The US Gross National Debt has jumped by $1.28 trillion as of today, compared to 12 months ago, to $23.04 trillion. And these are the good times. The economy is rocking and rolling, we’re told. How will this debt balloon during the next economic downturn? Yes, that was a rhetorical question. It’s better to not even think about it. And no one is thinking about it.
In a new research paper from the Boston College Center for Retirement Research, Andrew Biggs, Alicia Munnell, and Anqi Chen argue that there are four reasons for 401(k)s’ shortcomings—the system’s youth (the plan has been around only since the early 1980s), the lack of universal coverage, so-called leakage when participants withdraw funds early, and fees. Read more here: https://www.barrons.com/articles/401-k-s-arent-helping-americans-save-enough-for-retirement-these-researchers-found-four-major-shortcomings-51573308002?mod=bol-social-fb
The destruction of Social Security. Most see it as inevitable. By the year 2035, some project it will be insolvent. Others are more optimistic in that it will still be around, but provisions will be made to maintain its existence. In either case, it’s wise to look at planning for retirement pragmatically. In order to take this approach, looking at the economic projections makes sense, and developing a plan without social security income would be prudent as well…even if Social Security stays around after 2035.
If it stays around, some things will be utilized to extend the program. First off all, the US Government will raise taxes. They would look at raising the payroll tax that is used to fund Social Security. Also: I would not be shocked if all marginal income tax rates are increased. Next, the US Government would seek to extend the retirement age, the age where one receives Social Security, to an older age. This will allow more time for people to contribute into the so called “pay as you go program”.
Here is a interesting analysis on the current plight of social security: https://econimica.blogspot.com/2019/11/indefensible-conclusions-why-social.html
Housing starts and permits increased in October as total starts rose by 3.8 percent and permits for future construction rose 5.0 percent. Total housing starts increased to a 1.314 million annual rate from a 1.266 million pace in September. The dominant single-family segment, which accounts for about three-fourths of new home construction, rose 2.0 percent for the month to a rate of 936,000 units, marking the fifth gain in a row (see chart). From a year ago, total starts are up 8.5 percent while single-family starts are up 8.2 percent.
A random thought entered my mind…well not so random. The IRS recently published the marginal income tax rates for 2020.( Yes, I posted them..go here: http://taxfoundation.org/2020-tax-brackets/) Which is good news….for now. With all the other macroeconomic issues, (e.g. growing US deficit, the exponentially expanding US Government Debt, and extremely low interest rates), Financial experts are advising their clients to plow more money into tax deferred retirement vehicles: Most know these cast of characters, 401(k), IRA, and etc. While there is nothing wrong with this advice, per se, but consider the fact that with all those aforementioned macroeconomic issues, is it safe to assume that marginal income tax rates will be higher in the future? Even they are the same, the future retiree will have fewer deductions to offset the tax liability once they begin to draw down the funds from their retirement plans.
If rates are higher, then the accumulated funds will be taxed at a higher rate, as the funds are withdrawn at retirement. Does this mean one should not contribute to their current tax deferred plan? No, not really. It really depends on the person. However, it would be prudent to have some sort of program that provides an income that is tax free or very close to being tax free income. I’m betting tax rates will increase at retirement age, and many people will live longer. If my bet is correct, having a tax free income stream, at retirement, should be a top priority. A thought to consider.
Thinking Clearly about Capital, Interest, and Income | Robert P. Murphy: Capital and interest theory, and its relation to income, is a very complex area of economics. It is also one in which the Austrians have made major contributions, and these unravel current confusions.
My Tax Refund..Man!
Tax Season: The time of the year we are all hit with the fantastic commercials regarding getting the best refund, or the most refund, or whatever jingle to capture your attention. However, as I scan social media, and listing to various conversations with people, I see many people who are concerned about receiving a lower refund. Yes, a huge concern..or is it?
A relevant Read: Americans Work Almost 4 Months Just to Pay Taxes
The IRS Thanks You
We all know the IRS sends out “Thank You” cards to all of its clients, when they receive taxes during the year. Wait, they do not. The issue: If you are receiving a refund, this is simply a return of the tax withholding taken out throughout the tax year. In short, you are giving the IRS a loan.Great work.
Wait, hold up..a loan?
