and revenues more closely into balance?  If there is one, I have not seen it.

This solid, yet oddly-titled, report from Morningstar gives us an example of how investors can get scalded when they buy a hot fund [emphasis added]:

How Some Investors Ruin a Great Fund (Morningstar, October 13, 2009, Russel Kinnel)

The stock market’s powerful rally since early March has been a blessing for patient investors. Many of the funds that suffered the most during the bear market have experienced the biggest rebounds. But a lot of investors didn’t stick around for the comeback. And who could blame them? It’s hard to hang tough when your fund has sunk 50% or more. Yet fleeing short-term laggards or jumping to the hot fund du jour often undermines investors’ returns.

This point is very important.  Hot funds can and do turn cold and t is excruciatingly difficult to stick around when that happens.  The financial panic of 2008 and early 2009 took down volatile funds, but even steadier performers (Longleaf Partners comes to mind–llpfx) fell to an extent that surprised many professional investors.  Staying the course when investments move against us is very difficult.

This next information is quite startling as Kinnel fleshes out how investors in volatile funds can and do snatch defeat from the jaws of victory.  Morningstar continues:

We at Morningstar have a way of capturing the true costs of fund hopping. In addition to a fund’s total return, we calculate what an average investor in the fund really earned. Investor returns adjust the officially reported returns based on cash flows into and out of funds. The gap between the figures essentially tells you how well or how poorly investors did at timing.

…CGM Focus (cgmfx) and T. Rowe Price Equity Income (prfdx) illustrate how volatility affects investor behavior. Both are run by excellent managers (Ken Heebner and Brian Rogers, respectively) who have beaten their peers over the long term. Focus’ 10-year annualized return of 19.6% thumps Equity Income’s 3.7% yearly return through the end of September 2009–as it should, because Heebner takes much bigger risks than Rogers. Heebner makes huge sector bets, holds only about 20 stocks, and even sells short stocks that he thinks are primed for a fall. Rogers aims for a steady ride by focusing on reasonably priced, dividend-paying stocks.

But consider what investors actually earned. Rogers’ clients have kept nearly all of the fund’s meager gains, earning an average of 3% annualized over the past 10 years. Heebner’s have somehow turned their fund’s terrific reported results into an annualized loss of 14%. They managed that feat by piling into CGM Focus after its extraordinary 80% gain in 2007, only to get pummeled when Focus plunged 48% in 2008…

Buying high and selling low

Anyone who has invested in mutual funds for a while has heard of Ken Heebner.  His funds are legendary for volatility, but also for stunningly high returns at times.  Despite the excellent average annual returns, this Morningstar data indicates that investors have actually had poor results due to buying in after the fund had a very hot year in 2007 and then dumping the fund when it turned cold in 2008.

If you want to own funds like CGM Focus, then you need to have lots of patience.   An incremental approach wouldn’t hurt either. That is, buy a modest amount of a volatile fund’s shares and then, assuming you can handle the volatility, when the fund hits a rough patch, buy a bit more.  Also, make sure you have plenty of diversification in the rest of your portfolio such that you own funds that are less volatile.

Whatever your investment strategy is, you need to stick with it.  If you like high octane mutual funds such as CGM Focus, then make sure you have a strategy in place to deal with the bad times.   Alternatively, if you do not want all that volatility, then you could invest in lower return/lower risk funds that make it easier for you to ride out the market’s inevitably downturn.  Either way is OK as long as you match your portfolio to your own personality and willingness take risks.

Full Disclosure:  Kurt Brouwer owns Longleaf Partners Fund (llpfx)