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Why the retirement system is failing? January 8, 2009

Posted by shaferfinancial in Finance.
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This is not some big mystery, nor some crisis driven result.  No the retirement system is failing because it was designed to work under very different circumstances.  Blame technology, because it is what has caused the system to fail.

OK, let’s give a little perspective to the situation.  Our current retirement system was envisioned starting in the 1930s with the great society programs.  The government introduced social security and the labor unions in concert with the major manufacturers decided upon a pension system that was funded with current workers and/or current profits. And it worked, initially.  But, there was an undercurrent already destroying the foundation of this system.  That is technological advancement.  You see, back then workers, if they made it to retirement, only lasted 2-5 years, in retirement.  Certainly, there were statistical outliers that lasted longer, but they were so exceptional as to not cause harm to the system.  But technology improved workers lives, by taking over the nastiest jobs and allowing the body destroying manual labor jobs to be done by machines.  And then in the 1960s health care technology started to help people to live longer active lives.  So what was designed to work in the 1930s and 1940s started to crack in the 1980s.  Suddenly, people were living much longer.  Instead of 2-5 years in retirement, if they made it that far, 10-15-20 years or longer were no longer statistical outliers, but the middle of the bell curve.

So what happens is social security is now provided to an ever growing group of retirees.  Company pensions,  the same.  What was a manageable cost is now totally over the top.  Certainly, in the 1940s and 1950s most people could be excused for not seeing this coming down the pike, but starting in the 1980s there is no excuse.  But government bureaucrats, corporate managers, labor union leaders, and, of course, politicians turned a blind eye to this happening.

So what happens is in the 1990s pension fund managers start to realize what is happening, so they demand higher investment returns.  The corporations in turn, take on more risks, in order to feed the pension beast.  And as this process plays itself out, we see the results of this additional risk.  Now in the 1990s corporate managers saw all this in their bottom line and convinced the government and Wall Street to go along with the idea of getting rid of the old fixed income pensions, replacing it with 401Ks and IRAs. 

And this change was accepted for a period of time, because of the rising stock market where most people ended up putting their retirement funds.  The stock market was rising because corporate profits were rising as a result of the increased productivity that came with the computer age.  But, this decade has demonstrated the folly of this arrangement.  Enter into this problem every con man in the world, selling their “fail safe” investment system to riches.  In my opinion the biggest con men are the mutual fund sales people, but that is my axe to grind.   

So, why is the retirement system failing?  Because it was designed for a economy were people died soon after retirement.  But technology changed that fact, and no one has gotten around to rebuilding the system.  Once again, we can monkey with the parts, but the system will never become efficient until we redesign it from the ground up.

Point all the fingers you want, at the government, at corporations, at Wall Street, but the bottom line is that it is totally apparent now.  The ball is in your court.  What are you going to do about it?


Why Layoffs are so Devastating? July 22, 2008

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Before 1980, layoffs were virtually unheard of because companies and workers had come to a social compact that recognized the realities of layoffs were bad for both.  I won’t go into the details, but for about a 50 year time period management and workers were able to agree on the issue of layoffs as being bad for everyone, and therefore avoided it at all costs.  Companies like Procter and Gamble and IBM went further and created profit sharing plans that allowed their workers to share the prosperity by being given company stock based on performance and longevity metrics.  In the 1990’s, many of these folks retired with $500,000-$1,000,000 in company stock!  Hence, two generations of workers retired from these companies with large portfolio’s along with lifelong retirement benefits.

However, starting in the 1970’s and rapidly escalating in the 1980’s layoff’s and outsourcing became the main management tool for pumping up stock prices.  Since then, much research has pointed out the damage caused by this behavior to both the worker and the companies.  For industry, layoffs eliminated social capital, stored knowledge that enabled workers to use their experience and familiarity with co-workers to solve problems and increase productivity.  It eliminated the “all-in-this-together” feeling that enabled companies to withstand the vicissitude of the economy.  Companies started treating workers as replaceable parts, only useful for a short shelf-life.  Research has demonstrated that this damaged companies and damaged the bottom line.

However, the real devastation it caused the workers hasn’t really been discussed.  Most workers never reached the pay they received at their old companies and before they find jobs literally use up all of their savings.  Psychologically, it creates a situation where risk is avoided for fear of “another failure.”  Now let me remind folks I am not just talking about the industrial working class here, but also middle and upper management.  In fact, the psychological damage might be worse for them, as their ego was wrapped that much tighter into their educational and occupational attainment.