Yes, a loan. Even better: An Interest FREE loan. The tax paper work, that designates the withholding amount, tells your employer how much to take out in taxes each paycheck. When you file your taxes, you may receive a refund..maybe.
The Opportunity Cost: It’s Lost
Based upon that scenario, it is an interest free loan given to the IRS. As previously mentioned, you may receive all the money back. Contrast that if you owe the IRS: Penalties and interest are charged if you owe them. Are you able to borrow money from the bank without having any interest charged to you? No. Consider what could have done with the money withheld..oh and the lost interest. Most people are lining up to receive their tax refund sooner, as they are borrowing that money from a financial intermediary to receive their money..which was loaned out to the IRS.
Cash Flow Analysis: Employee vs Business
With regards to how taxes are levied, there is a fundamentally stark difference between an employee versus someone who owns, or controls, a business. With an Employee, when he is paid, his gross earnings are realized…only for an instant. After that moment, taxes are taken out of the employee’s paycheck. Note: The employee can have benefits come out before taxes are assessed, which potentially lowers the gross income amount—this amount is used to calculate the taxes withheld. After all of those taxes are withheld, the employee can spend what is left over. In short, Uncle Sam obtains his taxes first.
Contrast that to the business owner, assuming he controls/owns a business entity, he earns revenue for his business, pays out expenses, and sees a profit or a loss. A profit is the case if the business owner earns, in revenue, more than he pays out in expenses. The amount that is left over, profit, is used to determine how much in taxes are assessed. If the business shows a loss, the business owner’s tax liability is mitigated, in many cases. Example: Amazon. How does Amazon Pay $0 in Federal Income Taxes?
Taxes, withheld during the year by the taxing authority, is a loan once “refunded” at the end of the tax year. There is a difference, with regards to taxes, between being an employee versus a business owner. The ability to mitigate and take advantage of the tax code favors heavily toward the business owner. Of course, this is a very simplistic example, simply to demonstrate conceptually the differences, as these things can vary based upon the specific situation. That is why working with a tax professional is advised strongly when working with your taxes.
Relevant Article: Americans Work Almost 4 Months to Pay Taxes
“Become Debt Free! Pay off your home, then you don’t need the insurance! Once your home is paid off and kids are grown, you don’t need more life insurance! Stop paying all that additional insurance, its a rip off! You can save on the cost of insurance and invest in the Stock Market. You will grow your paper assets to the point where you are self insured at my good growth mutual funds that have averaged 12%.” ~ The TV Financial Expert
All of these concepts mentioned, in this quote, are given out by many mainstream Finance Gurus. They may not express these concepts verbatim, but these concepts are the underlying theme of this philosophy. In my opinion, this type of thinking is like betting on horse racing without understanding the details of equines in the race. And, it can be risky. Let us look into this in more detail.
Self Insurance in Action with a major Catastrophe
Let us suppose you have a home that is worth $300,000. The mortgage is paid off, and you are debt free. You have accumulated in your 401(k) type plan $1,000,000. You take off your homeowner’s insurance since you have been enough assets to be “self-insured”. A violent tornado hits your local town, destroys your home, many local homes, buildings, and etc. Your home and all of its contents are totally destroyed. Nothing is left. What happens?
For starters, you are out of a home. Your home needs to be rebuilt. How much will it cost to rebuild? The preliminary estimate to rebuild your home may cost $300,000. In this scenario, it may cost more than that. Why? If the tornado hits the local town, chances are that other homes are impacted. Since there will be a higher demand for labor and materials, the replacement cost of the home just went up. Just think how that will impact your $1,000,000 if you are “self insured”.
The contractors’ prices have risen, and same with the cost of materials. Materials that were destroyed from the Tornado, now must be transported into your town from another town. Prices of materials are now scarce, causing an increase in prices.
Let us not forget the home had other items, food, appliances, personal belongings, etc. All these items need to be replaced. Since there are not an unlimited supply of refrigerators, TVs etc, that either requires a wait for your type of appliance, or deal with a sharp an increase in the price of the appliances.
While your home is being rebuilt, you need a place to stay. If there are hotel rooms available, they also are scarce, causing the room rates for the local hotels to increase in price. Please do not forget, other people are seeking shelter while their home is being rebuilt; just like your family. This factor must be deducted from the $1,000,000 cash balance.
