June, 2009
by Dr. Thomas E. Bell, CMG Member, Michelson Awardee (Retired)
Tom received his Ph.D. in Management from UCLA many years ago, and was a consultant for about 25 years before he retired. He is a recipient of the A.A. Michelson award (in 1975), has served CMG as its Treasurer and its Secretary, and has repeatedly been on the CMG Board of Directors. He retired at the end of 2005.
About the Author
Dr. Thomas E. Bell
Even before I finished graduate school, I recognized that risk is not just an abstract concept; handling it poorly can ruin your life. Last October, my article on Asset Allocation for CMGers was published in MeasureIT; that article focused on risks and on allocating your assets to manage the risks to your retirement. Since that time, we have been subjected to a harsh series of lessons about risk that have focused many of us on identifying hidden risks, as well as looking for investments that may reduce the levels of risk to our retirement assets.
As in that earlier article, this article is focused on "risk" as the possibility that some disaster may occur and wipe out a significant part of our retirement assets[i]. The last few months should have convinced even the most optimistic person that skepticism about claims must be a central part of investment decision making. If you disagree and just want to believe the most enthusiastic promises, then you have an easy task - there are plenty of charlatans out there to oblige you in satisfying your desire.
My assessments in this article might strike financial advisors to the wealthy as overly conservative, but I doubt that many CMGers can lose a few hundred thousand dollars from their retirement accounts without extreme pain. Our annual bonuses (if any) just don't bring in a few million dollars each year like a CEO, so we need to be careful.
I'm very interested in the impressions of my fellow CMGers about the risks discussed in this article because I've moved out of some investments in the hope of reducing my risk. I need to reinvest now and I'd appreciate your opinions.
Accumulating and Managing Retirement Funds: More Explanation of Risks to Retirement Funds
In my October article, I suggested the following categories of risk for CMGers:
That list seemed to be pretty depressing, even though it also seemed to be pretty reasonable (especially in view of the reality that all but the last three of them have occurred recently, and the two of the last three have occurred within the last few decades). The only risk on the list that hasn't already occurred is the final one - widespread municipal, county and state bond defaults; that's still to come. However, the last eight months have taught me that additional explanations are needed about the types of risk, that more than one risk may be realized simultaneously, and that a couple of additional types of risk should be added[ii].
1. Plunging real estate prices. The rate of decline in real estate prices seems to have become more moderate recently, but it continues throughout most of the world. However, residential real estate prices are generally still above their levels nine years ago, in 2000[iii]. If you're interested in an analysis of the prices in one metro area, you can look at my article in the April 2008 issue of MeasureIT.
2. Disastrous plunge in one stock's price. Usually, the reason for such a plunge is that disastrous business problems have been discovered. Unfortunately, very rapid plunges are usually caused by hidden problems, so even vigilance doesn't help you very much (e.g., in the case of AIG where it happened all at once to me). However, most cases arise from an accumulation of problems, so you can detect them and get out before your losses are huge[iv]. Lots of internet alternatives are available to notify you when a change in an analyst's rating occurs; I happen to use Microsoft Money Central. Probably you should register for one of those. (Money Central is free.) And, of course, diversify, diversify, diversify to limit this risk.
3. Severe business problems at your employer. Employees frequently just can't believe that their employer may get in trouble, so they invest too much of their assets in its stock[v]. DON'T DO IT! With the current state of the economy, you may have difficulty getting a new job in a cut-back. If your retirement assets are invested in company stock and the company fails, you won't even be able to fall back on your retirement funds while searching for new employment.
4. Business problems in one industry sector. Financial service firms (e.g., banks, insurance companies) and automotive firms (e.g., Chrysler, GM, and their parts suppliers) are widely known to be having problems. Both the stocks and bonds of those companies probably aren't places where CMGers should invest. A friend of mine bought stock in a mortgage company because it was so low in price. It doubled in price within a week! That was just before it went to approximately zero. A low price doesn't necessarily mean a good buy.
