What About Inflation And My Retirement Plans?
U.S. trade gap rose 7.8% in April
The U.S. trade deficit jumped in April as a weak dollar pushed the costs of importing foreign oil to record levels. The trade gap rose by 7.8% to $60.9 billion, the largest deficit in 13 months, the Commerce Department reported. U.S. export sales of $155.5 billion were led by commercial aircraft, farm machinery, medical equipment and computers. ClipSyndicate/Bloomberg (10 Jun.) , The Washington Post/Associated Press (11 Jun.)
Paulson to press Chinese for trade changes
With legislation that would punish China for keeping its currency undervalued now unlikely to pass Congress this year, U.S. Treasury Secretary Henry Paulson is vowing to press Beijing for change. Paulson and other members of the George W. Bush administration will meet with Chinese counterparts next week in the latest round of high-level economic talks. U.S. officials say China seems to be using regulation and other barriers to protect Chinese companies from foreign competitors. International Herald Tribune (10 Jun.)
Asian central banks fight dollar climb
Central banks in Thailand and South Korea have sold dollars to support their currencies as recent comments by U.S. leaders drive up the dollar's value. U.S. leaders have geared up for "outright intervention" in world currency markets to break a linkage between a weak dollar and high oil prices, said Stephen Jen, chief currency strategist at Morgan Stanley in London. Bloomberg (11 Jun.)
Canadian central bank swings to inflation-fighting stance
Canada's central bank decided to keep interest rates on hold after months of cuts designed to insulate the country's economy from the spillover of a possible U.S. recession. A statement indicated the Bank of Canada now sees inflation as the main economic threat, putting it in line with the U.S. Federal Reserve and the European Central Bank. The Globe and Mail (Toronto) (10 Jun.)
Fitch says more U.S. LBO debt is troubled
The debt behind U.S. LBOs deteriorated more than other sectors of the debt market, and debt-burdened companies continue to find the lending window closed, Fitch Ratings said in a study released Thursday. Troubles in the economy and credit markets have led to more downgrades and defaults this year for LBO-financed deals. "The vast majority of the downgrades were driven by weak cash flows and weak revenue generation," Fitch Ratings senior director William May said. Financial Times (11 Jun.)
Survey finds confidence in global economy falls
Confidence in the global economy has dropped as central banks prepare to battle inflation, which will likely force down stocks and bonds. The Bloomberg Professional Global Confidence Index declined from 22.7 to 21 in May, with anything below 50 indicating a negative sentiment. Confidence had been rebounding after the index reached a low in March. ClipSyndicate/Bloomberg (11 Jun.) , Bloomberg (12 Jun.)
Analysts see housing slump continuing
U.S. homes may lose a third of their value as a result of the market slump caused by subprime-mortgage defaults, and the slide will probably last another two years until credit loosens again to attract new borrowers, top credit analysts say. "There are a lot more mortgage defaults to come," Fitch Ratings managing director Glenn Costello said. Reuters (11 Jun.)
Lieberman would ban institutional investors from commodities
U.S. Sen. Joseph Lieberman, I-Conn., said he will propose banning institutional investors from the commodities markets. A committee he chairs meets next week to examine whether speculation has driven the prices of crops and fuel to record levels. Another proposal would strengthen regulations limiting the stake that each speculative investor can hold in a given market, Lieberman said. The New York Times (12 Jun.)
BRIC countries raise borrowing costs to cool inflation, economies
The Reserve Bank of India unexpectedly increased borrowing costs on Wednesday to battle inflation. The increase in the repurchase rate, following similar action by Brazil, Russia and China, adds to concerns about a slowdown in the fastest-growing economies in the world. "The BRICs are better placed to withstand a slowdown, but that doesn't mean they won't feel it," said Jay Bryson, global economist at Wachovia. ClipSyndicate/Bloomberg (11 Jun.) , Bloomberg (12 Jun.)
Hedge funds lending to cash-starved companies
As shaken and risk-shy banks cut back on lending to companies, hedge funds are stepping in. More than 100 funds already specialize in lending, usually at interest rates much higher than those charged by banks. Big funds such as Fortress Investment Group and Citadel Investment Group are joining in. The New York Times (13 Jun.)
Lehman Brothers ousts president, demotes finance chief
After posting a $2.8 billion quarterly loss, Lehman Brothers ousted Joe Gregory, president since 2004, and demoted CFO Erin Callan, who was once viewed as a potential CEO. It is the latest management shake-up on Wall Street as banks continue to suffer heavy losses. Lehman's quarterly loss raises speculation about its future, and analysts question whether the changes will relieve pressure on CEO Dick Fuld. Financial Times (12 Jun.)