This may be a worst case example, but ask the folks during major storms if these things did not happen. Most homeowner policy holders quibble about the replacement cost, but never stop and analyze the complete economics of the situation in a major catastrophe.
This is why a comprehensive homeowner’s policy is very important. Insurance provides the leverage to protect a valuable asset for little cost relative to the value of the investment or asset. In this horrible case, the most of the retirement cash monies would have been protected from the tornado. The majority the risk was transferred to the insurance company for a fraction of the net worth of the insured. The insured would keep the $1,000,000 cash in the 401(k), plus the insurance company would cover the expenses related to the replacement cost of the home. The insured would also receive $300,000 from the insurance company to replace the home. The only cost incurred by the insured in this scenario if he had Homeowner’s Insurance, would be payment for the deductible.
Your 401(k)/IRA/Qualified Retirement plan being “Self Insured at Retirement”
Our previous example shows how having a proper Risk Management strategy can protect several assets in one catastrophic event, how about your hard earned cash retirement savings? Is it protected if you are “Self insured”? Let’s take a scenario to show how being “self insured” at retirement is equally insane as the prior example.
You are 65, and your 20-30 year low cost, cheap term insurance policy has expired. You could choose to keep it in force, but the premiums are now annually approximately in the four figures, as the premiums are increasing exponentially per annum. They also are projected to renew annually, so you opt out of the renewal. You have $1,000,000 saved in your 401(k) plan, no need for insurance, right? Your home is paid off, and according to your experts you are “self insured”.
Here are some things to consider that are potential catastrophic “Risks”:
1. Taxes- As the $1,000,000 is withdrawn, from the 401(k), it will be taxed as earned income. Depending on how much is withdrawn annually, this money will be taxed on the current Earned income tax schedule. Of course, the home is paid off, so no interest deduction is used. In case of an early death by the 401(k) account owner, the IRS will want this money to counted towards the Estate Tax. If the money is still inside a 401(k) plan, the beneficiaries will need to ensure that that money is rolled into a qualified plan. If it is not, it will be taxed again. These funds must be withdrawn, from Qualified plans, before 70 1/2, otherwise more tax penalties shall take place against those funds.
2.Health Concerns-One of the fast growing segments of our population are people living to be age 100. But, there are obvious health concerns that are more common with the elderly population than the younger population. Let’s hope that $1,000,000 can fill in the gap for those needs. If those needs are not met, then the need for Long Term Care, Pharmacy visits, Occupational Therapy, Physical Therapy, or other rising health care needs can not easily ignored if you are “self insured”.
3.Day-to-Day Expenses-People worked their entire lives to enjoy retirement. What will be the quality of life? How long will that money last? Will you outlive your retirement savings? Cost of food, gas, other goods and services change with are Fed monetary policy and Government Spending. What will be the cost of gas? These things impact your wallet.
4.Safety of Principle-Based on the external factors of inflation, interest rates changes, stock market, bond market, and other external financial vicissitudes, will your hard earned retirement savings be surreptitiously eroded do to these factors? If so, how can you mitigate these risk?
5-Baby Boomers-This age segment of the represents approximately 28% of the total population. This age segment will make all the resources needed for this age segment more scarce, the net effect will be an increase on the price of services and goods specific to the needs of retirees and other age groups.
Based on these factors, having just cash in the bank at 65 may not be enough. All these concerns must be considered.
What needs to be done?
Taking control of your financial future is the first step. Becoming more familiar with the world of investing, insurance, etc is a way of mitigating these risks. Another way is transferring this possible risks to an insurance company, advisory firm, etc. These entities are experts in management of risks and assets.
The current popular belief that one product or one plan is the silver bullet for every situation. Unfortunately, this is not the case. The other myth, is that one product is cheaper or better than other products. This is also not the case. Each product exists to serve a purpose. If no one needed that product, it would not exits. It is your job to fit the correct product into your goals and plans.
In closing, simply being “Self-Insured” for retirement is equally as foolish as the person that removes his hazard insurance policy from his home. It eliminates the use of leverage, which is a vital tool in developing, maintaining, and protecting wealth. Having a proper risk management strategy is equally important for your cash savings as well as for your other fixed assets.