5. Broad downturn in stocks. In general, stock prices turn down when investors conclude that company earnings will decline. In addition, they go down when the public becomes nervous and only pays a reduced amount for companies' expected stream of future earnings (that is, the price-earnings ratios - P/Es - go down). The two effects exaggerate the decline beyond what the earnings alone would make appropriate. The P/E ratio seems to be going up now (June 2009), so we are currently seeing a bit of rebound. If earning projections increase, the rebound should accelerate (I hope).
6. Corporate bond defaults. In or out of bankruptcy, bond holders may receive some amount for their bonds. This may be as little as a few cents on the dollar, or as great as the face value of the bond. So don't give up all hope if you hear that a corporation is going bankrupt. On the other hand, don't expect that your interests will be considered as being as important as bigger creditors or labor unions.
7. Inflation. I don't expect inflation this year, and possibly not next year. However, I expect that after next year the Federal Reserve will have the ability to get the inflation rate up to its target level of 2%[vi]. The interesting question is whether the Fed (or anyone) can keep the inflation rate from going way up (e.g., 6% to 11%). I'm skeptical that all the current spending will be controlled and that taxes will be raised enough to pay for the new programs. If you'd like more of my opinion on inflation, you can read my article in the August 2008 issue of MeasureIT.
8. Higher taxes. Do you really believe that taxes will not increase for 95% of the public in 2009 or 2010 in comparison with 2008? If you live in California, you already know you'll be paying more in 2009 for state taxes (income taxes, sales taxes, auto registration fees, etc.) Do you believe that a "carbon tax" won't affect you? Are you convinced that a value-added tax would only apply to "others"? Do you believe that inflation won't push you into a higher tax bracket? I suspect your answer is "No"; I didn't think you were foolish. The problem is that we don't know whether the higher taxes will primarily involve income taxes (through higher rates, reduced deductions, or income-related fees like Medicare taxes), or tax increases resulting from fees that are passed through to us. That makes financial planning difficult because we don't know whether to position our investments to minimize income-related taxes, or to frantically build up assets any way possible to pay all those fees.
9. Municipal, county, and state bond defaults. Imagine that you are the Mayor of a medium sized town, and you find that you can't pay all the expenses. Your town may have set public employee salaries too high, or promised retirement and medical benefits that were too generous, or sold too many bonds to fund some things that seemed like really wonderful ideas at the time. Now what do you do? Well, the city of Vallejo, CA declared bankruptcy. I understand that they currently are still paying on their bonds, but I wonder how long that can last. And I wonder how many more cities have the financial problems of Vallejo - or the State of California. When the number of troubled municipalities, counties, and states grows too large, some decisions will probably need to be made about whether to pay the retirees' pensions or the bond holders (aka, "speculators" who refuse to share in the sacrifices we all must make). No one knows what will happen, but I consider this area a major risk to the value of tax-exempt bonds that will play out over the next 10 years (and perhaps quite soon in California[vii]).
Accumulating and Managing Retirement Funds: Additional Risks to Retirement Funds
As I watch the financial news, I realize that my October article missed a couple of major risks for CMGers. These involve deception/fraud and political intervention. People who made investments subject to those risks now wish they had realized the importance of those risks so they would not have lost the bulk of their retirement funds. Explanations are given below.
10. Deception and Fraud. After repeated warnings, you've decided to limit your appetite for high yields, and decided on just getting 10% to 15% return per year. You've looked at the available funds where you can invest, and you've decided that you should be more diligent in your search. Therefore, you've checked with good friends, and they recommended a fund, with a complex trading strategy, that has been yielding reasonable returns year-after-year. This looks good, so you make a small investment through an investment advisor. After a year, you've found that you actually got a 12% return; the statement says so. And you hear that one of your friends is now living off her returns. At that stage, having done lots of due diligence, you invest everything you have in the fund. Isn't it satisfying to be careful in your investments?
GOT YOU! You just got taken by a Ponzi scheme! (Hopefully, no CMGer is the person described in the above paragraph. But there are thousands of others to whom this applies.) You need to keep alert to avoid these schemes. Over the last few months tens of billions of dollars of Ponzi schemes have been revealed, including the Madoff scheme.