Fuld said to be actively listening to offers for Lehman: Richard Fuld, CEO of Lehman Brothers, is pondering takeover offers and large investments in the troubled bank, sources say. Lehman's future is in doubt following its disclosure that it may lose $2.8 billion in the second quarter and that it has undergone a management shake-up. CNBC/Reuters (12 Jun.)
SEC may require ratings firms to disclose more
The SEC has proposed new rules that would force agencies that rate bonds to make more information about their work publicly available. The SEC would require ratings firms to make a clear distinction between corporate or government bonds and the structured products at the center of the subprime credit crisis. The three largest ratings agencies welcomed the SEC action. The CFA Institute Centre for Financial Market Integrity and the Council of Institutional Investors said investors would benefit from greater transparency and separate measures for structured-finance bonds. The Wall Street Journal (subscription required) (12 Jun.)
Pressure mounts on oil speculators
The chairman of the House Energy and Commerce Committee added his weight to the legislative push against commodities speculation. U.S. Rep. John Dingell, D-Mich., and the committee's top Republican co-sponsored a bill to allow the Energy Department to gather data on factors influencing oil prices from federal agencies and commissions. The bill is among many proposals to pare the influence of energy speculators on price-setting. But the efforts to rein in bets on oil prices are still too far from reality to affect prices, analysts say. MarketWatch (12 Jun.)
Bernanke warns of growing cost of health care
Increasing government spending on health care threatens to endanger economic stability, Federal Reserve Chairman Ben Bernanke warned Monday. "Soon it will begin to have effects on interest rates, it will have effects on economic growth, and on stability," he said. The cost of health care amounts to more than 15% of the entire U.S. economy and there is scant evidence spending will slow, he said. Reuters (16 Jun.)
Iran pulls $75 billion out of Europe
Iran has pulled about $75 billion in assets from Europe rather than risk seeing the money frozen in retaliation for continuing its uranium-enrichment program. Iran is refusing to kill its nuclear ambitions despite Western governments warning of new punitive steps. "Part of Iran's assets in European banks have been converted to gold and shares and another part has been transferred to Asian banks," deputy foreign minister Mohsen Talaie was quoted as telling a moderate Iranian weekly paper. Reuters (16 Jun.)
Speculators and their role in food, fuel prices
Who are the speculators blamed for boosting global food and energy prices independent of fundamental supply and demand? Speculation is a part of the daily business of farmers, investment bankers, bakery entrepreneurs and hedge fund managers. While farmers and bakers have long hedged against price increases, criticism focuses on financial enterprises. Banks holding the savings of small investors and hedge funds have piled into the business, potentially adding turmoil to food prices and markets. Spiegel Online (13 Jun.)
G-8 leaders warn of growing inflation threat
Finance ministers from the Group of Eight industrialized nations warned at their weekend meeting that inflation presented an increasing risk to their economies. The comments matched inflation warnings by central bankers in the past two weeks. The IMF improved its outlook on the U.S., Europe and Japan, saying all had done better than expected in the first quarter. But IMF Managing Director Dominique Strauss-Kahn said pain remains in the forecast. "Even if the slowdown is not going to be very deep, it is going to be protracted," he said. ClipSyndicate/Bloomberg (16 Jun.) , Financial Times (16 Jun.)
Fed's comments on inflation hinder housing rebound
Anti-inflation rhetoric from U.S. Federal Reserve officials has had a chilling effect on the country's struggling housing market. Hawkish comments by Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn led money markets to see an interest-rate hike in August as a near certainty. That produced a steep rate increase for fixed-rate mortgages, a drop in mortgage applications and a plunge in home-loan refinancing. Reuters (19 Jun.)
Global trade tilts in favor of unprepared U.S.
The cost advantage Chinese manufacturers used to enjoy is disappearing with rising fuel and labor costs and the appreciation of the yuan. This creates an opportunity to rebalance global trade, an opportunity the U.S. hasn't seen in a generation. But U.S. companies can't adapt overnight. Withered factories and supply networks will need abundant time and capital to rebuild before the U.S. can become a major force again. BusinessWeek (19 Jun.)
Factory activity down, jobless claims dip
Factories in the U.S. Mid-Atlantic region have yet to see an expected boost from export demand. Figures from the Philadelphia Federal Reserve showed business activity fell for a seventh month. Meanwhile, the number of U.S. workers filing new claims for jobless benefits totaled 381,000 last week. "This is recession territory, at least if the experience of 2001 is a guide," said economist Ian Shepherdson of High Frequency Economics. FinancialWeek/Reuters (19 Jun.)
Paulson says Fed should have broader emergency powers
The U.S. Federal Reserve might need to make money available to a broader range of financial institutions if there is a market meltdown, and that could mean offering emergency funding to investment banks, Treasury Secretary Henry Paulson said. U.S. lawmakers are considering whether to give the Fed explicit authority to take emergency action in case of a threat to financial stability. Reuters (19 Jun.)
