What About Inflation And My Retirement Plans?

Are you reading the news? Take a look at how inflation is raising its ugly head. Then read what this means to your 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.

The Crazy Markets You Are Invested In (Part 2)

The Negative trade balance began in the mid-70s, less than 30 years later both the government and consumers were running up debt at an alarming rate. See Chart on the left-hand side of this page.The only way America can continue in its role, is to borrow. How is this borrowing made possible? Let’s first look at gold.

Gold has a past and a present and it has not been a great preserver of wealth during the last 30 years and in this respect it has not been any better than paper money. A bull market in gold or in technology shares or in real estate are all the same, no real wealth is being created, people are just switching their preferences. In the end, trust in gold is the same as trust in paper money until you go back even further in history and then you realize that gold has a much longer history than the paper dollar and because of this, both gold and paper dollars have a future, but gold has much more of it.

Jesus said, “Render unto Caesar that which is Caesar’s” referring to gold and silver coins with Caesar’s head on it. America has dead presidents on its money too but the difference is that a gold denarius is worth today, in terms of buying power, what it was worth 2,000 years ago. And US paper dollars lose 2 to 5 percent of their purchasing power every year. What do you think they will be worth 10 years in the future?

The world’s two largest currencies, the US dollar and the British Pound have both lost 95% of their value in the past century, which is especially remarkable because gold was linked to these currencies for most of this time. For the dollar the final link with gold finished 37 years ago. 70% of the world’s central bankers and Warren Buffet have been increasing their reserves in Euros since 2005.

That is not so surprising given this background of rising debt against the dollar. The dollar is in fact and rational thought, nothing more than electronic information that exists to keep track of it. Relatively few dollars ever make it to paper and many end up in the pockets of drug lords and African politicians. Therefore, most of the US dollars made are not even useful for starting a fire because they do not even tangibly exist.

Gold is the only money that exists in tangible form. Sure it goes up and it goes down just like money say the economists. You can protect yourself from inflation in other ways say the speculators. Gold pays no dividends or interest, gold will not make you happy, but it is better in the long run than anything else. Longevity is not the best recommendation, especially if you do not live as long as the ½ life of gold which is already inert, or nearly immortal. But this feature, gives it staying power, and this is what gives it virtue.

Gold is money that no central bank promotes and none destroys. The world’s improvers will always be with us. They spend more than they have to boss us around, they use civil service jobs and bombs to get their way. Given enough money, the poor can be fed and housed, the middle class can be given free medical, low cost housing loans and social security, and the rich get contracts and favors. Enemies can be created, then bombed, and then reconstructed into seeing the world from our point of view. It is all a circus show and it all costs money.

How do you get more money for these spectacles? Gold refuses to cooperate. US dollars and other paper money barely needs encouragement, the printing presses are already hot. But everything in life has a beginning, a middle, and an end, just as surely as each day passes. Each day that passes in which the present trends don’t come to an end brings us a day closer to when they will end. Stability, leads to instability. The longer things remain stable, the more people are convinced that they will never change.

Today’s house flippers are taking on riskier positions, instead of buying one house, they buy two. Instead of living modestly, they live large, they gush in the direction that the market leads them. What does this really mean? It means that investor’s perceptions of risk are over influenced by recent history. It means that people look for meaning in things where there is none, that they misapprehend the randomness of events. Over the broad sweep of market history, prices have gone up from barely 100 after the crash of 1929 to over 10,000 where it is today. However, adjusted to inflation, the Dow is only about 500, and most of that increase is cyclical.

The Dow, having moved from under 1,000 to over 10,000, from 1982 to 2008 investors would have to believe that the tendency is to go up, that’s its recent history, right? Today’s current investors have made their bets as to whether prices will go up or down, and this is reflected in the stock market or real estate markets currently. Some believe it will go up and some believe it will go down and so the cycle repeats itself as investors eventually come to realize (by a feeling) that they are paying too much for the opportunity to follow the prices going up, and then, some event, and things tend to crash.

Over the last 100 years the average price investors tend to pay for $1 of stock market earnings is $12. Today, investors are paying $20 on the S & P 500. They believe it will go up, they are not wrong, they are just paying too much to find out when. What were the odds that Bear Stearns would disappear this year, let alone in 2 weeks? A crash in the stock market would be accompanied by the usual complaints, but a crash in the real estate market would be much worse.

Households that have come to rely on equity build-up to keep themselves solvent will have to cut back on consumption. This would produce job loss, personal bankruptcies, mortgage failures, and falling prices. We know how America was built on debt and an increase in the money supply to feed it. We don’t know how it will end or when it will end. It is rather like thinking about your own death, you would rather not, and generally you tend to avoid the subject. Still, it is the kind of thing you ought to be prepared for! A sensible man may not know the hour, the day of his demise, but he does not doubt that it is coming! He does not want to wake up to a market crash with a portfolio of junk bonds, tech stocks, multiple homes or US dollars. He wants to pour himself a drink of Tequila Gold.

After 20 years of mostly falling interest rates, mostly falling inflation rates, and mostly rising asset prices (stocks and real estate) Americans have come to believe that this is the way the world works. Interest rates mostly go down, real estate prices mostly go up. It’s a beautiful thing. What would happen if real estate prices start to go down as they already are? The answer is, nobody knows. Everyone is scrambling to add more money, re-write the rules, and change the benchmarks.

