Journal of Financial Planning: June 2011
Lewis J. Walker, CFP®, CRC®, is president of Walker Capital Management Corporation and Life Transitions Advisors LLC. He is a founding shareholder of The Strategic Financial Alliance Inc., an independent broker-dealer in Atlanta, Georgia. Walker can be contacted at lewis@lifetransitionsadvisors.com.
The title for this column was suggested by a provocative article, “American Profligacy and American Power” by Roger C. Altman and Richard N. Haass, in the November/December 2010 issue of Foreign Affairs. The Council on Foreign Relations (CFR) publishes the magazine, and the editorial content indicates what the Washington insiders, the influential power elite, are thinking. Opinions aired in the magazine often emerge as government policy.
Sub-titled “The consequences of fiscal irresponsibility,” the article acknowledges that federal debt has reached unsustainable levels. As Congress deliberates, members of our “divided house of government” should heed the writers’ warning: “If U.S. leaders do not act to curb (our) debt addiction, the global capital markets will do so for them, forcing a sharp and punitive adjustment in fiscal policy.”
The Congressional Budget Office sees debt reaching 90 percent of GDP by 2020. In a more pessimistic assessment, the International Monetary Fund estimates that U.S. federal debt could reach banana republic-like levels of 100 percent of GDP as early as 2015. Since 2000, federal spending has grown at a rate of two and a half times what it did in the 1990s. Federal debt has tripled from $3.5 trillion in 2000 (35 percent of GDP) to $9 trillion in 2010 (62 percent of GDP).
Think that’s bad? On top of the $9 trillion, the debt of government-sponsored enterprises adds another $8 trillion, much of that attributed to Fannie Mae and Freddie Mac, which have yet to be reined in. State and local governments owe roughly $3.3 trillion. Will Congress let cities and states go bankrupt?
Apocalyptic? Potentially. Developing nations are our biggest lenders, with China number one. Any slowing by other nations in the purchase of U.S. debt securities could cause interest rates to skyrocket. In times of tension, central bankers could be more dangerous than admirals and generals.
Demographics are colliding with economic reality. With the first boomers reaching age 65 this year, health-care and Social Security costs will rise rapidly. We will have to accept benefit cuts, higher co-pays, and/or a later retirement age for full benefits. Taxes will rise, not necessarily in income taxes alone. Austerity in the form of a budget and tax squeeze at all levels of government is in the cards.
The Collision Between Economics and Demographics
A classic bromide in our profession warns us to be wary of the pronouncement, “It’s different this time!” Perhaps, this time, it is different!
Consider economic cycles and demographic trends. In the 1970s, as the financial planning movement was in its infancy, a new word was coined to explain a conundrum—stagflation. Keynesian theorists could not understand how we could experience economic stagnation and inflation at the same time. Tax rates were sky high and interest rates were headed for the stratosphere. The oldest baby boomers were in their late 20s and early 30s as the decade unfolded, many with young families. Retirement was a long way off.
In the 1980s, the boomer bulge saw the oldest boomers move into their early 40s as the stock market took off on a long-run tear when the credit-crunch recession, engineered by Paul Volcker and Ronald Reagan to tame inflation, ended. The difference then was a prime rate peak of 21.5 percent at the end of 1980; long-term decreases in interest rates helped to power the equity and bond markets, as accumulation became the mantra. Much of what we learned about investing—dollar-cost-averaging into rising markets, modern portfolio theory, asset allocation, and portfolio management—was a product of the great bull market.
Enter the 1990s, as the older boomers began to think about retirement. Who can forget the 1999 book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market by James Glassman and Kevin Hassett, released just before the dot.com bubble burst. This year, Glassman published a mea culpa in the Wall Street Journal, but we should cut the guy some slack. How many really saw the 2000s coming—the tech wreck, 9/11, two wars, two bear market cycles in 10 years, and go-nowhere market averages over a decade?
Along the way, stockbrokers and insurance agents became financial advisers, independents became financial planners, the CFP® certification emerged to dominate the alphabet wars, financial planners became wealth managers, wealth managers became financial life planners … and so it goes.
Here we are in 2011, the first year of the second decade of the 21st century. The oldest boomers turn 65 this year and a tsunami is about to swamp entitlements. The age wave is lapping at the shores of retirement even as boomers deal with aging parents and their needs, and in some cases, disabled or special needs adult or minor children or grandchildren.