In this type of fraud, old investors are paid from investments made by new investors. Of course, the Ponzi management takes its payments too, and those payments may exceed any actual income that is earned. These schemes can go on undetected for years (even decades), and are usually only uncovered when the rate of new investments can't sustain the payments to old investors. In the meantime, statements are issued to investors that assure them of the fund's success. On revelation of the scheme, you likely won't get any help from the SIPC (Securities Investor Protection Corporation) insurance fund because you went through someone other than the fund itself.
The situation may be even worse than losing all your savings. Your friend who has recently withdrawn funds to live on may be required to return that money in a "clawback" lawsuit. Since the withdrawn funds actually came from others who made recent investments, she may be required to return them. Not only does she lose her retirement savings, but she may lose her other assets (perhaps her home).
Even if you don't fall for this outright fraud, you can be deceived by mutual fund managers who charge high explicit (and maybe many obscured) fees. The common claim is that, for higher fees, you get much higher returns. This claim may be true in some cases, but usually the one getting the higher income is the fund and its management. You can read all the disclosure material from lots of mutual funds and perhaps discern the situation, but I don't have that much time. I initially check the evaluations on Morningstar.Com and then read the details only about the most appropriate funds. When you venture into the financial markets, "Be careful out there"[viii].
11. Political Intervention. The past two years have certainly shown us that political intervention in the marketplace can make some firms survivors, some losers, and some beholden to the Federal Government. The risk of political intervention usually occurs simultaneously with some other risk (e.g., business problems in one business sector).
The resulting risk for a CMG investor isn't whether the security you purchased shows that it is a "secured" bond (with more priority for return of principal), but whether it may interfere with the political preferences of the decision-makers in Washington[ix]. As demonstrated by actions over the last two years, decisions about who will be saved, and who will be left to crash, are often made with only a little planning, and they sometimes seem to be based heavily on who made the largest campaign contributions.
To us CMGers, making huge political contributions to protect our investments is clearly infeasible. Our best action seems to be keeping out of the way of the charging rhinos. (In case you're interested, one old-time CMGer has observed that I am completely bi-partisan in my disgust for politicians of both major parties - as well as the minor ones.) The real problem we're confronted with is that agreements and contracts seem to have become very minor annoyances for politicians who intervene in the economy in whatever way seems to suit them best. This situation creates a huge difficulty in evaluating investment alternatives.
Since we CMGers are not (as far as I know) international financial players, we need to consider available alternatives that are "below the radar" of the politicians; other alternatives seem to be very risky. For the current situation, that means we probably should assume that investments are very risky if they may conflict with union prerogatives or might limit major financial interests. Many other investment alternatives exist, so we probably should choose carefully and avoid investments that may lead to political intervention.
My wife states that she'd be happy if we could just maintain the value of our investments (including the effects of inflation) over the next few years - even with no increase in real value. She'd be overjoyed by a percentage or two of increase. She just doesn't want to have more of those cases of AIG stock or Tribune bonds[x].
Just think about all those government employees who will be eligible to retire at 55 (and others at 60 or 65). I cringe when I consider the impact on all governments' budgets, but I am also alarmed by the probability that they will have a HUGE political ability to protect their interests (especially in comparison with CMGers). We lose.
Lifestyle Decision: Possible Returns v.s. Risk
If you had all your retirement funds invested in stocks two years ago, you probably don't want to choose that approach again. The assumption has been that stocks yield more than bonds, so you should emphasize stocks until you are close to retirement. That assumption certainly hasn't been valid over the last decade (or maybe two decades, depending on your investments). But even over a longer term, stocks may fail to yield better than bonds.
Robert Arnott, in his article titled "Bonds: Why Bother" [xi], has argued that bonds usually give better returns than equities, but equities occasionally climb dramatically for a short time. If this is true, then each of us needs to consider carefully which investments may be best for us, based on analysis of individual securities. That statement is certainly not easy to implement for a couple of reasons.