Go figure, the world richest economy lives off the savings of the world’s poorest. Americans buy what they cannot afford, and the Chinese build factories to produce stuff that we cannot afford, but buy anyway. It is the dandiest thing, the whole global “economy” advances apparently so long as U.S. Housing prices continue to rise, as long as more and more money is made.

Whatever this new “economy” is, it is not a traditional economy. Income that should be helping consumers spend is not there, manufacturing jobs are disappearing or being outsourced overseas. Savings have disappeared. Most of what we read is “noise” – more meaningless stuff. In America the average home went up in value 44% in real terms between 1995 and 2005. People buy property now like they did in the tech stock bubble, there are demographic factors they say, earning don’t matter. It is all a greater fool’s game, betting that someone else will come along and pay you more for it. There is no real economy in that. How the new homeowners are going to pay higher prices on falling incomes is not clear, is it?

Remember when people felt the reason why stocks would continue to go up was because baby boomers must save money and they had to put it somewhere? Then, when stocks went down after 2000, they reasoned for the same reasons, why real estate prices would go up, and so they end up chasing bubbles while the real story of what is happening in America is lost in the “noise”.

Well, after an unprecedented rise in real estate, the biggest boom ever, twice as big as the last one in 1980s according to the FDIC, we are nearing, one day at a time, the edge of the abyss. Perhaps the real story is prices for houses have risen in real terms 66% since 1890, but most of the increases happened in two periods: right after WW II and since 1998. Other than these two periods the real prices for real estate have been either flat or going down. Today lenders have come up with creative means to lend money to people who can’t pay it back. Go Figure, and now maybe you can understand why the Fed has increased our money supply and reduced interest rates, to keep the consumer economy working, to increase our apparent standard of living at the expense of great indebtedness (40trillion) payable ultimately, by the many generations of the non-voting unborn.

Things have changed since the last real estate bubble in the 1940’s, then the U.S. economy was growing and healthy. America had a positive trade balance, the biggest in the world. Wages were going up, families were expanding. Now, families are getting smaller, incomes are stable or declining, and for culture of consumers who spend more than we earn, we desperately need housing prices to go up in value and we need the saving of the poor in China and elsewhere in the 3rd World.

The more things change the more things remain the same. The time is now, the rational man and the prudent man get prepared while the crowds wait anxiously for the next signal.
The probable reality is that the Feds will “fix” the problem by throwing more money at it, continuing to devalue the US dollar knowing it holds a trump card in its military that has a vested interest into convincing the rest of the world from seeing things from the American point of view, and that is to keep using the US dollar.

This means that the dollar continues to be the world’s primary currency, backed by a stable government of laws and order. You see, our US dollar is really the equivalent to Imperial currency. As long as it is the world primary currency and everybody wants it to trade with, then it has intrinsic value to foreigners. This is also why it is in the US military’s strategic interest to advance a net work of trade routes around the world, so the 3rd world will continue to invest their savings in US dollars and so the American consumer will continue to consume, so long as housing prices keep increasing and so the dance goes until it stops and it always will.

Purchasing Power Meltdown
Since the US dollar began falling and emerging markets began booming in 2003:
Corn is up 39.5%
Coffee is up 71.1%
Wheat is up 133.9%
Crude Oil is up 140.8%
Gold is up 149.8%
Soybeans are up 159.2%
Gasoline is up 203.6%
Platinum is up 224.2%
Silver is up 257.7%

And thousand s of products that contain these things cost you more everyday.
Cheers!


Author’s note: This discussion paper for the dental audience is largely re-edited content taken from Empire of Debt: The Rise of an Epic Financial Crisis by Bill Bonner and Addison Wiggin, 2006, John Wiley & Sons. 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.

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Pay Now - Pay Later, Why Our Staff Need Our Help

Can behavioral finance solve the problems with retirement planning?

Yes, do “it” for them!
Our staff face very different challenges today in planning for lifetime financial security from what previous generations did.

The Pension Protection Act of 2006 was the biggest pension reform legislation enacted in more that 30 years. What made it so different was its recognition of behavioral finance. I’m talking about the accumulation phase of retirement savings and the realization of how difficult it is to build a nest egg.

The problem, specifically, is that 1/3 of those eligible to participate in a 401(k) or other employer sponsored savings plan, do not enroll. The Pension Protection Act was designed to change that.

But first, why is it so difficult to have a savings plan?

Why is it Americans have no savings? It is because of the consumer-based culture (better to buy than to save) and here is the evidence.

1) Savings provides no short-term benefit unlike a mortgage, which results in being able to buy a home.
2) In contrast to an unavoidable chore, i.e. taxes, there are no deadlines.
3) Unlike penalties that can come from, for example, failing to have car insurance; failing to structure financial planning entails no penalties.
4) Education is not enough. Research has shown that there is a substantial disconnect between what financial seminar participants intend to do and actually do end up doing. In fact, there is very little difference in activity between those who do take educational seminars and those who do not (7% vs. 14% - 2001 study: working paper University of Chicago)

What are some of the reasons given for not saving?
- To little money available for savings after paying for basic living expenses
- Money needed to pay off debt
- Unexpected drop in income
- Changing one’s mind
- Lack of self-control
- Loss aversion – risk

And when they do make a decision to save, they follow the path of least resistance when choosing plan options – often least risky and not necessarily in the person’s long-term best interest. Once they choose an option, they are reluctant to revisit it, or to increase contributions as salaries rise, for example. To make matters worse, employees may become paralyzed by having too many options, which prolongs any decision and can reduce their ability to make a rational decision.