Layoffs are so common that it is estimated that the average worker will be laid off several times in their career.  Despite the realization that it can and does happen to everyone, those that are laid off, emotionally, see the event as their failure.

I often counsel people who have been laid off.  It is very difficult to get them to take risks, even obvious ones, to break the pattern.  I know I am surprised at this, thinking that folks would do anything to avoid a future layoff and the financial issues it presents.  But, for folks in that situation, they see it much differently, trying to regain self worth by finding another employer that “will value them.”  That is why I get everyone to think in more entrepreneurial ways, even if they have no intention of quiting their job.  The time to get started is when everything is status quo on the job department, before the psychological damage is done.

Sometime people tell me they don’t need a wealth coach because everything is going well for them at work.  Sometimes, they have a defined benefit pension that promises them a fruitful retirement.  But now we are in a situation that private industry has looked to the bankruptcy courts to eliminate those pensions, and even local governments are having issues with meeting those pension obligations.  The future does not look good for even government workers and those defined benefit pensions.  So what is your strategy for the current work environment?  Do you even realize you are a totally replaceable part?  Isn’t it time you start acting like the free agent you really are?  Or are you going to wait for the axe to come down on you?

Taking on the Herd! July 15, 2008

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Once a month I go out into cyberspace to see what is out there of interest.  You get a real good understanding of how the herd is created, maintained, and led to slaughter doing this.  So I thought I would post today about the underlying assumptions that engender the herd creation.  Of course the uniformity of opinion on the net/blogs is truly amazing given the supposed openness of the medium.

The first assumption is the hatred of debt.  Now, all these assumptions have an strong emotional component to them, but debt has perhaps the strongest emotional tug to it.  Mainly aimed at those folks who carry large credit card debts and have no self control over purchasing consumer items, “financial experts” have created careers by telling people how bad debt is and making them feel really bad about themselves for having it and paying interest.  There is very little discussion on how debt functions, other than as a way for banks to make money off of people.  It is usually the first thing these experts say to do, get rid of credit card debt and then start paying down that mortgage.

Here is what the experts don’t tell you.  Rarely does a person build any substantial wealth without the use of debt.  Mortgage debt has produced more wealth for folks than mutual funds, bonds, or any other financial instrument.  In fact, the more wealth a person accumulates, the more debt, at least in the accumulation stage.  Debt is pretty simple to understand.  If the cost of the debt is less than the appreciation or value created by incurring that debt then the debt creates positive net worth.  The trick of course is to make sure you can service your debt while this appreciation or value is created.  Without the use of debt there is few if any folks who could create wealth.  So by creating a fear/dislike of debt, these experts are conditioning folks to fail and to fall into the next assumption.

You can create wealth by making small monthly inputs into mutual funds.  Sold as a risk-free way of building wealth, mutual funds have a soiled history and data indicates that again rare is the person who builds real wealth through mutual funds.  The latest permutations are the low expense index funds and exchange traded funds (ETFs).  Taking on one of worst abuses of the mutual fund industry (high expenses and fees) these folks encourage the concentration on fees and expenses correctly arguing that by limiting these and foregoing active trading one can decrease risk (variability) and approximate the market return.  This view is especially popular among the young.  Not surprising, because its hard to imagine the challenges of keeping dropping money into an account that come later with children, lay offs,  sickness, etc.  Its pretty easy to drop a little money into a 401K when you are young even if this means being a little more frugal than your peers, but wait to the kids need new shoes for school or that latest computer game, or you need to fly across country to take care of an ailing parent!  History has demonstrated how hard it is to have 35 years of uninterrupted inputs into a retirement account.  And if you have some interruptions, then that 8% rate of return you thought was adequate, disappears into smoke.  The fact remains that people who acquire wealth, need to gain double digit rates of returns because of intervening life events.  And if you start late in life, forget about creating wealth or even a decent retirement getting only 8% on your investments.  And if you retire into a poor return environment you are doubly screwed.  Simply put, that risk free investment has demonstrated to be almost a guarantee of a poor retirement.