Setting Your Priorities. The first problem is that you may not have the time to do detailed analyses. Your personal priorities may mean that doing detailed analyses is simply impossible. If so, you might hand over your assets to an investment advisor and hope that individual is competent and motivated to put your success as his/her first priority. As clients of Madoff can explain, you must be very careful with this approach; they had far too much trust in him.
If your personal situation requires that your retirement assets be protected (and perhaps increased) you simply MUST spend time ensuring that correct decisions are made.
Setting Reasonable Objectives. A friend of mine called me to ask for help with his retirement savings. He said he'd done a computation of his needs for retirement, and he needed to make at least an average of 20% a year so he could retire at 55. However, he didn't have any time to devote to investing. Would I please take a moment and tell him how to achieve his objectives.
Of course, his objectives were not reasonable. I told him that I'd appreciate his telling me if he found a way to be successful in achieving those objectives.
In order to limit your risk to a reasonable level, you may need to work longer, to settle for a less expensive retirement, or to make significant revisions in your personal life. You may be tempted to make very risky investments in the hope of getting your retirement assets up to what you believed they were 18 months ago. However, that alternative is very inappropriate unless you are quite skilled and have time to devote to intensive investing. And that would really change your life-style.
Accumulating and Managing Retirement Funds: Lower Risk Alternatives
Instead of looking for investments that are more risky, you may be interested in investments that are less risky - for at least a part of your assets. Some alternatives that might be worth your consideration are described below. Please note many other alternatives exist; these are only some to start with.
Federal Government Nominal Bonds (Treasuries). US Treasury bills, notes, and bonds are considered to be the most secure and liquid investments available in the world[xii]. You can buy or sell these instruments at any time, and the commission on transactions is generally low. The extreme safety and liquidity of Treasuries leads to very low interest rates. They are called "nominal" bonds because the face values and interest amounts stay at a nominal rate (not adjusted for inflation).
The primary risk of Treasuries involves inflation. With a low interest rate (i.e., sometimes less than 2%), an inflation rate of 2% may lead to continuously decreasing value in these instruments. Federal, but not state, income taxes apply to income from Treasuries.
Tax-Exempt Bonds (Municipals also called Munis). Most Munis are "double tax-exempt" - there's no federal or state income tax[xiii] applicable. Because all the income from most Munis is tax-exempt[xiv], they generally pay a lower rate of interest than taxable bonds (e.g., commercial bonds). Sometimes, Munis pay unexpectedly high rates of interest, and some specific Munis pay higher interest most of the time. The former situation is an anomaly in the marketplace, and the latter situation arises because the issuer of the security is judged to be at higher risk of default.
Note that Munis are nominal bonds; their values do not increase with inflation. In addition, the issuers of these bonds do not have the same stability as the Federal Government. In California, one county (Orange County[xv]) declared bankruptcy, and a city (Vallejo[xvi]) did it too; both avoiding defaulting on their bonds. The future of the State of California is an exciting topic, and we don't know how its multiple types of bonds will be paid. Other states (including New Jersey[xvii] and New York[xviii]) are also being confronted by inadequately funded retirement plans. Therefore, both inflation and default[xix] are primary risks for Munis.
A secondary risk of Munis is political intervention. I worry greatly about the possibility of political intervention if it appears that a number of municipalities (or other entities) need to decide between defaulting or failing to pay retiree pensions/benefits (or make contributions to the pension funds). With both Social Security and Medicare costs increasing rapidly, I doubt the Federal Government will be able to provide the generous benefits promised by the states, counties, and municipalities. Wouldn't it be easier to simply declare all bond holders as "speculators" and eliminate the vast bulk of the debts? That would allow more contributions to the pension funds. Right?
Certificates of Deposit (CDs). CDs are issued by either banks or credit unions, and they are insured by the FDIC (which also insures bank deposits) or the NCUA (which also insures credit union deposits). You can get CDs at credit unions or banks, or you can get brokered CDs; brokerages may buy a large CD and then sell parts of it to clients. The guarantee on directly-purchased CDs can lead to quick repayment of principal in case of a default, but even with brokered CDs you should be paid within a month. (I've never had a default involving a CD, so I don't know much about that topic.) NOTE: CDs are low risk if they are issued by a US bank or credit union; I wouldn't buy one from an off-shore bank (e.g., from the Stanford Group).
