Hurricane Harvey? North Korean Missiles? Stocks Shrug

So, okay, Hurricane Harvey may be the worst storm to hit America in a while.  The damage is really bad, and getting worse.  Projections for recovery time are lengthening by the minute as rainfall totals rise.  The economic impact will clearly be big.  Energy extraction and refining are being hit.  The Gulf states have a number of petrochemical and plastics plants, but they aren't manufacturing much.  The Gulf ports are major transshipment points for a lot of stuff, but not much transshipment is taking place.  The cost of rebuilding may reach $100 billion or more.

Meanwhile, the fat kid in North Korea keeps firing off missiles, in one instance over northern Japan.  He may think he's being clever, pushing the world to see how far he can go.  But shooting missiles over another country is a way to start wars.  The Japanese held their fire.  But North Korea's missiles aren't the picture of reliability and sturdiness.  If one flies in an unintended trajectory, or falls apart at the wrong time, physical impact on Japan or maybe South Korea is quite possible.  Then what?  Kim Jong Un has been on a path of escalation in recent months.  He's announced that Guam--U.S. territory--is his next target.  Since he seems intent on escalating, he will approach a flashpoint. 

But do stocks care?  Not one bit.  Even though U.S. stock futures dropped sharply last night, all indexes closed up today.  Mega hurricane--meh.  Barrage of North Korean missiles--meh.  Discord rife between and among the President, Congress and both political parties--meh.  Merrily we roll along.  Plus ca change, plus c'est la meme chose. 

Why do we have such insouciant stocks?  The likely explanation is the Fed.  Market participants have gotten so used to Fed bailouts that no one believes stock indexes can fall more than about 3% at the most, and therefore don't panic sell portfolios.  In some respects, this market stability may seem desirable. 

But market stability based on government subsidies is ultimately chimerical.  The Fed produced that stability by screwing over large numbers of people.  By keeping interest rates extraordinarily low for almost a decade now, the Fed has decimated pension plans.  A lot of middle class people who depended on their pensions are now lower middle class, or even poor.  Retirees and others who relied in part on interest income from their savings have learned to like dog food in lieu of steak, or even hamburger.  Holders of long term care insurance policies have faced extortionate rate increases, or possibly the prospect of spending old age in homeless shelters until they qualify for nursing homes that take Medicaid (which sometimes aren't exactly top class institutions).  Those that still have some faith in the future and want to save for a rainy day need to tighten their belts and put aside more principal, rather than count on the compounding of interest income to make their golden years glow.  That means reducing current consumption, which is a drag on the economy and may partially explain why economic growth remains tepid.

As long as the Fed supplies financial opioids for stocks to mainline, the market will be copacetic.  But problems lurk.  Stock valuations may not truly reflect investment values.  Instead, they probably incorporate a large dose of government subsidy.  That would mean people are paying too much for stocks.  This story won't have a happy ending.  Market forces can't stay suppressed indefinitely and government subsidies can't last forever.  The failure of Communism in China and the Soviet Union prove that point.  Things generally feel good when you're on narcotics. But you don't get good quality sleep on opioids--and investors shouldn't be sleeping too soundly now.

How To Reduce Volatility in Your Retirement Income

The S&P 500 has dropped three days in a row, and after all the market calm of recent months, many investors must be thinking that the apocalypse looms.  There are understandable explanations for the recent downdrafts.  Islamic radicals of the Sunni variety have rapidly seized several towns and cities in Iraq, along with American weapons and vehicles provided to the Iraqi government (and the administration worries about giving small arms to moderate Syrian rebels?).  Iranian paramilitary troops, who are Shiites, supposedly are fighting alongside Iraqi government troops to retake territory seized by the Sunni radicals. Is Iran now a more important ally of the Iraqi government than the U.S.?

Russian tanks have reportedly rolled into Ukraine, where the fighting is escalating.  Bashir Assad is winning in Syria, and the moderate rebels that the U.S. supports seem to be almost inconsequential.  Most of East Asia is squabbling over this island or that, with contending nations issuing many a proclamation declaiming a neighbor as a ratfink, a double ratfink or even a triple ratfink. 