Let’s go back in time and to a different Continent. As we design this time machine, we will go back to around the 1630s to Holland-the home of the first recorded Economic Bubble. But before boarding this Delorean, let us look at some things here first. Let us take this quote from the great Economist, Ludwig von Mises:
“He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief; accordingly he will restrict his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.” (Mises, 1998, p. 423)
As our time machine has landed in Holland, we picture the citizens of Holland speculating on Tulips. The actual pricing is nebulous but, in circa February 1637 the price of Tulips hit their peak; and then dropped precipitously (Wikipedia, 2011). Prior to this drop, people were selling all sorts of possessions just to get their hands on precious tulips and as a result, the hysteria was on! “People selling or trading their other possessions in order to speculate in the tulip market, such as an offer of 12 acres (49,000 m2) of land for one of two existing Semper Augustus bulbs, or a single bulb of the Viceroy that was purchased for a basket of goods (shown at right) worth 2,500 florins.” (McKay, 1841).
Soon after the drop took place, it finally ended circa May of 1637–where the estimated price at that point was well below the level predicted earlier that year in February; but at the level predicted November of 1636 (Wikipedia, 2011). The hopes and dreams were gone and vanished. Soon the Dutch were at a point where not one Tulip Bulb could be sold at any price in the winter of 1637 (Sayre, 2011).
As we board our time machine and visit year 2011, we have just seen a similar scenario in the Real Estate market. A countless number of workshops, infomercials, info packages, RE Gurus, etc appeared between in the marketplace between the years 2004-2008. These gurus were experts sent to us to help everyone become wealthy via Real Estate; specifically through flipping houses. Flipping homes is highly speculative venture. Banks were loaning money based on this speculation on the hopes that the prices would increase and the borrowers would pay back at a higher rate of interest.
The Banks were willing to deplete their cash reserves in exchange that this form of speculation would eventually yield a handsome profit. Of course, both the Federal Reserve and the US government made this particularly easy by establishing lower interest rates on the loans. However, similar to the Tulip mania, this too fell down like a deck of cards. The Law of Diminishing Returns and the Economic concept of elasticity do not discriminate. Now in cities, many homes are overbuilt and the vacancy for home inventories increased due to foreclosure, which is parallel to a similar event that took place in the 1600s-the crash of the tulip mania- one can conclude ultimately that the net effects both events are no different.
This same tale can be reviewed in the 1990s with the Tech stock bubble also, or other asset bubbles throughout history. A current tale is brewing with Baby Boomers with their investments inside of 401k type plans, and currently they are seeing great losses as they are approaching retirement.
Of course the current battle cry is investing in Gold, which has its upsides; and also some obvious flaws. Gold is not immune to the aforementioned Economic Principles too. Savvy investors realize this, and have retained most of the Gold reserves waiting for the lemmings to drive up the price more.
How can you protect your hard earned wealth from these types of mania attacks? You must become educated in how the process works. Increasing your financial knowledge base is a starting point, and you should never assume that the price of an investment always goes up in price. All goods and services have the ability to go down in price, especially after a great run has occurred. Right now the Stock Market has hit its low also, so what type of strategy is in play with your 401k plan?
McKay, C. (1841). Extraordinary Popular Delusions and the Madness of Crowds. Unknown: Unknown.
Mises, L. v. (1998). Human Action. Auburn : Ludwig von Mises Institute.
Sayre, H. (2011). The Humanities: Culture, Continuity and Change Volume 2. Upper Saddle River, NJ: Prentice Hall.
Wikipedia. (2011). Tulipmania. Retrieved from http://en.wikipedia.org/wiki/Tulip_mania
Key Excerpt: “Some economists have been arguing that the “equilibrium real interest rate” (that is the “natural interest rate” or the “originary interest rate”) has become negative, as a “secular stagnation” has allegedly caused a “savings glut…”
The notion of a negative interest rate is against nature. The concept of interest rate is based on the human action of choice and preference, as the actor moves in space and time. For example, we choose things based on the preference of things that will provide us some sort of “pleasure”. If a person chooses item (x) before item (z), this means that in that moment in time, item (x) is preferred over item (z). This process happens in space and in time. Time has passed forward, as the actor moves from item (x) to item (z). The definition of the natural rate of interest is the price ratio of goods at two different points in time. Based on this definition, and the notion of time, and space, the natural rate of interest can not be negative. Also, we can not go backwards in time based on our actions. This notion makes the concept of negative interest rates fallacious.