FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 13, 2007

IN THIS ISSUE:

1.  Yet Another Warning

2.  A Summary Of The Problem

3.  Congressional Hypocrisy

4.  What About The “Trust Funds?”

5.  What This Means For Your Retirement Security

Introduction

Those of you who read financial publications such as this know that a crisis is looming in Social Security, Medicare and other government entitlement programs.  No one likes to talk about it.  The media ignore it.  But the crisis is coming; it’s only a question of when; and “when” is getting closer and closer, what with the first of some 78 million Baby Boomers starting to retire next year.  Yes, next year!

While our spineless politicians routinely defer dealing with this looming crisis, the chairman of the Federal Reserve seems obliged to remind us, once in a while, that something should be done now, before it’s too late.  My guess is that this entitlement warning must be part of a “Policies & Procedures Manual” that is passed down from Fed chairman to Fed chairman.  Volcker warned us, Greenspan warned us, and now Bernanke has issued his warning.

However, as I will discuss below Bernanke’s latest warning had a new twist.  Unlike his predecessors who pleaded that something should be done before it’s too late, Bernanke warned that it is already too late.  I believe he is correct.

In recent Senate testimony, Fed Chairman Ben Bernanke warned that we are experiencing “the calm before the storm” in regard to Social Security and Medicare funding.  As the Baby Boomer juggernaut careens toward retirement, the US government is faced with gigantic entitlement promises it cannot afford to fulfill, at least not without some major negative economic consequences.

For the last 25 years or more, Congress and the president have heard the warnings from Volcker and Greenspan that it was time to pay the piper in regard to Social Security and Medicare.  Nothing was done.  Actually, that is not correct: Congress has spent all the money in the trust funds and replaced it with government IOUs (T-bonds).

I have written about Alan Greenspan’s warnings on the looming entitlements crisis in the past, if you care to go back and look. I have also written about President Bush’s plan to overhaul Social Security, for which he was ridiculed.  Now we have new Fed Chairman Ben Bernanke warning us that it is now too late to try to fix the problem, and he has been largely ignored.

It continually amazes me how a problem of this magnitude can be ignored for decades, when we all know it will end very ugly at some point, and we know the day of reckoning is growing closer and closer.  Yet there is no sense of urgency on the part of Congress to do anything to avert this looming financial crisis.

In this week’s E-Letter, I will discuss the latest warnings issued by Fed Chairman Bernanke.  We will revisit the basics of the entitlements problem, discuss some potential solutions, and end with some ideas on what you need to be doing about it.

Brief Summary Of Bernanke’s Comments

In his first testimony before the Senate Budget Committee since the Democrats gained control of Congress, Fed Chairman Ben Bernanke laid it on the line: the US faces a “vicious cycle” of rising federal deficits and interest rates unless Congress acts quickly to shore up funding for both Social Security and Medicare.  And what’s his idea of quickly?  Bernanke declared:

“The right time to start was about 10 years ago.”

To my knowledge, neither Greenspan nor Volcker made such a bold statement.  Why the early start?  That would have given us a few years before the Baby Boom generation actually started retiring to allow any solutions to have an effect.  Now, with the oldest Boomers just a year away from early retirement, the barbarians are already at the gates.  No time to dig a moat – pick up your bows and arrows.

Bernanke’s comments also included some very specific economic consequences of inaction.  Once Baby Boomers start to retire, the federal budget outlook is expected to become considerably worse.  Bernanke estimates that Social Security and Medicare spending will rise from 7% of GDP today to almost 13% by 2030.  I think his numbers are conservative, and they are based on a continually growing economy.

Bernanke concluded that the most likely result would be: “The US economy could be seriously weakened, with future generations bearing much of the cost.” What else is new?  Plus, in a possible effort to pre-answer an objection, Bernanke also said that economic growth alone would not fix the impending fiscal problems.

Since we haven’t yet perfected the technology for a time-machine to go back and implement a solution on Bernanke’s target date of 10 years ago, the best we can hope for is a Congress that will take the bull by the horns and fix the problem NOW, before it gets too much worse.  Unfortunately, I see little chance of this happening, as I will discuss later on.