Domestic politics also create uncertainty for the markets.  Eric Cantor, House Majority Leader, was just defenestrated in a primary election by a guy from far right field whose name, even if we mentioned it now, you probably wouldn't recognize.  (But we're going to, because it's Dave Brat, a marvelously fitting name for a guy who ousted the Majority Leader.)  Cantor, who outspent his opponent's six-figure campaign by $5 million, convincingly proved that money isn't everything.  Not even in politics.  The Koch brothers must be scratching their heads about what checks to write next.

The markets will always be plagued by volatility.  And it tends to pop up when you least expect it.  That might be inherent in the definition of volatility, but you know what we mean.  Yogurt happens, but you don't want your retirement finances smeared with yogurt.  While there are no complete protections against the ups and downs of life, here are a few ideas for calming the financial waves.

Build Up Social Security Benefits.  Disregard the hyperbole.  Social Security will be there when you retire.  Maybe not exactly as it is now, but nevertheless in a meaningful form.  Any politician who votes to eliminate or sharply reduce Social Security retirement benefits will end up doing an Eric Cantor faster than Eric Cantor as voters reject the idea that they should have to eat dog food in their old age.  Work as long as you can to build up your benefits.

Get a Pension.  If you're lucky enough to get a pension, stick out it long enough in that job to qualify.  Although classic defined benefits pensions are usually found these days only alongside the remains of diplodocus, lasso one if you can.  Other pension arrangements, like cash balance plans, are a lot better than no pension. 

Save More.  Saving more is a salve for portfolio instability and financial insecurity.  Those that have the saving jones won't have to get loans.

Use Retirement Accounts.  Retirement accounts like 401(k)s, IRAs and so on offer tax advantages that let you leverage your retirement savings, while limiting your ability to prematurely spend your savings.  A particular advantage to a 401(k) account comes if your employer provides a matching contribution, which is the freest money most people can get.  Use these accounts as much as you can.

Diversity Your Investments.  The values of all assets wax and wane.  But they usually don't wax and wane in unison.  More commonly, some assets get yeasty while others do the fallen souffle thing.  And vice versa.  So a diversified portfolio is usually kind to your antacid budget.  There are moments, like the 2008-09 financial crisis, when it seems like almost all assets belly flop.  But these cognitively dissonant interludes are the exception and not the rule. 

Consider an Annuity.  A fixed annuity (one that pays a specified dollar amount per month) or a fixed annuity adjusted for inflation can be a reasonable way to provide a steady income.  Annuities aren't cheap, and you should buy only from an insurance company with a strong credit rating. Don't put more than about one-third to one-half of your portfolio into an annuity because cash needs in old age can be unpredictable and it helps to have a nice pool of cash or cash equivalents.  Be very cautious about variable annuities--they often have high expenses, and the point here is to reduce volatility, not subject yourself to it in another form. 

Health Insurance and Long Term Care Insurance.  Financial volatility can sometimes come from sudden increases in expenses, and not just decreases in portfolio values.  Health care and long term care needs are the biggest landmines in the journey through retirement.  Most retirees are covered by Medicare, but if you're not, then buy something else.  The Affordable Care Act, despite all the teeth-gnashing on the right, is likely to be a good option if you don't have anything else.  If you have a significant net worth, consider buying long term care insurance, especially if you have a spouse who may depend on that net worth after you've gone to the great Dance Party in the sky.  It's expensive, but so is long term care.  If you want more than the quality of care given to Medicaid patients, long term care insurance may be a good choice.

Part-time Work.  Okay, you want to hear about retirement, not employment.  But part-time employment reduces the extent you need to draw down your savings, so you can keep more powder dry for later.  It also lessens your risk of dying from the boredom of day time TV.  It may boost your Social Security benefits (depending on your work history).  And the dignity of work is better than the indignity of looking for sales on dog food.

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies.  The benefits of the Fed's low interest rate policies were easy to see at first:  cheap credit, stimulus to housing, a boost to the economy.  The costs didn't seem so great. 