The bottom line is this, how employees respond depends upon how retirement plans are presented. For example, automatically enrolling in an employer sponsored plan results in a higher rate of participation. Employers who actually increase employee contribution rate over time actually find employees go along and overcome the “psychological factors” to do nothing that comes from procrastination, lack of inertia, status quo bias, and a general unwillingness to make small sacrifices today for a greater gain down the road.

The reality is that very few people actually achieve all their goals. According to the 2007 Fidelity Research Institute, a typical US household was in track to replace only 58% of its income in retirement, not the suggested 85%. And among retirees 55 years of age and older who were surveyed, more that half (53%) retired earlier than planned. Further, employees who expected retirement income to account for 28% of income in retirement reported it only accounted for 6%.

So there you have it, too often decision-making biases and shortcoming get in the way of your employee’s ability to choose the “right” things. It is up to you as the “protector/employer” to do the right thing and get together with a financial planner and minimize the behavioral variables by, for example, automatic enrollment, escalating contributions rates and age appropriate investment plans.

Our staff need us to do this for them, it is complicated stuff and we all have a tendency to put it off because it is not fun, don’t we.

Employees know that aside from what they create for themselves, there are few, if any, financial safety nets available to them in old age. The retirement plan is only a hope, and Social Security is uncertain. Longevity and health care costs are increasing. Family support is not as available as in prior generations, and arguably, there are also unrealistic expectations about appropriate savings rates and expected investment returns.
The realty is that the employee’s central concern about how to maintain his or her standard of living into old age is not adequately addressed; the additional risks of longevity, inflation, and principal loss remain for the employee. In a Wealth Management 101 exam, the financial industry would—or should—get an F; as they have not proposed a solution that truly meets the employee’s needs.

How can you help?
With respect to age appropriate investing, there has been a shift as big, exciting, and challenging as when Markowitz’s work first forced investment professionals to recognize the importance of investment diversification or asset allocation. And that shift has been into hedging and insurance as additional means to an investment’s return.
Employees now have access to inflation-indexed annuities for their IRA accounts through a new distribution channel that offers meaningful competition: real-time, apples-to-apples quotes from several top insurance companies. This development may be as big in investing industry as the shift from loaded to no-load mutual funds or from the commissioned broker to the fee-only planner model.

So, your role is to provide retirement planning counsel to your employees for the intangible return of being recognized as a caring, supportive leader in your practice. It is already a win-win; why not make it a win-win-win. Do it now, pay now or pay later.

The Changing Retirement Paradigm

I recently read the results of an AGD sanctioned survey of some 1600 online members. The operative question was, “What are their retirement goals?”

Practice management pundits often throw around 6% as the percentage of dentists who can retire in a manner to which they have grown accustomed. 6% doesn’t sound like very many, what’s behind this statistic. Thankfully, Kim Graham Lee, (CEO of Hufford Financial Management) has a research report in the AGD Impact, November 2007, which details some interesting observations and limited encouragement.

Here is her “30 second story”:

• “Full retirement” is not in the vocabulary of most dentists. Dentists enjoy what they do, and most do not have any intentions to retire fully from their profession. Only one out of three dentists plans to retire completely.

• AGD dentists have sought information and engaged in a number of financial planning activities to help them with retirement funding, yet many admit to not being entirely knowledgeable about investing or confident in their planning.

• Most dentists are not on track financially to meet their retirement goals, especially considering that the majority intend to live a lifestyle that is on par with, or higher than, their current standard of living. The best-case scenario is that 3 out of 10 AGD dentists will have enough income at retirement to meet their current standard of living. There is a gap between perception and reality.

The results showed a surprising result that represents a changing paradigm, that most AGD dentists have no intention on full retirement. Gone is the notion of retiring at 65. This is actively being re-branded into “the new” aging workforce.

More than half envision working part-time well into “retirement”. What is retirement anyway? There seems to be a new trend, like double income families, now its called “bop till you drop”. And, “yes”, it is a necessity, without proper planning, to do what most (70%) have to do, and that is, KEEP WORKING.

All money aside, and most say that money is not the primary reason why they keep working; they say they work to keep busy, to stay in touch with colleagues and patients, and continued learning. Yet, only one out of two in the sample has even calculated how much they might need in retirement, if ever they were to fully retire.

It is interesting how we perceive the future; either it is something that comes after the present or it is something we anticipate and plan for.

Amazingly, only 50% have worked through retirement goals and financing with their spouses. I wonder if this is the same number of dentists who don’t have any intention of retiring and have yet to calculate how much they might need?

The paradox is that of 11 competing financial priorities, including planning for a vacation, saving for retirement comes in at the top of the list, the number one priority.

In terms of actual retirement savings, Brian Hufford says, “Which situation is preferable: 1) having no debt at age 50 and the ability to have $700,000 saved at age 62; or 2) having $300,000 of debt at age 62 while having $3.7 million saved? This seems like a silly proposition, but the great majority of dentists choose the first strategy. To realize the second alternative, a dentist must start saving early and save consistently every year.” Making savings your primary goal”. This is also called the power and magic of compounding returns.