Regulators threaten to get tough on shadow banking
Shadow banking has become a $10 trillion market and a vital source of funds to spur the U.S. economy, but the subprime meltdown exposed major flaws. "The shadow banking system model as practiced in recent years has been discredited," said Ramin Toloui, executive vice president at Pimco. Industry observers say Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and other large brokerage firms may have the most to lose if regulators tighten the reins on shadow banking. MarketWatch (19 Jun.)
Big businesses pass cost of inflation on to customers
Big businesses are passing on higher costs to their customers, increasing concern that this is the beginning of an inflationary spiral. Dow Chemical and South Korean steelmaker Posco announced dramatic price increases Tuesday. Mining giant BHP Billiton said the near-doubling of iron ore prices achieved by rival Rio Tinto on Monday was not enough. Companies faced "tremendous cost pressures" and had the "obligation" to raise their prices in response to higher costs, DuPont chief executive Charles Holliday said. Financial Times (24 Jun.)
Greenspan sees U.S. recession more likely than not
There is a greater than 50% chance that the U.S. will slide into recession as inflation makes further interest-rate cuts unlikely, former Federal Reserve Chairman Alan Greenspan said. "A rebound at this stage is not something I think is in the immediate outlook," he said. Reuters (24 Jun.)
Smaller central banks hesitate in inflation fightCentral bankers in developing nations are reluctant to join a push for higher interest rates that could curb inflation but would also hurt their poor. Their inaction could play a growing role in spiraling global inflation. "If emerging markets don't tighten, then advanced economies import more inflation," said Arvind Subramanian, senior fellow at the Peterson Institute for International Economics in Washington. The Globe and Mail (Toronto) (25 Jun.)
Fed expected to signal anti-inflation bias
The Federal Reserve's rate-setting committee will leave the key U.S. interest rate unchanged at 2% after Wednesday's meeting, all 102 economists surveyed by Bloomberg News said. The Fed instead appears to be laying the groundwork for a shift to an anti-inflation stance and future rate increases. Bloomberg (25 Jun.)
Buffett offers little economic cheer
Billionaire investor Warren Buffett says he can't predict when the U.S. economy will recover from its current slump. "It's not going to be tomorrow, it's not going to be next month, and may not even be next year," he said. The country is in the middle of a period of stagflation, with the economy slowing at the same time inflation worsens. "I think the `flation' part will heat up and I think the `stag' part will get worse," Buffett said. Bloomberg (25 Jun.)
Inflation adds to credit-crisis woesRising worldwide inflation is promising to be a greater worry than the credit crisis. "A lot of companies are ill-positioned to deal with an additional whammy of rising costs," Barclays credit analysis head Mark Howard said. Industries that are able to pass along higher prices are in better shape, including companies in agriculture, biotech, and utilities, he said. FinancialWeek (26 Jun.)
Japan's inflation hits 10-year high
Japanese households cut their spending by 3.2% in May, the government said Friday, adding a further drag on the world's second-largest economy. Households account for nearly 55% of the Japanese economy. Their spending pullback is a further recession warning since corporations are already struggling against skyrocketing energy and raw-material costs. Forbes/Thomson Financial News (27 Jun.)
Central bankers agree on inflation threat
Central bankers from around the world seem to share the view that inflation is their biggest economic challenge. Bankers meeting in Switzerland concurred that booming food and energy costs are related to demand and might not be temporary. Once industrial countries have managed the financial turmoil of the past year, "the issue that is remaining and that is becoming more important is containing inflationary pressures," Chile central bank president José de Gregorio said. CNBC (30 Jun.) , The Wall Street Journal (subscription required) (30 Jun.) , Reuters (29 Jun.) , Bloomberg (29 Jun.)
So what does this mean to your retirement plans?
Defined-contribution plans can enable dentists to accumulate tax-deferred savings that far exceed their expectations. On retirement, however, they may be shocked to discover how a seemingly ample savings amount translates into only a modest level of sustainable annual income on an after-tax, after-inflation basis. How shocked, well, let’s see.
Most dentists, even those who are relatively knowledgeable, do not recognize how a large savings accumulation can translate into a relatively modest annual flow of payments. Additionally, this “annuity shock” can actually be exacerbated by the success of tax-deferred accounts, such as 401(k) plans and IRAs. How so?
Consider a postretirement investment having a 6 percent nominal earnings rate subject to 20 percent taxes and 3 percent inflation.
A $300,000 accumulation would be able to fund an after-tax, after-inflation 20-year annuity of only $16,000 from a tax-deferred account and $18,000 from a taxable account.