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so.  Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why.  Pension funds rely on safe long term investments that provide solid returns.  U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios.  AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments.  But pension plan returns came under stress as the returns on these low-risk investments nosedived.  And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall.  Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent.  Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions.  Shrinking cities like Detroit have little ability to make them.  Something has to give, and pensioners seem to be doing a lot of giving these days.  Detroit's problems go well beyond low long term interest rates.  But the city really didn't need the Fed to push it closer to the abyss. 

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped.  Most people aren't skilled at managing their finances.  When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances.  When people have fewer or no private resources, cutting benefits from the government becomes political anathema. 

Low interest rates hurt older folks in other ways.  As income from their interest-bearing investments dries up, fear drives them to become serial economizers.  That's a hard habit to break even after rates rise again (assuming they do).  Consumption may be impaired for a long time.  In addition, long term care insurance is getting scarce and expensive.  While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem.  Fewer people are able to afford such policies.  So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources.  Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower.  But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

 The Fed is taking a page from corporate America:  focus on short term returns at the risk of increasing long term costs.  The great corporate success stories don't follow this plot line.  But there's not much chance the narrative will change.  The Fed's easy money merry-go-round keeps the stock market buoyant.  With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper.  Ultimately, everything in Washington happens for political reasons.  And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.

Costs of Quantitative Easing

The law of unintended consequences haunts economic policy.  The Federal Reserve's quantitative easing program, now in its third phase, is meant to provide economic stimulus.  However, it also drags on the economy.  Let us count the ways.

Reduced Interest Income.  Hundreds of billions of dollars of interest income have been lost because of the Fed's longstanding campaign to drive down borrowing costs.  Losses of this magnitude undoubtedly have dampened consumer demand.  Even though QE likely sprung loose some personal income by providing lower mortgage rates for homeowners to refinance, tight standards applied by banks making mortgage loans have limited the refi impact of lower rates.

Reduced Retirement Savings.  As bond yields shrivel up like corn in today's drought-ridden Midwest, many retirements look bleaker.  Even though the stock market has boomed, large numbers of shell-shocked savers abandoned stocks after the 2008-09 market crash and haven't participated in the gains.  Instead, they ducked into bonds.  Although the improbable bond rally of the past few years generated capital gains for many bond holders, the basic return sought by bond investors comes from interest paid.  That has been paltry.  As retirements look bleaker, many workers cut back on current consumption in order to save more.

Pension Pain.  Despite appearances from some recent press coverage, pension funds cannot take large risks, overall, with their portfolios.  However much publicity pensions' alternative investments may generate, a large part of pension assets must be invested in high quality bonds.  As returns on these puppies shrink, employers corporate and municipal confront the necessity for greater contributions.  Workers may be laid off, citizens may receive fewer public services, state and local taxes may be raised, shareholders may endure lower returns, and those workers still employed may have to make greater pension contributions.  All of which would further discourage current consumption.

Insurers Backpedal.  Insurance companies' returns on their investments are falling.  This means policies that depend on long term returns, such as annuities and long term care policies, become more expensive or even impossible to buy.  Or else, they offer fewer benefits.  Policy holders suffer.  Those people who want to provide for themselves, through long term care policies, annuities, whole life and similar products, have a harder time.  More people end up having to rely on government programs like Social Security, Medicaid and so on.  That's not good in an age of serious federal deficits.

Yield Curve Flattens Bank Incentive to Lend.  Back in the days when they made loans, banks would borrow short term (usually through demand deposits, interbank loans via the fed funds market, and savings accounts) and lend longer term.  The difference between short term interest rates (historically lower) and longer term interest rates (historically higher) provided profits for the banks.  But the yield curve (the graph of interest rates from short to long) has been flattened by the Fed's monetary policies.  There isn't that much difference any more between short and long term rates.  Potential profitability for banks has been squeezed.  Banks have less incentive to lend, and fewer loans means less potential for economic growth.

