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Saturday, April 09, 2005

Presidents Doing Stupid Pet Tricks

Yeah, it really was a stupid trick. And a cheap publicity stunt that George Bush pulled earlier this week.

While on a tour, stumping for Social Security reform and private accounts, President Bush visited the vault where the Social Security Trust Fund is stored. His mission was to make the point that there is no actual money in the trust fund, merely IOUs.

Well, the IOUs in question are in fact U.S. Treasury bonds. Investors all over the world, including foreign governments, hold Treasury bonds. When a state, local or federal government or even a business offers a bond, it is essentially borrowing money and issuing a piece of paper promising to pay back the loan with interest. That's all a bond is.

There is, in fact, a problem that too much American debt is held by foreigners and if they lose faith in America’s credit and its ability and willingness to pay back its debt, these investors will cash in their bonds before maturity even if it means losing interest and paying a penalty. Better, after all, to lose some interest than to lose both interest and your principal if the U.S. government really intends to default on its debt.

Now, if a few nervous investors did this, it wouldn’t create much of a problem for an economy as large as that of the United States. But if a very large number of investors with a significant amount of bonds all called in their IOUs at the same time, we would have trouble paying them all off at once. It would be like an old fashioned panic and a run on the bank.

Just as no bank actually has all of its depositors’ money on hand and couldn’t pay out everybody all at once, if every bondholder demanded his money at the same time, it would wreck our economy and you and I would be living in tent city alongside Donald Trump. We’d all lose our shirts.

However, the truth is most sophisticated investors are not worried about their Treasury bonds. U.S. treasuries have “the full faith and credit of the United States” behind them. And despite President Bush’s clowning, that is more than a mere slogan. America has never, ever, defaulted on its debt. Even in the darkest days of the Great Depression of the 1930s, America always met its debt obligations.

But while sophisticated investors know this fact, many average Americans don’t and that’s whom this cheap stunt was aimed at. It was meant to convince you and me, with a startling visual display, that Social Security was in more trouble than we realized.

But the truth is that if Social Security were to be privatized, we would want to have the very same IOUs that the President just made fun of in our own private accounts. In fact, one of the proposals to minimize the risk of private accounts is something called a lifecycle account, which would automatically balance the account to include the proper mix of stocks and bonds – or worthless IOUs, to the naïve citizen watching the President’s fun photo op.

Here’s the truth about stocks, bonds, investing and lifecycle accounts.

A life cycle account automatically re-balances an investor’s retirement portfolio as he gets older and closer to retirement.

They are a good tool for the average person who simply doesn’t have time to study the stock market, research corporations’ profit margin, calculate profit to earnings ratios and returns on investment, and learn investment theory and strategy. This includes most people with a full time job and a personal life – that’s why there are professionals who get money for being stockbrokers, investment specialists and financial planners. Coincidentally, all rich people, unless they are professionals at it themselves, hire these people to manage their wealth. Investing should come with a warning, “if you are not a trained professional, do not try this yourself at home.”

The theory behind lifecycle accounts (and it’s a good theory for investors even if they take the “do it yourself” approach) is that the younger the worker, with the most years to work, the more of their retirement nest egg should be put into stocks. That’s because stocks outperform bonds and give a higher return for your investment. But they are also riskier than bonds. The stock market, and individual stocks and mutual funds, are more subject to the ups and downs of the market, thus they are more volatile. If you hit a bad patch in the market when you are relatively young, you can recoup your loss. The stock market never stays permanently down. But it also doesn’t stay permanently up.

So, as you get closer to retirement age, you want to take less risk because you have less time to make up any loss. That’s when a smart investor, or a lifecycle account, rebalances the portfolio to reflect more caution, also called managing risk. That’s the point when there should be more treasuries and other bonds than stocks in the portfolio.

One word of caution, though, a portfolio should always contain a mix of stocks and bonds. Even younger workers should never take the riskiest options since saving and investing for retirement is a long-term process and you always want to keep your account growing not shrinking. And bonds sometimes are losers too, so at any age, balance is important. But over all, bonds are a safer investment and as you get closer to retirement, the balance of the portfolio should be weighted in their favor.

So, this means that the very bonds that Bush tried to imply were worthless IOUs are the same bonds you and I would actually want in our private accounts. And any investor who doesn’t realize this is frankly too inexpert to be managing his own retirement account. And believe me, many people are that naïve. Which is why a lot of people, including me, oppose private accounts.

Another reason I’m opposed to them is because you only get out what you can afford to put in. Studies have shown that the wealthy benefit handsomely from private accounts because they have more money to put into them in the first place. If everybody can put in 4 percent, but 4 percent of $500,000 is more than 4 percent of $50,000, of course a wealthy person is going to do better with a private account than with Social Security, while you and I won't. It's simple mathematics.

And even Einstein would probably have had to admit that “the miracle” of compound interest could only take you so far. Not that I’m trying to demean compound interest. It is a remarkable economic concept that can benefit anybody smart enough to save some money. But even with this, poor people who just don’t have much money to put into their accounts will do better, in the long run, in the present Social Security system.

So will most of the middle class. The truth is the stock market is too dicey to risk your retirement nest egg in and the cautious approach that lifecycle accounts promote doesn’t always provide enough growth to match or do better than the present system either. In fact, two countries that have already gone to systems of private accounts, England and Chile, have found them to provide disappointing returns for the average worker, and some English economists are suggesting that Britain change to a retirement system similar to our Social Security.

A decent society provides for its weakest and neediest citizens. And it keeps faith with its elderly. When somebody who has worked hard all his life, raised a family, paid taxes and contributed to the common good is too old to work, society should not throw him away like a used paper towel. At least, that’s what I believe.

Who knows what the compassionate conservatives, like George Bush, believe. They certainly don't believe in honesty or Bush would not have pulled his stupid pet trick at that vault.

1 comment:

unlawflcombatnt said...

Anonymous,

Great letter. I'll have to post some comments later. You've got a lot of good information here.

Mike

http://www.unlawflcombatnt.blogspot.com/