It is also important to note that not just Paul Volcker, Alan Greenspan and Ben Bernanke have warned of the impending Social Security and Medicare crises.  The Congressional Budget Office and Social Security and Medicare Boards of Trustees have also issued reports stressing the necessity of taking action as soon as possible to avoid even worse problems in the future.

It is not like this is a big secret, nor is it a secret that time is running out!

Congressional Hypocrisy:  Do What I Say, Not What I Do

Both Social Security and Medicare benefits are considered to be “entitlements” under the federal budget.  As such, they consist of a promise of an increased current benefit to some, and increased future benefits to others.  And therein lies the problem.  Politicians have learned that they can get on the good side of voters by increasing the promised benefits from these two entitlement programs, while at the same time leaving it up to a future Congress to fund them.

For decades, both major political parties have supported increases in promised benefits without commensurate increases in funding.  In some ways, this tendency to mortgage tomorrow for a benefit today is like what happened with corporate defined benefit pension plans, which were the target of the recently enacted Pension Protection Act. 

Large corporate employers found that they could satisfy workers (and sometimes unions) by promising higher levels of employee benefits in the future.  Doing so created an unfunded future liability which, in essence, is a debt on the corporation owed to its workers in future years.  If used responsibly, actuarial science can employ this tactic to create a win-win for both the employer and employees.   However, US corporations allowed their unfunded liabilities to get out of hand, and Congress felt the need to step in. 

The irony of this situation is off the scale.  Congress established rules to restrict American businesses from doing much the same thing that it has been doing for decades.  In fact, Congress is worse.  Not only did they not fund all of the increased future benefits, they also spent all the money put back to pay for the Baby Boomers’ retirement.

And now, as the Baby Boom generation enters retirement, it’s time to pay the piper.  Yet, our elected representatives still want to drag their feet and tinker at the margins without making any effective reforms – all the while spending more and more money every year.  All of the past buying of votes with promises of increased Social Security and Medicare benefits has created the mother of all unfunded liabilities.  And ultimately, who will have to pay for this?  That’s right – you and me, the American taxpayers.

What About The Trust Funds?

Much of the Social Security and Medicare debate is framed around the term “insolvency.”  This is assumed to happen when the “trust funds,” that have been built up from the surplus of taxes over expenditures, are exhausted.  In the case of Social Security, insolvency is predicted to come in 2040, which is very optimistic in my opinion.  For Medicare, projected insolvency is just around the corner in 2018, if not sooner.  However, like Santa Claus and the Easter Bunny, the Social Security and Medicare trust funds are little more than fantasy. 

Over the years, surplus funds were collected over and above what it took to fund benefit payments.  As a result of Greenspan’s 1983 recommendation, tax rates were raised so that an even greater amount would go into these trust funds in an effort to extend the solvency of the program.  During that time, however, Congress spent the money in the trust funds and replaced it with special Treasury securities that represent nothing more than an IOU.  A 2002 Congressional Budget Office Policy Brief probably best described this arrangement:

“Trust fund holdings, as internal liabilities between government accounts, are not assets of the government. Nor do they represent money owed to program recipients individually; payments to Social Security recipients and beneficiaries of other social insurance programs are based on a variety of rules set by law unrelated to trust fund holdings. A federal trust fund is basically an accounting device that measures the difference between the income designated for a specific program and the expenditures made to its beneficiaries. The accumulated difference, or balance, often represents a reserve of future "spending authority" for the program, but it is not a reserve of money for making payments.” [Emphasis added]

“In the future, when receipts for such programs as Social Security fall below their expenditures, the legal authority to pay benefits will exist as long as their trust funds have balances, but the government will have to generate cash to pay benefits either by running a surplus in the rest of the budget--which would probably require cutting other spending or raising taxes--or by borrowing from the public.”

Note the last part of the CBO’s statement.  If we’re not running budget surpluses by the time entitlement expenditures are expected to overtake tax revenues (fat chance!), then the government will have to borrow from the public.  That means fund the “spending authority” with Treasury Bonds.  To me, that sounds a little like paying your VISA bill with your MasterCard.  And don’t forget, someone will have to buy all those T-bonds!