The Fed has sworn on a stack of printed money to keep short term rates darn near invisible until at least mid-2015.  It may achieve some of its objectives.  But it will also create unintended consequences.  The impact of these opposite reactions to the Fed's actions may be greater than the central bank foresees.  There are few real life experiments in economics.  But if we look at the most obvious example of the impact of a central bank squashing interest rates for years at a time, we can see that Japan has remained moribund for two decades since its financial and real estate crashes in the early 1990s.  The Bank of Japan has ruthlessly stamped out any positive upswings of interest rates in that nation.  But that hasn't produced the spark needed to revive Japan's economy.

It now looks like the Fed will keep rates unnaturally low for the better part of a decade.  Given Japan's experience, one wonders what is in the Fed's playbook.  If it's a sensible fiscal program from Congress and the White House, the next question would be what is the Fed smoking?  But if the Fed is acting on the reasonable assumption that we will have fiscal dysfunction for the foreseeable future, only the arrival of Godot, it would seem, would offer reason for optimism.

How to Avoid Running Out of Money in Retirement

The fear of running out of money may be the biggest financial dilemma for most retirees. There's no perfect solution to the problem. But plenty of people have long, enjoyable retirements and leave something behind for their heirs. So the problem isn't insurmountable. Here are some ideas.

Build up your Social Security and pension credits. Whatever Congress and the President do to reform Social Security, they won't abolish it. It will be there in one form or another when you retire. Working as long as possible to maximize your benefits ensures a lifelong stream of inflation-adjusted payments. While Social Security won't cover more than the basics, life is easier when you have the basics covered. If you're fortunate enough to have a pension, work as long as you can to boost your pension payments. Working longer, although not as much fun as shuffleboard, is one of the best ways to make sure you're as well prepared as possible for retirement.

Save. The more you save, in retirement accounts or otherwise, the better off you will be in retirement. Non-savers, by definition, have already run out of money, and poor savers will quickly fall into the abyss. It's important to have a pool of cash available for big expenses like assisted living and other medical bills. If all you have are comparatively small streams of payments like Social Security and perhaps a pension, and you need to go into assisted living, you'll have effectively run out of money even though you're still getting a monthly income.

Pay down debts. Ideally, you should have no mortgage and little or no other debt by the time you retire. Debt, and its accompanying interest expenses, are negative savings. Some financial advisers will conjure up scenarios where you supposedly might be better off with a mortgage or some other debt. But debt involves risk, and the recent financial crisis and Great Recession amply demonstrate that risk can easily lead to losses. Financial stability is very important for a comfortable retirement, and debt destabilizes.

Invest conservatively. The older you get, the less time you have to recover from investment losses. Keeping some money in assets with potential for appreciation, like stocks, is a good idea because of long term risks of inflation. But be cautious about investing in stocks and other volatile assets. Perhaps a third of your portfolio might prudently be kept in stocks. As you get older, that proportion should shrink so that you don't get walloped by the stock market when you're 83.

Consider an annuity. It's easier to establish a budget if you have a predictable monthly income. An immediate annuity can provide either a fixed monthly payment or one that rises with inflation. (The latter is costlier, but you get additional peace of mind.) Annuities are issued by insurance companies, and they can go bankrupt. If you want the benefits of an annuity, consider buying two, each for half the amount you want to invest, from different insurance companies. Both should have solid credit ratings. With two different insurers, you diversify your risks.

Be cautious with variable annuities. They tend to have high expenses and varying (as the name indicates) payments. That uncertainty of payments may, for some, defeat the purpose of an annuity.

Note that annuities lock up the capital you invest in them, meaning you can't get access to it. All you can get are the payments. You'll almost surely need some liquid assets during retirement, for medical expenses and large items like cars. Never spend more than half your savings on annuities. Indeed, given the limitations of annuities, spend only the minimum amount needed to give you the peace of mind you're trying to secure.