Why is it that among these dentists, their savings percentage peaks between ages 50 and 54 (the median is 16 percent of net profit)? Is it because they did not start saving early enough?

It was learned from the study that the most common source for retirements funds were from investments in stocks, bonds and mutual funds even though 70% acknowledged that they were not very investment savvy. Despite this, 77% were confident that they would not have to work in retirement, even though they intend to. And this is where reality and wishful thinking hit the road! The survey concludes that 70% of those surveyed will not have sufficient retirement income to maintain their current standard of living. Surprised? You can learn more from the article directly. http://www.agd.org/publications/articles/?ArtID=2450

The Economy And What To Do?

What is your personal plan for your debt and use of cash? With today’s “interesting times” we are once again faced with the proverbial uncertainty of the markets, both in the real estate and stock and bond markets. Why has been addressed in a previous blog (April 07).

What are you thinking?

Are you thinking of reducing your debt load and using cash only for future purchases? Are you thinking a cycle is a cycle is a cycle? Are you experiencing paralysis by analysis? Are you thinking about your kids too?

Have you been maximizing your 401K, profit sharing plan and/or RRSP contributions to reduce your current tax load? You can contribute up to either 25% of your income or $44,000 which ever is less to your 401K. After your tax investments, what are you thinking about for your personal investments? Do you pay yourself first? Do you contribute 10% of your income towards your retirement savings? Do you work closely with a financial planner and accountant? Have you a plan for your retirement? When? Are you concerned if mortgage rates go up?

Is there such a thing as good debt or bad debt? To answer this question I have to say first that there are many different ways to hold one’s perspective about debt and that is what makes us who we are. There is no right or wrong, only how you feel at the end of the day and that your actions are validated by your thinking. Hopefully you are giving as much thought and more to this subject than you would be, for example, for your next vacation.

For example, if you freed up your mortgage, does that make financial sense. Well, that depends on who you are and how you think. For some, I would say that it is better to not pay off your mortgage and invest your money in investments that return a greater return than the cost of borrowed money. That is the logic of investments in the first place. But, with that comes the uncertainty and the risk which is easier to take if you are younger because you have more time to make up any loses and to align yourself with the information that over time, the stock market has out performed the bond market.

So, what to do? Again, it is anybody’s guess, however outside of the logic of financial opportunism is the need, for some, for their gut security of a known tangible investment, your home. Therefore, investing for your home is investing for your peace of mind and is not necessarily the best investment in terms of financial return which leads me to conclude that asset diversification, including your home, is what is really the best thing to do. If your home had an cash flow producing asset, a guest cottage or a rental unit, so much the better. Good luck!

You will need it because this market is also about the real estate market and its effect on credit. To put is simply, the US dollar has lost 30% of its value recently because of its trade deficit, which means the US is buying more than it is selling. Further, because of the US housing bubble has offset the currency loses (psychologically), few are aware of the seriousness of this dilemma. If the US reduces interest rates to further extend the status quo, then this will be at the expense of the value of the dollar and inflation, meaning a big time already unsustainable housing bubble will follow with inflation. If the US increases its prime-lending rate, this will prop up the value of the dollar, but force many over-extended mortgages, millions of Americans, to go bankrupt. This is the squeeze we are in because cash flow is becoming a problem both for individuals with mortgages and highly leveraged institutions holding “high risk mortages” that were packaged and repackaged over and over until they appeared to be a “less risky” basket of assets. Besides individuals, pension plans, insurance companies and even banks have bought into these financially engineered products, many of which have been determined to be worthless. Nobody really knows for certain the full extent of worthless securities and who owns them at this point in time (and the markets don’t like uncertainty). In addition, there still continues to be the possibility of a recession lead by a declining US housing market (more uncertainty).

I should be mentioned not to throw out the baby with the bath water, meaning at this time the liquidity crisis is not considered an economic crisis. There is still plenty of confidence in the US behemoth and although it lacks credit, it still has plenty of assets. However, the impact from the “liquidity crisis” is not over. For instance, the peak of the US sub-prime mortgage rate defaults is expected to occur sometime in April of 2008.

So what do you own?

Ask Your Financial Advisor to Explain This:

Ask Your Financial Advisor to Explain This:

As always, there are some things that you can control and some things that you cannot control - things like the economy, demographics, and supply and demand. Today, I will be writing about the economy because we live in “interesting times” and because things are different now than they have been in the past 50 years.

First, there are high short-term interest rates in Europe and the United States. Why mention Europe? Because the point of this article is to make the point that the US is not in control of its money and to ask the question, “Is that your money too?” This discussion is being put forth to start some dialogue and to get you to think about some of things that are out of your control, like the economy, and to prompt you to ask your financial advisor for their take on this change.

Case in point, right now there is a fully inverted yield curve on U.S. Treasuries and the global economy is thriving, new records of economic activity are being measured, stock markets are up, and debt creation is soaring. Traditionally, this situation is the opposite of what one would expect. Why?

Let me explain… an inverted yield curve, defined as three-month Treasuries yielding more that 10-year Treasuries, always means recession, not boom. “The yield curve has predicted every U.S. recession since the 1950’s…”, so what is going on?