Why Won’t Our Elected Leaders Take Action?

At the risk of oversimplifying the arguments, I think that the reasons our elected representatives in Washington D.C. haven’t taken action before now fall into three categories:

1.  Complexity – The task of projecting future costs and benefits for Social Security and Medicare is incredibly complex, requiring the application of actuarial science, which is the process of applying mathematical and statistical methods to predict a range of probable future outcomes. 

Important to any actuarial analyses are the assumptions used.  As you might imagine, the assumptions surrounding future funding of Social Security and Medicare expenses are many and varied.  They include fertility and mortality rates, health care costs projections, projected tax revenues, future inflation, interest rates, productivity growth and a host of other factors.  Even a relatively small adjustment to any of these assumptions can have a large effect on the probable outcome, especially when making projections for decades into the future.

Adding to the complexity is the fact that not all actuaries agree on all of the methods and assumptions used for projecting Social Security and Medicare costs.  For example, the Social Security Trustees estimate the program to become “insolvent” in 2040, while the CBO says this won’t happen until 2046 (all based on a continually growing economy).  Thus, it’s not all that hard to find a ‘scientific’ basis for virtually any position a politician may want to take.

2.  Problem?  What Problem? – As noted above, changes in the actuarial assumptions can produce widely varying results.  Thus, there are some politicians who claim that Bernanke and Greenspan are just alarmists, and that there’s going to be no problem with Social Security and Medicare funding in the future, based on their own assumptions.

The biggest problem I see with this position is that it’s going to be tough when we get several more years down the road and realize their projections were too optimistic.  However, the presence of at least some studies that show there will be no future funding problems gives some politicians the “plausible deniability” they need to do nothing.  That way, they need make no politically unpopular votes now, and if their assumptions do turn out to be wrong in the future, they’re likely to be retired and collecting their government-guaranteed Congressional pensions.  How nice (for them)!

3.  Politics As Usual – During his Senate testimony, Mr. Bernanke briefly mentioned possible solutions to the funding dilemma – raising the retirement age, increasing payroll taxes or increasing the amount of income subject to payroll taxes (known as the Taxable Wage Base).  Another possible solution suggested by some experts involves “needs-testing,” where those with significant assets would either lose part of their benefits, or pay income taxes on a greater portion.

In the Social Security and Medicare discussion, I think it’s safe to assume that: 1) no one in the US wants to pay more in payroll taxes; 2) no one wants to receive less benefits in the future; 3) no one wants to be forced to wait until age 70 to retire; and 4) no one wants to pay taxes on all or a portion of their benefits.  As a result, it’s not very surprising that few politicians want to enact any of these unpopular solutions to shore up these entitlement programs.

While the gutless politicians in Washington choose to ignore it, I believe there really is a looming crisis in relation to Social Security and Medicare solvency.  I think those that say otherwise are just a continuation of the “let a future Congress worry about it” political attitude that created the problem in the first place.  I believe it will be a crisis because we have postponed doing anything meaningful to fund future entitlement benefits.  As a result, virtually all of the possible solutions – raising the retirement age, raising payroll taxes, needs-testing, or cutting benefits - are viewed as draconian, which is why we’re not likely to see a change anytime soon, especially with the Democrats in power.

The Democrats have made an art form out of claiming that reductions in the increases of an entitlement are actually “cuts.”  Therefore, it will be very difficult for them to support any proposal that might mean lower increases in future benefits, much less cutting or restricting them.  The same will likely go for increasing the retirement age.  Never mind that the average lifespan was much shorter in 1936 when Social Security was first established than it is now.

Also don’t look for an increase in the Social Security FICA tax on all workers.  Democrats see this as a regressive tax that disproportionately affects lower-paid employees.  Thus, this idea is not likely to get much traction in a Democratic-controlled Congress.  We also know that private accounts were DOA when proposed by President Bush, so send that one to the showers as well.