Compounding the retirement income funding challenge, with the possibility of 20 to 30 years in retirement—longevity risk is the scary new phrase in the risk/reward lexicon.
Yes, it is different this time! Those peering at retirement and those already in retirement have been unnerved by market turmoil and uncertainty. Conventional wisdom suggests that risk be taken off the table, and traditionally that is done with greater allocations to fixed income. Yet this is not 1981, with the prime rate coming off of 21.5 percent. This is 2011 with the prime rate at an unsustainable historical low. Many variable rate loans keyed to LIBOR or the fed funds rate also are at multi-decade, unsustainable lows. We know that interest rates are headed upward. The only question is, how fast?
As financial planners, we are aware of the challenges. The public at large and investors in particular are waking up. Fear of “outliving my money” is growing. As 2011 dawned, the Federal Reserve continued to inflate the money supply (M2) at a 7 percent annualized rate. Quantitative easing will end, and price inflation will become more pronounced. Unlike the super cycle that started in the 1980s, the retiring boomers face a future dominated potentially by rising interest rates and inflationary pressures, the opposite of what happened in the 1980s and 1990s.
Life Transitions Planning and Investment Strategies
While many financial planners and RIAs have been there for some time, thanks to reform legislation, regulators, and growing press and public awareness, we are all fiduciaries. “Doing what is in the best interest of the client” will seek greater definition within the process of appreciative inquiry, the formulation of holistic asset allocation plans and investment policy statements, comprehensive financial plans, life transitions planning that goes beyond money, and ongoing monitoring and guidance across generational lines as we morph into family managers. Investment planning will be couched in deeper conversations as we deal with life transitions challenges, alternatives, resources, and expectations.
In approaching the challenges of aging and special needs, a growing area of concern to regulators, we need to pay more attention to liquidity. We have no idea how the controversies surrounding health care will work out, as entitlement programs face shortfalls at state and federal levels. The answer must be higher levels of liquidity and the ability to self-fund contingencies.
Those under age 55 are likely to see reductions in Social Security, Medicare, and Medicaid programs, and we should counsel debt reduction and higher levels of saving across the board. Dollar-cost averaging into diversified equity programs, inside of retirement programs as well as in taxable accounts, continues as a viable strategy for those in an accumulation mode.
For older Americans, especially those who are increasingly risk averse, the process is tricky. As rising gold and commodity prices signal inflation, fixed income adjusted for inflation and taxation is a dicey proposition. Balancing the need for income and cash flow with safety and liquidity needs is no slam-dunk task. Non-traded REITs, annuities, and other alternative investments have limitations where liquidity and flexibility are of concern. Moderation and prudence in asset allocation decisions is more critical at older ages, because time to recover from unfortunate decisions and the vagaries of markets is lessened.
As the boomer wave moves into retirement en masse, we will see more anxiety about not having one’s bank balance go to zero before one’s blood pressure does. Fear of outliving one’s money is a dominant concern, especially among widows or the 80 percent of married women likely to become widows. “Reality checks” can be disturbing.
Are Those Real Numbers?
The 4 percent rule is gaining cache—not taking more than 4 percent per year out of one’s portfolio to minimize the risk of running out of funds. We know that for every $40,000 per year, or $3,333 per month, needed, hardly a princely sum, a capital pool of $1 million is required. Many boomers have not saved anywhere close to that number! When faced with reality, the response often is, “Dude, are those real numbers?”
Assume that our target is 4 percent to spend, net of tax. Plus we want at least 3 percent to hedge inflation, a number likely to be low. Assume that the client is in an average (not marginal) 20 percent tax bracket, federal and state. A total annualized average return of 8.75 percent is required. If the 5 percent rule is invoked, the required return jumps to 10 percent!
If you add real growth objectives to the mix, say, a modest 3 percent over inflation and taxation, even higher annual yields are required to meet targets.
With fixed-income yields at significant lows and the 30-year bond bull market over, by most reckoning, achieving after-tax, inflation-adjusted real yields is a challenge, especially for risk-sensitive clients.
Yes, Virginia, those are real numbers and there is no Santa Claus! Austerity will be forced on governments and on boomers in retirement if they do no planning and do not wake up and smell the coffee. The alternative may be a senior coffee at McDonalds versus lattes at Starbucks. Their choice.
What an exciting time to be an adviser!