To understand this logic, you have to understand that the banks, (the source of all money), make their money by borrowing short and lending long for cars, mortgages, boats, etc., so the greater the spread between the short and long rates, the more profitable the banking business. But, invert this yield curve and the banks find themselves paying more for deposits on savings accounts than they earn by lending. For the global economy, traditionally, this used to mean bad news because the U.S. spending fuels export driven economies of Asia, Latin America, and the Middle East. A credit crunch, (increased short-term lending rates), used to mean world pain. Not so today, what’s changed?

Consider a new paradigm, that the structure of the world’s economy has changed. Author, John Rubino, says consider these things:

1) Today, we have the free flow of capital around the world. This means that cash moves in and out of any one market without any restrictions. This also means that the inverted U.S. yield curve is only inverted from a U.S. investor’s perspective. For example, over in Japan, where they have artificially low over night bank interest rates, (something like 0.5% on what in the U.S. would pay 3%), there is an interest in investing their Yen into our U.S. over night notes because for them, a U.S. inverted yield curve is a steep yield curve! This concept of investing in one bank from another is called the carry trade, the over night carry trade. What has changed is that now Japanese banks and other capital from around the world are participating in the carry trade.

2) There is, at least, one more reason that is even bigger than the amount of money the Japanese are pouring into the U.S. over night market carry trade. I’m talking about the central banks, the mother ship of all banks of any given country, that are buying U.S. dollar debt. The central banks of Japan and China have something like 3 Trillion dollars of U.S. bonds. These government banks have chosen to recycle their trade surpluses back into U.S. Bonds. The reason they do this is because if they did not do this, their own currency, the yen and renminbi, would become less valuable at international exchange rates making the cost of their exported goods more expensive to the U.S. market that they serve.

3) The reason why this is working is because of the new paradigm in the economy, namely that 90% of all foreign money that is buying U.S. securities, is no longer private investors, but foreign governments. They are buying Treasuries, Corporate bonds, mortgages, and stocks because by doing so they keep their own currencies “fairly” valued so the status quo continues, namely the Japanese and Chinese keep selling competitively priced goods to the U.S. consumers, and at the same time, by actively exchanging the trade surplus created into the purchase of U.S. debt, they effectively are giving the U.S. the equivalent of unlimited credit with which to buy more goods at an ever increasing trade surplus that keeps getting “sanitized” by the re-investment of the trade surplus back into U.S. Securities. Got it?

OK, good, because there is just a little bit more to all of this. What has happened with this recycling of debt to a seemingly unlimited potential, is a massive demand for high-grade debt notes, more in fact than the entire U.S. Treasury has. In fact, that’s the reason for something called, “Securitization”, or the building of lesser-grade debt into higher-grade bonds, like gathering up a bunch of home mortgages or credit card imbalances and creating a SPV, “special purpose vehicle.”

Now, here is the reality check… Securitization’s impact on business practices in the financial sector has been seismic. U.S. banks no longer have to hold debt for long periods of time. They can sell it to foreign central banks and use the proceeds to make more debt available and hence, banks have been transformed into the suppliers of raw material for the global economy. This also explains the U.S. banks willingness to lend money in spite of the inverted yield curve. Knowing that they don’t have to hold this debt, they repackage it into an SPV and sell it to central banks with a trade surplus.

The final piece of this transformation is the credit insurance that has recently come on side, meaning they have created new ways to insure against losses involved in borrowing, enter the CDS, “credit default swap” that insure against any losses involved in defaults by a given borrower. Enter hedge funds that have discovered that writing CDS is like writing flood insurance in a drought period. The challenge in finding flood insurance is in finding people who want it, but who doesn’t want cheap money. So, what has changed is that now the banks provide the credit as they always have, but this time the hedge funds are providing credit insurance so the resulting re-packaged “high-grade” debt is being snapped up by central banks that have a trade surplus with the U.S.

I’m not finished yet… armed with cheap credit, a growing number of companies are buying back their stock. For large companies, a strategy of stock buybacks is used to support share prices in the absence of any internal growth opportunities. For the smaller companies, this could make them a target for a leveraged buy out from private equity firms armed with cheap money. Global M & A rose 38% in 2006. And default rates are falling because even the most troubled company can get credit these days.

The result is that the U.S. government is not totally in control any more; securitization has made bank reserve requirements irrelevant. Meanwhile, most financial transactions that are electronic are perceived to be safe and liquid and so can perform some of the functions of money. Combine this new-age credit creation with huge trade imbalances and the result is a unique set of challenges for today’s central banks. Imagine that you are running the U.S. Federal Reserve Board, your economy is running an alarming trade deficit, U.S. dollar backed bonds are ending up in the accounts of your biggest trading partners’ central banks and in response you have engineered an inverted yield curve, which always worked in the good old days, but you know what, it isn’t working now, is it?

This time is different, the banks are still lending like crazy and credit is still cheap. Why? Perhaps the global financial system has shifted away from gradual interest rate changes that were connected simply to shifting mortgage rates. This time, there is a new player on the field that is driving demand for the supply of money and that is the M & A lending activity that is trumping the mortgage backed securities of yesteryear.