About the only solution the Democrats are likely to support is anything that would shift the burden of paying for a Social Security and Medicare fix onto high-income individuals.  There is currently no cutoff for the Medicare portion of the FICA tax, whereas there is a cutoff on the Social Security portion of the FICA tax  (currently $97,500).

So I can see the Dems supporting legislation that would make the Social Security portion continue on ALL income, thereby shifting the burden to the “rich.”  There are plenty of reasons why taxing the rich in such a manner is not a good idea; I could write pages on the subject, but space does not allow this week.  But there is one problem with this scenario that is rarely discussed.

The inherent problem in this tax the rich scenario is that if taxes are paid on all wages, then benefits must accrue on all wages as well.  That being the case, the increased taxes may or may not be enough when you consider that increased benefits for the wealthy also have to be funded.  Thus, tax increases on high-income individuals may not be effective unless it is coupled with needs-testing.

Put differently, taxing the rich to fund Social Security might only work if you also cut off or limit their benefits.  That would likely be political suicide!  I doubt the Democrats are ready to go there yet, especially between now and 2008.  But if Hillary wins the White House next year, this option will definitely be on the table, in my opinion.

As noted above and in my January 23 E-Letter, the Democrats are not likely to take on any controversial issues so as not to give the Republicans any negative ammo for the 2008 presidential race.  As I have said before, political conventional wisdom says Social Security is the “third rail” of politics – touch it and you die.  Thus, don’t look for solutions to come from this session of Congress, which will last from 2007 through 2008.

The really sad part is that, by waiting to enact effective reforms, our representatives are passing up viable alternatives that are much less draconian than what will be required when their backs are really against the wall in a few years.

What All This Means For You

While I firmly believe that both Social Security and Medicare will continue to be available in some form well into the future, I also think that changes will be required to keep spending on these entitlement programs at levels that will not tank the economy.  Therefore, the level of benefits you may receive in the future may not be what has been promised.

As a result, I always counsel my clients to plan for retirement as if they were not even covered by Social Security.  That way, if you are successful in your investment plan, any Social Security benefit that may be paid will be gravy.  The following simple rules can help you to build a retirement nest egg so that there is some “gold” in your golden years:

1.   The first and most obvious rule is that you should elect to participate in any tax-deferred/retirement programs offered to you through your employer.  Recent law changes have made it possible for even the smallest of employers to sponsor 401(k)-type retirement plans, even if the employer cannot afford to contribute to the plan or match employee contributions.  If your employer does not sponsor a plan, ask him or her to check out the SIMPLE IRA or a SEP IRA, or consider opening up your own IRA.

2.   You should also contribute the maximum allowed every year to your own traditional or Roth IRA, even if you are covered by an employer’s plan.   Currently, the maximum contribution to an IRA is $4,000 ($5,000 if over age 50) for a single person, or $8,000 if both husband and wife are employed ($10,000 if both are over age 50).  These limits are set to increase to $5,000 by 2008 ($6,000 if over age 50).  If you are not covered by an employer plan, you should be contributing to an IRA.  For more information about Roth and traditional IRA contribution limitations, see IRS Publication 590 available on the IRS website (www.irs.gov).

Your contributions to a traditional IRA may not be deductible if you do participate in an employer plan.  However, non-deductible IRA contributions still grow tax-deferred until you withdraw them after retirement, and growth attributable to Roth IRA contributions can qualify to avoid taxation altogether.  In addition, some employer plans allow you to make after-tax voluntary contributions that also grow tax-deferred, and are invested along with the assets of the plan.  Be sure to ask your employer about this.

3.   Once you decide to take advantage of all of the retirement savings vehicles available to you, you also need to maximize your contributions to these plans to the extent possible.  If you can’t contribute the maximum percentages, do what you can and try to increase your percentage each year. 

4.   Another rule of successful retirement planning is to use time to your advantage.  In a nutshell, this means to pile as much money up as quickly as you can when you are young.  This gives the magic of compound interest the maximum number of years to work to your advantage.  If you procrastinate about participating or maximizing your contributions while young, you lose valuable years for compounding. 