Many dentists would be shocked to learn that what they might consider a rather significant sum would generate such a modest level of sustainable annual income. Another source of surprise is that it does not matter a great deal, under these conditions, whether the $300,000 is lodged within a tax-deferred account or in a taxable savings account lying outside any tax shelter.
It should be emphasized that, although tax-deferred and taxable savings face roughly similar annuity factors. It is worth trying to understand why these factors are so much lower than many would expect. In the taxable account, the 6 percent interest rate — including the 3 percent inflation component — is first subject to a tax payment of 20 percent that reduces the after-tax earnings rate to 4.8 percent. The insidious “tax” from inflation then strikes a second time to take away another 3 percent each period, reducing the nominal 6 percent to a net rate of 1.8 percent. It is the convergence of effective rates of return due to takes and inflation, under our baseline assumptions, that leads to the taxable and tax-deferred accounts of having virtually the same net annuity factors.
Higher Taxes and Inflation RatesThe preceding discussion focused on an effective tax rate of 20 percent. Higher tax rates erode the net payments and consequently lead to lower annuity factors. Higher tax rates would also lead to a wider differentiation between taxable and the tax-deferred accounts, with higher taxes having the more deleterious impact on the tax-deferred account. So now you know how taxes and inflation can lead to a misperception of what constitutes an ample level of savings.
Although the tone of the preceding comments may have been rather grim, there is some good news in these annuity factors. Suppose an individual also receives a stream of annual nominal or inflation-indexed payments from a corporation or some government entity, e.g. social security. This is in effect a Defined benefit stream of income and it will grow larger in present-value terms. For example, a 30-year stream of fully indexed payments that starts at $15,000 would be equivalent, under the baseline assumptions, to a tax-deferred accumulation of $370,000. The size of this implicit sum might be a pleasant surprise to you. Do you want to know more about this? https://www.cfainstitute.org/memresources/communications/privatewealth/june08/article_1.html
Do you want to make it even better?
Social Security’s handbook contains 2,728 rules. One of these — Rule 1516 — permits Social Security recipients to repay all benefits received in the past on their earnings records and reapply for much higher benefits from scratch.
Social Security charges no interest on the repayment, and the IRS allows the recipient to deduct the repayment or take a tax credit for the extra taxes already paid because of past receipt of Social Security benefits.
Yes, this is hard to believe. But it is true. Repayers need to file Social Security Form 521, and IRS Publication 915 discusses the tax deduction/credit. The gains from taking this option can be sizeable. Take Peter and Kate, who are 70-year-old retirees with $200,000 in regular assets and $200,000 each in retirement accounts. They invest all these regular and retirement account assets in safe assets yielding 3 percent after inflation. Peter and Kate will each receive $13,250 this year in Social Security retirement benefits.
Peter and Kate took Social Security when they were age 62 and have been kicking themselves ever since. Had they waited until now to apply, they would each be eligible for $20,693 per year — their full retirement benefit adjusted by Social Security’s Delayed Retirement Credit; that is, they would be receiving 56.2 percent more in real Social Security benefits this year and every year in the future.
But dreams can come true, and thanks to Rule 1516, Peter and Kate can secure this benefit increase. True, they will each have to repay $94,556 in past benefits received. But it is worth it. Their sustainable consumption expenditure rises, on balance, by 21.7 percent!
How else could Peter and Kate raise their living standard by 21.7 percent? Well, they could find $220,000 lying on the street. With $420,000 in regular assets rather than $200,000, they would be able to sustain the same living standard through age 100 as they would by simply repaying and reapplying for Social Security — something that will take them all of an hour.
What Age Groups Stand to Gain from Repaying and Reapplying?
The results for the other assumed initial ages indicate that households ranging from their mid-60s to mid-70s may gain significantly from this option. Buying inflation-indexed annuities from a reliable, low-cost provider can raise one’s living standard. But buying such annuities from the safest and lowest cost provider, namely, Social Security, can raise one’s living standard in this by a lot more than buying form a commercial annuity broker which would cost you about 40% more than repaying your social security and reapplying.
What is the Gain from Taking Benefits at 62 and Repaying and Reapplying at 70?
If Peter and Kate are age 62, what are their living standard gains from taking their benefits at age 62 and then at age 70, repaying them and reapplying for higher benefits? Taking their benefits at age 62 and never repaying entails a sustainable spending level of $50,410. Taking their benefits starting at age 70 offers an 11.8 percent higher level of sustainable spending. But taking them early, at age 62, and then repaying and reapplying at 70 offers an even better deal — a 15.8 percent higher sustainable spending level than simply taking benefits at age 62. But again, this third option will only be an option if Social Security preserves Rule 1516! Want to learn more about this? https://www.cfainstitute.org/memresources/communications/privatewealth/june08/article_5.html
Author’s note: This discussion paper for the dental audience is largely re-edited content taken from CFA Institute's private wealth resources. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.