Now for the trillion dollar question - is money this cheap sustainable or are we headed off the cliff inevitably, with everybody’s debt mounting and mounting for a great fall? Eighteen months ago, our overseas debt became greater than our overseas assets, a situation, that in the past, would have caused a decline in the value of the U.S. dollar. The U.S. is now the world’s greatest debtor. Those countries holding this debt, largely Japan and China, are dependant on U.S. consumer spending. A rapid falling dollar would be more of a problem for Japan and China than for the U.S. Meanwhile, U.S. banks are continuing to make money on the inverted yield curve by taking more and more risks on credit. For example, 71% of all companies with Standard and Poor’s credit rating had the lowest quality rating in 2006; in 1980, by comparison, only 32% had this poor rating.

How big is this new economy? The value of global credit insurance alone is half the size of the global GDP and it is growing exponentially. Much of it is held by hedge funds that don’t publish audited balance sheets. So, it is clear we are in uncharted waters, and we already know that the social security is not properly funded so we cannot count on that design for our futures either.

Thinking like a CEO means taking into consideration all the situations that are in your control and all the situations that are out of your control, like the economy. I hope this little piece has given you a heads up and reasons to discuss this overview with your financial advisor(s).

Health Savings Account Can Save Your Dentistry Practice “Real” Money

Rising health care costs including dentistry are taking a toll on Americans. According to a recent report by a consulting company, Mercer Human Resources Consulting, health care premiums paid by employers rose 6.1% in 2006. If you provide health care to your employees, these premiums are eating away at your profitability.

While managing health care costs is becoming a priority for our law makers, the debate for national health care continues. But there is a government program already in place that can help you and your employees reduce health care costs. This is the Health Savings Act (HSA) which was enacted by President Bush in 2003.

Employers Benefit from Reducing Costs
What if someone walked up to you and said your dentistry practice can save money with respect to health insurance while still maintaining the same level of care for your employees? This sounds almost too good to be true, but if you incorporate HSA into your health insurance coverage, you can make this happen.

The HSA program is meant primarily to benefit individuals, but employers can use it to reduce their insurance costs as well. Here is a brief summary of how the program works. Individuals can reduce their insurance premiums by enrolling in a qualified high-deductible plan and simultaneously opening an HSA through a financial institution. The HSA would be funded (up to the amount of the insurance deductible or the maximum ceiling amount) ahead of time, either by the employee or employer. Most medical expenses (including the insurance premium) can be paid from this account. The beauty of the HSA is that all money contributed to the account by the employee is considered pre-tax (like a 401(k) or IRA) and therefore reduce the employee’s taxes.

For employers, the HSA can be used to cut your health care costs dramatically. First off, you can lower employee premiums by enrolling in a health insurance plan with a higher deductible. Then help your employees sign up for a HSA and fund it at the start of the enrollment period. While your premium cost has dropped, the good news is that you are not taking anything away from your employees. Your employees get the same level of health care service. To the extent the employer contributes to the HSA, the employee does not realize the funded amount as income.

For 2006, the highest deductible for your employees under the HSA program is $2,700 for a single person or $5,450 for a married couple. In 2007, the highest deductible for a single person is $2,850 and for a married couple, $5,650.

As the employer, the cost for paying the employee health care plans and also funding their HSA accounts are fully expensed each tax year. On an after-tax basis, the total cost of the health insurance plan with the higher deductible plus your funding of the HSA for your employees will be less than what you are currently paying. By using HSA, your gross payroll will be smaller which has the additional effect of reducing your contribution for your worker’s social security payment. At the same time, your employees can continue to enjoy the same level of health care service.

Your Employees Benefit Too with HSA
In addition to dropping the cost of health care, your employees will get some additional benefits. For example, in situations where the health insurance will not pay for a particular procedure, this amount can be paid from the HSA which you have already funded. Additionally they can use the HSA to pay for dental care, eye care, and even non-traditional medicines.

Also, the HSA account would be owned by the employee with the added benefit that the unused amount can roll forward into the next year and taken with them if and when they change jobs. In the case where an employee has excellent health, the funds in the HSA can be invested in mutual funds or money markets – similar to an IRA.

Summary
In lieu of a grand plan to reform health care, the government has created a program - the Health Savings Act - that can help employers reduce the cost of their employees’ health insurance. By allowing an employer to sign up for a plan with a higher deductible, the insurance premium will drop. At the same time, employers will sign up and fund their employees’ HSA account. Both of these costs can be expensed. Thus, nobody loses anything and the health care costs for the employer decreases. It’s a win-win for all!

Posted by Henry Wong (hwong@pariveda.com)

Walking Through the Economics of HSAs – Big Savings

From our cursory overview of Health Savings Accounts signed into law by President Bush in late 2003 as part of the Medicare bill they seem to have outstanding potential to help families and individuals both lower current health care costs and sock away tax-free funds for future qualified medical expenses. Let’s dig a little deeper and quantify the economic benefits to participants by walking through a real-life comparison.

As noted in our first post on this topic, the Health Savings Account (HSA) program works in conjunction with high-deductible insurance plans. Instead of purchasing traditional, low-deductible insurance participants purchase qualified high-deductible insurance (at least $1,100 deductible for individuals, $2,200 for families in 2007) while setting up a tax-deferred Health Savings Account with a financial intermediary. The high-deductible insurance offers the Health Savings Plan participant savings in the form of lower annual premiums while the Health Savings Account affords a tax-advantaged means of saving for medical expenses.