I've found that brokered CDs generally give a greater yield than those purchased directly from banks, so I just give Joe Delano a call and ask him what he can get me. I've bought CDs in a laddered manner; some reach maturity each year. That enables me to cushion sharp turns in prices. I feel that the primary risk involving CDs is inflation; they are nominal instruments and they will decline in real value when inflation occurs. At times, CDs pay good interest rates, but sometimes the rates are quite low. You need to check on current rates, and perhaps hold off if rates are too low.
Treasury Inflation Protected Securities (TIPS). TIPS are issued by the Federal Government[xx] and have the same protection as Treasuries. However, the TIPS market is smaller than the market in nominal Treasuries, so TIPS are a bit less liquid that Treasuries. TIPS are issued with terms of 5, 10, and 20 years. The distinguishing characteristic of TIPS is that their principals are adjusted so that the same REAL value is maintained in the face of inflation. They pay a low rate of interest, and the interest is computed on the adjusted value of the principal.
Unless TIPS are held in a tax-deferred account (e.g., a 401(k), an IRA), income tax must be paid on any increase in principal each year. This can be a disadvantage because 1) the tax may exceed the interest income (so the holder has negative cash flow for the bond), and 2) the tax must be paid long before the increase is realized (so the payment must be made with dollars that are not discounted as much as the realized increase in value). I think I made a mistake by buying some TIPS for a taxable account; I didn't build my spreadsheet before the purchase. (Bad Tom. Bad, bad Tom.)
Although TIPS don't pay very high interest, they are free from most of the risks of other low-risk investments. TIPS are the kind of investment that my wife likes right now - very secure in real terms, and paying a bit of real return above that.
And In Conclusion
All my comments about investment alternatives are very short summaries of the complex rules, attributes, and exceptions involving the instruments. I've just tried to give you a feel for the alternatives that people may have neglected to tell you about. If you have an interest in any of these, you can use your Internet connection to Google the topic, and you'll get more information than you can digest. If you'd like to check on the prices and characteristics of these instruments, or several others, you can go to the following URLs to find information:
I've done quite a bit of computation of results between the lower-risk investments described above. (As I have previously documented, you shouldn't make an investment in a financial instrument unless you can build a spreadsheet showing its characteristics. When I don't build that spreadsheet, and invest anyway, I usually regret not building it.) The results, interestingly to me, show that different instruments are most attractive depending on market conditions, the durations of the instruments, the rate of inflation, and the taxability of the account. Of course, I may be wrong on this because I don't have all the sophisticated models that professionals use.
If you are interested in the alternatives I've described above, send me an email and (depending on the degree of interest) I'll put together some documentation that's a bit more detailed in another article.
Lessons Learned
1. The scoundrels are obviously out in force. You need to check statements, look at investments, and TRUST NO ONE (not even yourself). Re-compute repeatedly.
2. Build spreadsheets you believe in before investing.
3. Risks are all around us, and we need to think carefully about the POTENTIAL risks of every investment; don't just take one person's word for it.
4. Low risk investment alternatives exist, but the taxable effects and achievable yields need to be considered carefully prior to purchase.
5. Unexpected risks (like political intervention) keep popping up; it's necessary to be prepared for re-evaluation at all times.
6. Given the investing environment, each of us needs to decide what portion of our assets should be in very low risk investments (like TIPS).
7. We need to stop believing that written contract terms will dictate how commitments will be handled; we need to look carefully at the politics of the situation too.
I'd appreciate your thoughts on the risks and the potential investments discussed in this article. We've all had a bit of education on risk over the last couple of years, and others may have had different experiences than I have. Please let me know your thoughts. Just email me at the address below.
If you'd like to reach Joe Delano or me, please put [CMG] at the beginning of your Subject Line. Our email addresses are:
[i] Financial analysts, especially options traders, equate "risk" with volatility. That definition is not applicable for this article.