Think about long term care insurance. Although increasingly expensive, long term care insurance gives you hundreds of thousands of dollars of buying power if you have to go into assisted living or have other major similar needs. Long term care insurance helps to preserve your savings (which may be important if you have a spouse or partner whose financial security you wish to protect). In addition, if you want to avoid a nursing home that accepts Medicaid patients--some feel that such nursing homes provide lower quality services--long term care insurance could be essential to affording a more exclusive facility.

Work part-time. Okay, working isn't exactly what you had in mind for retirement. But it allows you to spend less of your savings while you're able to work. If and when you reach the point where you can't work, you'll be glad you worked as long as you did.

Aaaaagh!!!!! Insurance!!

Given a choice between visiting a dentist and buying insurance, most people would opt for the dentist. At least, you can get novocaine for the worst moments.

But if you’re serious about building wealth, it's important to protect yourself from risk. We’re not talking about investment risk. You know that stocks, real estate and other assets can decrease, as well as increase, in value. We’re talking about personal risks, and risks to your property.

What happens to your finances if you’re seriously injured and can’t work for months? What if a guest slips and falls in your home? What if you or your spouse dies, and leaves you to raise the kids alone? What happens if the next Katrina heads your way and turns your house into a pile of kindling? These are all examples of situations that could drain away your savings. How do you protect yourself?

1. Get health insurance. The most common reason people declare bankruptcy isn’t reckless spending. It’s unmanageable medical expenses. If you’re uninsured, do your best to get coverage. Be willing to sacrifice a lot of lifestyle in order to be protected. If you’re uninsured and have a health crisis, you won’t have a lifestyle. If you have trouble finding coverage, contact your state health authorities. Some states have programs to assist residents to get coverage.

Also, take care of your health. Avoiding a health problem is better than treating one, even if you have to eat some fruits and vegetables.

2. Get disability insurance. According to the Social Security Administration, something like 8.6 million workers and their dependents received Social Security disability payments in 2006 (www.ssa.gov/OACT/STATS/OASDIbenies.html). This figure doesn’t include people who received private disability payments, but no Social Security. Disability is a fairly common problem. Look for a policy that defines disability as your inability to work in your field or profession (and, indeed, your specialty within your field or profession). A policy that defines disability as your inability to do any kind of work (flipping burgers, anyone?) doesn’t provide much protection.

3. Get homeowners insurance. Make sure the policy limit is high enough to cover the current cost of reconstructing your home. Also have plenty of liability coverage, in case a guest slips and falls on your property--$300K is not too much. And think about whether you should get optional flood coverage--you don't need a Katrina to have a flooding problem (a sewer backup is all it takes).

4. Bulk up your auto policy. Make sure you have plenty of liability coverage--$1 million is rational in these litigious times. And don’t overlook the property damage coverage. Some luxury cars today cost over $100,000. Having $100,000 of property damage coverage isn’t a bad idea.

4. Consider life insurance. If you have dependents, life insurance may be a good idea. There’s no fixed rule of thumb for how much you need. Add up your other financial resources (savings, Social Security survivors’ benefits, any employer’s benefits for survivors, and your spouse’s income if he or she would work even if something happened to you), and then figure out how much insurance you’d need to get the little ones through college. Increase the amount if you want your spouse to stay home and take care of the kids.

5. Consider an umbrella policy. An umbrella policy provides additional liability protection, above and beyond your auto and homeowners’ policies. You can buy millions of dollars of coverage. It’s a good idea if your net worth is six or seven figures.

6. Consider a long term care insurance policy. This type of insurance covers nursing home expenses and other long term care costs (including some care at home). Medicare doesn’t cover most of these expenses. Medicaid does, but you need to spend down your savings to qualify for Medicaid. Long term care insurance is a way of protecting your savings. It could make sense if you have a six or seven figure net worth. Look for a policy with level premiums and an inflation adjustment in the amount of coverage. This stuff is expensive if you wait until your 60s (we’re talking thousands a year). If it seems to make sense for you, buy as early in your life as you can because it's much cheaper if you start when you're younger.

Okay, enough already about insurance. Here’s the story for your inner artist if you’re thinking of a career change. http://www.cnn.com/2007/SHOWBIZ/05/31/lego.artist/index.html.