The final assumption, and probably the hardest one for people to get over is that you can create a decent retirement by being an employee.  This is demonstratably false under today’s environment, but was at least partially true in the last three generations.  When defined benefit pensions were the norm, companies honored a pact with their workers for mutual advancement, lay offs were unheard of and social security and medicare were solvent into the foreseeable future people retired comfortable if they were willing to work hard at a job.  But that is not the environment now, unless you work for the government.  And even local governments are starting to balk at the defined benefit retirement plans that are driving them into bankruptcy. In essence we are all free agents now, dependent on ourselves to produce, save, and invest.  So why be an life-time employee, if you are really a free agent, only of temporary use to your employer?  Now I am not saying quit your job.  But you have to start thinking like an employer at all times.  Usually, this ends up with making plans and implementing a strategy that includes running your own business during periods of your life and using your built up capital to leverage into creating value of some sort.

I conclude with some words from conservative commentator Paul Poirot, writing in 1950.  Not that I ascribe to all his words, but believe that he describes the world we now live in:

“The only security any person can have lies within himself.  Unless he is free to act as an individual, free to be productive, free to determine what part of the production he will consume now, and what part he will save, and free to protect his savings, there is no chance he can find security anywhere….In an industrial societey of specialist, who exchange products, the process of saving involves the investment of money in productive tools which will return income to their owner to whatever extent those savings might be useful to a new generation of productive and thrifty men….Government gifts to the aged [pensions] cultivate a robber instinct among men who are in search of security.  In a society of free men the aged will find protection, have always found it, by their own efforts or by those younger men and women who look to their elders for instruction and guidance in the ways of truth.”

When Mr. Buffett speaks, we all should listen. March 5, 2008

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The most successful investor over the last 45 years has been a man by the name of Warren Buffett.  The fact is no one has come close to his record.  So when he speaks we should all listen.  The latest annual report for his company, Berkshire Hathaway, Inc. is out and as usual Mr. Buffett delivers pearls of wisdom in it.

First, lets look at his record.  Since 1965, when he bought the vehicle that is now Berkshire Hathaway, the average book value annual rate of return is 21.1%.  Since 1965 that means his total return is 400,863%!  Compare that to the S&P 500, which has an average return including dividends of 10.3% in that time period.  The S&P’s total return is 6,840%.

But some people have suggested the old man has lost his touch recently.  So let’s look at the last 10 years, a time period I have personally owned his stock.  If you would have invested $1,000 in Berkshire Hathaway ten years ago it would be worth $3,062.08 today.  If you could have invested in the S&P 500 10 years ago with $1,000 it would be worth $1,554.40 today. So you would have twice as much money investing with Mr. Buffett as you would have investing in the S &P 500 stock index.  Of course to invest in the stock index you would have to invest in a index mutual fund and pay its expenses.  Now the lowest expenses run at least .5%, but the majority run much more than that, as much as 4% (average is 2.5%).

Now, tell me again why the financial planning industry almost universally suggests investing in stock market indexed mutual funds?  Or even worse, investing in actively managed stock mutual funds, which on the whole get a worse return?

Go on listening to the advice of the financial planning industry, go on following the herd!!!!

But, I digress.

What did Mr. Buffett feel is important to talk about?  Well, one thing is the pension situation.  He suggests that the rate of return 363 out of the 500 largest companies that have pension plans in the US assume for their pension plans is unattainable.  We will talk about that assumption in a second, but first what does this mean?  It means, that future pension demands will outstrip what the companies have put away for the pensions, therefore reducing their worth in the future.  Are they planning to go to the bankruptcy courts to shed these pension plans?  Several large companies have already done this.

Here is his direct language:  (By helpers he means money managers and financial planners)

“I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about doubledigit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.”

What is the average assumption for these pension plans?  8%!  The average pension plan carries 72% of its assets in equities, so the equity section of each plan must get almost 10% return after fee’s are paid out.  Fee’s he points out that are “far higher than they have ever been.”

Here is another direct quote on investor returns:

“Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.”

No wonder those “helpers” don’t want you to invest in Berkshire Hathaway, if these words are in the annual report!!!

There is much more in the annual report worth reading.  A quick google search should find it.

I think I am going  to invest some more in Mr. Buffett!

***Nothing in this blog, or in this post, should be considered “investment advice.”  It is only the ramblings of the author, whom should be considered a mad man at best***

Picture of Mr. Buffett Below