[ii] The list could be organized into different categories, and many additional risks could be added. For example, people trading in bonds must consider changes in interest rates, but I suspect that very few CMGers are bond traders, so I left interest rates off the list.
[iii] For example, prices in the LA metro area are at about 161% of their 2000 prices. You can find the latest Case Shiller results for 20 metropolitan areas at the following URL: http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_052619.pdf
[iv] I watched Tribune Company, and sold my shares of it early.
[v] Unless you have an unusually extensive understanding of your company's finances, you really shouldn't invest more than about 10% of your retirement funds in its stocks - or bonds.
[vi] The choice of an inflation target is open to considerable discussion, as reported by the Wall Street Journal at the following URL: http://online.wsj.com/article/SB124006652812232007.html. An interesting 2007 assessment of the targeting of inflation rates is given at the following URL: http://www2.bc.edu/~irelandp/targets.pdf. In addition, an article by the current Chairman of the US Federal Reserve (published in 2003) titled "A Perspective on Inflation Targeting" is given at the following URL: http://www.federalreserve.gov/boarddocs/speeches/2003/20030325/default.htm
[vii] One suggestion has been for the Federal Government to guarantee the bonds of California. Not everyone believes this is a good idea. You can find a negative view of the idea at the following URL: http://californiacitynews.typepad.com/california_county_news/The%20Danger%20of%20Guaranteeing%20California%20Debt%20by%20Chriss%20Street.pdf
[viii] This was the statement in bidding the officers goodbye after roll call on the TV program "NYPD Blue".
[ix] As pointed out in The Wall Street Journal, the creditors who are being hurt in the Chrysler "restructuring" included more than just "speculators"; retirement funds for Indiana's state police and teachers (along with others) are being hurt. But it's politically easier to just brand them all speculators. The article is available at the following URL: http://online.wsj.com/article/SB124286497706641485.html#mod=todays_us_opinion
[x] In the case of Tribune, I sold the stock but neglected the bonds. (Bad, Tom. Bad, bad Tom.)
[xi] Arnott's article can be found at the following URL: http://www.indexuniverse.com/publications/journalofindexes/articles/149-may-june-2009/5710-bonds-why-bother.html
[xii] Treasury Bills have terms ranging from a few days up to 52 weeks. They typically are sold at a discount from their face value; the difference is the yield. Treasury Notes are issued with terms of 2,3,5,7, and 10 years. They pay interest every 6 months. Treasury Bonds also pay interest every 6 months, but they are issued with terms up to 30 years. You can learn about these debt instruments at the following URL: http://www.treasurydirect.gov.
[xiii] The state tax exemption only applies if the issuer is in the same state as your residence.
[xiv] Some tax-exempt bonds must be included in the ATM computation for taxes, but most are not.
[xv] For an interesting summary of the situation, look at the following URL: http://www.erisk.com/Learning/CaseStudies/OrangeCounty.asp
[xvi] After declaring bankruptcy, Vallejo won permission from the bankruptcy court to scrap its contract with the fire fighters. A proposed new law in California would require cities to receive permission from a state board (staffed by four state legislators - politicians) prior to declaring bankruptcy. You can read about the situation at the following URL: http://online.wsj.com/article/SB124346998818460615.html#mod=todays_us_page_one
[xvii] A summary of the New Jersey situation can be found at the following URL: http://money.cnn.com/2009/05/12/news/economy/benner_pension.fortune
[xviii] An article about New York, as well as New Jersey, Pennsylvania, and California can be found at the following URL: http://online.wsj.com/article/SB123716064273635495.html#mod=todays_us_money_and_investing
[xix] Many munis have very high ratings because they have been insured against default. Unfortunately, the insurers decided to expand their businesses by insuring collateralized mortgage obligations (which are in great trouble). Therefore, it's not certain that you can count on such insurance paying you if the underlying bond defaults.
[xx] Inflation-linked bonds are also issued by private firms (primarily large insurance companies). I bought some of those along with TIPS. Unfortunately, many financial firms are in real trouble, and the value of my commercial inflation-linked bonds has decreased by about 50%. That's why I haven't included them in the list of low-risk alternatives.