HSAs can be funded up to the lesser of the insurance plan deductible or a government imposed maximum - $2,700 in 2006 and $2,850 in 2007 for individuals, $5,450 in 2006 and $5,650 in 2007 for families. As medical expenses are incurred, the participant may elect to pay for them using HSA funds. Any HSA contributions made by the participant, whether used during the year or left to accumulate, can be deducted from gross income come tax time.

High deductible insurance has historically been viewed with the stigma of lower quality coverage perhaps owing to the demographic it was originally intended to serve – those otherwise un-insurable. Yet with the advent of HSAs, the plans have been re-worked to appeal to a broader audience, with coverage typically similar to traditional health insurance offerings. Check out your insurance provider’s offerings and we think you’ll see what we mean.

Nonetheless, in order to conduct a relevant economic comparison between traditional and HSA insurance options, it’s crucial to ensure that each plan’s benefits are identical, or at least very similar. For our analysis we chose offerings from Blue Shield of California, specifically the “Shield Spectrum PPO Plan 1500” (traditional insurance) and the “Shield Spectrum PPO Savings Plan 2400” (HSA qualified). Our selection of Blue Shield of California as an insurance provider and the specific plans chosen are not recommendations, but instead meant to merely serve as an example of how we go about evaluating comparable offerings. There are certainly a vast number of health insurance providers available to you and product offerings that may, or may not, be more suitable.

In order to keep our analysis succinct we consider only coverage for a 40-year old individual in this post. It’s likely, though not confirmed, that evaluating family coverage as well as individuals of different ages will result in similar economic conclusions. If there’s interest, perhaps we’ll formally cover additional comparisons in the future. Let us know your thoughts.

Comparing Coverage
A quick overview of the comparability of the plans: The traditional insurance offers individual purchasers a $1,500 annual deductible and $40 fixed co-payments while the HSA-qualified offering has a $2,400 annual deductible with $35 fixed co-pays. Upon reaching the deductible, subscribers to the traditional plan make 30% co-payments with preferred providers (50% for non-preferred) until their out-of-pocket expenses reach $6,000 per year. Interestingly, individual subscribers to the HSA-qualified offering make identical 30% preferred provider co-payments only until reaching $3,200 of out-of-pocket expenses in a given year.

Readers can find a thorough comparison of the two plans here, but all-in-all we view the plan coverage is very similar.

Comparing Apples with Apples
In comparing the potential benefits of pairing a qualified high-deductible insurance policy with a Health Savings Account relative to traditional health insurance it’s necessary to look at each option on an after-tax and “apples to apples” basis.

In this analysis, there are two different tax effects that need to be considered. First, any HSA contributions provide the participant valuable tax benefits in the year they’re made, but leave funds tied up in an account that can only be accessed for health-related expenses. Alternatively, individuals subscribing to traditional insurance coverage receive no tax break for HSA deposits, yet the money they use to pay for their health expenses is not constrained – it could be used for healthcare, clothing, or even entertainment (perhaps a big-screen TV?).

Clearly the different constraints on the cash used to pay for medical expenses under the two strategies make this an “apples to oranges” comparison. Yet there is a way in which to make them directly comparable – simply assume any remaining funds in the HSA account at year-end are liquidated, paying all taxes and penalties needed to do so. Then, in each case, the individual would maintain comparable insurance throughout the year, and begin and end with un-encumbered cash.

From a practical perspective, the process of liquidating an HSA account at the end of the year is a “worse case” scenario that makes little sense, and we advise against doing so. Yet from a theoretical perspective it does serve the purpose of providing a better economic comparison between the two strategies and allows us to confidently state that “HSA accounts provides at least this much value relative to their traditional counter-parts”.

The second set of tax implications that need to be considered is the affect of itemized deductions on schedule A of the individual’s annual tax returns. If you recall, medical expenses (including insurance premiums, deductibles, co-payments, etc.) in excess of 7.5% of the tax filer’s Adjusted Gross Income are typically eligible for deduction. So, while out-of-pocket costs for the traditional insurance buyer may be higher, the possibility of an economic benefit afforded through itemized deductions is also higher.

However those choosing the HSA strategy are further disadvantaged relative to traditional insurance buyers when it comes to itemized deductions. According to the Internal Revenue Service you cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the tax-free distribution from your HSA. In fact, you cannot include any contribution to the HSA or any distribution from the HSA, including distributions taken for non-medical expenses, in the calculation for claiming the itemized deduction for medical expenses.

So, while those with HSAs gain tax benefits from contributions made to the account, these benefits are partially offset through lower deductions for itemized medical expenses on Schedule A. We take both aspects into account in our analysis.

Onto the Analysis
We ran through a range of scenarios for our hypothetical health insurance buyer changing Adjusted Gross Income from $40,000 to $220,000 and the level of medical services purchased from $0 to $15,000 in a given year. The goal is to see whether any clear trends develop with regards to the relative merits of traditional versus HSA plans using out-of-pocket and after-tax, after HSA liquidation costs for comparison.

We present the case of an individual with $40,000 Adjusted Gross Income and Medical Services of $500 in the case below.

Under this scenario the out-of-pocket expenses during the year were similar yet the after-tax, after-HSA liquidation cost of healthcare were markedly lower under the Health Savings plan – primarily due to the lower insurance premiums required.

Putting our results in tabular form, here’s what we find.