Here’s an example:  If an investor makes an annual IRA contribution of $4,000 from age 25 until retirement at age 65, these contributions will grow to $1,119,124 assuming an average annualized return of 8%.  However, if he waits until age 35 before starting to contribute, the value at age 65 decreases to only $489,383, a difference of over $625,000!  (Note:  The growth rate of 8% is used for illustrative purposes only, is not guaranteed and does not represent any actual investment.)

5.   When switching jobs, resist the temptation to spend retirement distributions.  Take advantage of direct rollover opportunities to maintain the tax-deferred status of your accrued retirement benefits.  I have clients who have multiple rollover IRAs, one from each former job.  However, these IRAs continue to grow tax-deferred, and when combined, can amount to quite a nice retirement fund for these clients.

6.   If you must borrow from your retirement funds, plan how and when you will repay the loan as soon as possible.  I am not one to say that you should never borrow from your retirement funds; emergencies can happen.  However, such loans should only be made as a last resort, and the money should be repaid ASAP. 

7.   If you are already at or near retirement, but have children and grandchildren who are starting their working careers, share this information with them and encourage them to participate in their employer’s retirement plan. 

Many parents and grandparents try to help their children and grandchildren by giving them money for major purchases and other “necessities.”   Other than a down payment for a home, I can think of no better gift than to make money available for them to maximize their participation in their employer’s retirement plan. 

Most parents and/or grandparents never think about helping their kids maximize their contributions to their retirement plans because only the owner(s) of the plan(s) can contribute the money.  Here is a way parents and/or grandparents can help that is rarely used or recommended.  You can cover some of their monthly household expenditures, so that they can have the maximum percentage withdrawn from their pay and placed into the retirement plan.  As they get salary increases and get on a better financial footing, you can either stop the assistance or redirect your gifts to be used for their kids (college planning, transportation, etc.) 

Gifts that enable maximum participation in a tax-deferred retirement plan will pay dividends far beyond your lifetime, and in an amount that will be much greater than the value of the initial gift itself.  Think about it!

8.   Make wise investment decisions.  Today, there are many investment options that are available to retirement plans, ranging from low-risk CDs to very high-risk products that can potentially lose all the money you put in them.  If you have read my E-Letters for long, you know that I recommend that most people use professional Investment Advisors to help make their investment decisions.  

While there are some Advisors, and some investment products, that are not available to retirement plans, there are many that you can access depending upon the plan’s list of investment options.  Professionals can also assist you in determining the optimum mix of investment options available in your plan, known as “asset allocation.”  This is one area where we may be able to help you.  (More on this below.)

Most large companies with retirement plans have a Human Resources Department that should provide educational materials about investing and may be able to recommend qualified professionals to help make retirement plan investment decisions.  Check with your Human Resources or Personnel Department staff to see if such resources are available.

Conclusions

All of the above can be summed up as follows:  1) Use every tax-deferred option available to you; 2) Save as much as you can in these plans, as early as you can; 3) Don’t borrow from your retirement plan unless absolutely necessary; and 4) Encourage your children and grandchildren to do likewise.   The miracle of compounding should be fully understood by you and those you care about.

When it comes to how you invest those retirement assets, it gets more complicated.  Like other investments, you want to diversify your retirement plan investments.  Some plans have limited choices, while others have many different options.  The key is that you want to invest wisely and for the long-term.  After all, it is your future and none of us want to end up being a burden on our kids.

As noted above, there are professional Advisors and professionally managed investments that are available to many retirement plans, including individual IRAs.  If you need help in this area, we at Halbert Wealth Management are happy to assist you.  You can call us toll free at 800-348-3601 or you can visit our website at www.halbertwealth.com.   

Very best regards,

Gary D. Halbert

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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc., a Registered Investment Adviser under the Investment Advisers Act of 1940. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of the named author and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific advice. Readers are urged to check with their financial counselors before making any decisions. This does not constitute an offer of sale of any securities. Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have their own money in markets or programs mentioned herein. Past results are not necessarily indicative of future results. All investments have a risk of loss. Be sure to read all offering materials and disclosures before making a decision to invest. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.