Regardless of Adjusted Gross Income and medical services required, the HSA account proved to be the better option economically on an after tax, after liquidation basis. That said, for low service levels the HSA will require the participant to pony up more cash during the year.

Further Thoughts
Want to have your cake, and eat it too? Consider the following ideas offered by the HSA for America (quite a good resource) on their blog:

Put no money in the account, except when you incur a medical expense. This strategy allows you to legally "launder" any money used to pay medical expenses. In other words, by depositing money into your HSA, then immediately withdrawing it to reimburse yourself for medical expenses, you are making your medical expenses all tax-deductible. You may want to use this strategy if you are on a tight budget and want to keep your cash outlay as low as possible.

Fully fund the account, or at least put in as much as possible based on your budget. Take money out of the account any time medical expenses are incurred, and let the rest grow tax-deferred. This strategy will maximize your tax deduction, while making your HSA funds available to pay any non-covered medical expenses before your deductible is met.

Fully fund the account, but pay all medical expenses from a non-HSA account. Reimburse yourself for medical expenses at a later date. This strategy will allow you to maximize your tax deduction, and will also allow you to maximize the tax-deferred growth of your HSA. You can then reimburse yourself, tax-free, at any time in the future for medical expenses incurred over the ensuing years.

Furthermore, the idea of maximizing contributions to your Health Savings Account annually and waiting until the end of each year to determine the source to use in paying for your medical expenses based on your taxable situation may be of even more value. If you decide to pay out of the HSA account, simply write yourself a re-imbursement check. However in cases where you have excess cash on hand and qualify for tax deductions for amounts spent above 7.5% of your AGI it may be advantageous to pay for your medical expenses outside your HSA account.

Health Savings Accounts – A Survey of Options

In prior posts, we provided an overview of Health Savings Act signed into law by President Bush in 2004, laying out the details and mechanics of the plans relative to regular health insurance options and providing an economic comparison between the two. Our conclusion was that High Deductible Health Plans combined with Health Savings Accounts provide individuals and families a terrific way to both lower ongoing medical insurance costs and accumulate tax-free savings for future medical service needs.

In this post we take our analysis a step further, surveying the landscape of the budding Health Savings Plan account options available through a number of financial institutions. With over 1,100 banks, credit unions and brokerages offering plans, our survey isn’t exhaustive but our finding do point out the varying range of services and fees charged by HSA providers at large. We believe this can be of further economic benefit to those wishing to avail themselves of what we think will be a well-adopted and rapidly expanding health-care alternative.

The survey table can be found here.

Who are these guys anyways?

The first thing that struck us in looking at the various HSA account offerings is the plethora of startup firms dedicated solely to servicing this small, but growing, opportunity. Firms such as HSA Bank, 1^st HSA, Exante Bank, and Health Savings Administrators are all big online marketers with products that offer both savings and investment alternatives. The upside – convenience, as it’s easy to either enroll over the web or download an application. The downside – it’s impossible to know if any or all will be around in five years and, as first movers in the field they’re all looking to exploit the opportunity with fee structures that verge on embarrassing.

Fees, fees & more fees
So let’s talk about fees because the second thing that struck us in looking at HSA offerings is the wide range of fees that are currently being charged. In all, the prospective investor could be faced with possible setup fees, monthly maintenance fees, closing fees, check fees, and/or debit card fees – and that’s just for savings accounts. Add in investment management options, which can range from a select group of mutual funds to the more open platform of a linked discount brokerage account, and one may also incur mutual fund maintenance fees, as well as account minimum balance and transaction fees.

HSA-only opportunists all charge account setup fees and monthly service fees along with a variety of incidental fees.

Yet the good news is that fees are generally coming down as bigger financial institutions enter the game. Products from heavyweights BankAmerica and Wells Fargo, though limited in their investment options, charge only monthly service fees, albeit somewhat high at $3.75 to $5.

Starting Out – Go for Low Cost
Let’s face it, at their core Health Savings Accounts are meant to be backstops for our medical spending needs. As such, the first few years of having an HSA account should be dedicated to funding the account, not investing the balances. In this case you’re probably best off with a low-cost option, and among the lowest cost are those offered through local community credit unions. (We surveyed offerings from Patelco and Stanford Federal Credit Union in the San Francisco Bay area, but offerings in your area are probably comparable.) You’ll have to become a member and may have to open a traditional savings account to gain access to a chosen credit union’s HSA products, but the generous interest rates earned on the account coupled with the monthly maintenance fee savings likely more than justify the trouble.

For those wishing to forego the hassle of opening up a new banking relationship, look to your current financial institution’s offerings. Calculate the “all-in” annual cost of the offering and see how it stacks up for you. Keep in mind that for major bank’s products surveyed by us, you’ll need over $2,000 in BankAmerica’s HSA product and $900 in Wells Fargo’s before you actually earn any money, taking current interest rates paid and monthly maintenance fees into account.

Building the Nest Egg – When and How to Invest
In our opinion, one should have at least two years of possible out-of-pocket medical costs squirreled away in an HSA account before contemplating investing the balance. For individuals that likely amounts to balances of between $6,000 and $10,000 and for families its likely double. Again, your first priority is to ensure the money is there, if and when you need it.

Even with two years saved, we’d advise HSA participants invest only using lower-risk strategies, plenty of diversification stock sectors and a healthy portion (at least 40%) of income producing investments such as bonds and preferred stocks.