Big City Woes

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Bob Marley, the reggae singer, sang “The bigger they are, the harder they fall” and the lyrics strike a chord in big cities around the U.S. New York, Chicago, L.A., Philadephia, Detroit, Phoenix and Atlanta are among the cities reporting huge deficits.

In a 6/24/09 WSJ article, Douglas Belkin details Chicago’s woes and finds that fat fiscal spending in past years has deepened the budget crisis as the recent economic downturn has sharply reduced revenues.

Chicago’s experience should be a lesson for other cities. Through high sales taxes, increasing fees and privatization of city services like parking meters, Chicago’s revenues jumped in past years. City politicians pumped the extra revenue into their operating budget while residents paid higher fees from these now privatized services.

As sales tax and property tax revenues have declined, the City has fewer revenue sources to fall back on. While Morgan Stanley continues to rake in collections and high towing fees on many of Chicago’s parking meters, Chicago is laying off and furloughing city workers.

Arnold Schwarzenneger, governor of California, has repeatedly argued for a “rainy day” state savings fund. From this economic downturn, both state and city politicians can learn a lesson that they may not have learned in childhood – the value of saving.

Financial Regulation

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In 1966, Congress passed the Fair Packaging and Labelling Act, which required manufacturers of retail products to list the contents and weights of their products. The food industry fought hard against it. Breakfast cereal makers were accustomed to packing their cereal in big boxes to trick the consumer into thinking that they were getting more product.

In 1969, Congress tried to pass a law mandating unit pricing but the food industry lobbied hard against it and the bill died in the Senate. The reasoning was that consumers could figure out the unit price or the price per ounce of a product by themselves or bring recently introduced battery powered calculators with them when they went shopping. In 1970, some grocery stores began to offer unit pricing as a convenience feature to lure customers. Unit pricing in grocery stores is now commonplace.

Many years ago there was one mortgage product, a 30 year fixed loan, making it fairly easy to compare mortgages. Because easy comparison by a customer is not always good for the seller, mortgage companies competed by introducing a complexity of “points”, closing fees and prepayment penalty packages to distinguish their mortgage product from their competitors.

The 15 year mortgage arose a few decades ago, followed by a variety of mortgage products. This profusion of choices can be a boon to a consumer but it can also be confusing. This variety and confusion is an effective sales tool, making it more difficult for a customer to compare products and prices.

Just as the food industry fought packaging regulations, the financial industry will fight similar regulations on their products. Under proposed financial regulations, teaser rates of “0% interest for 6 months” will have to be followed by plain English of what that teaser rate will reset to in six months. No longer will credit card companies be able to bury the truth in impossibly small print referencing the greater of the LIBOR rate (what’s that?, you ask) or the Federal Reserve discount rate (what’s that?, you ask again). Mortgage companies would have to offer at least 2 – 3 standard products, like a 30 year fixed loan, that a consumer could compare pricing with a competing mortgage company. While this legislation works its tortuous way through Congress, the finance industry will be busy lobbying against it and figuring out how to outsmart it.

ETF Max

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A month ago I wrote about investing in leveraged ETFs, enumerating several risks and the erosion of a investment returns in a see-saw market.

As more brokers recommend these products to their clients as a tool to limit risk or improve returns, the Financial Industry Regulatory Authority (FINRA) is cautioning brokers to exercise some care in how they present these products to their clients.

State Tax Declines

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There are many summer sounds to be heard on June nights but this year one of those sounds are the gnashing of teeth in state capitols throughout the U.S.

In a May report, the non-profit Rockefeller Institute summarized early state reporting of income tax for the first quarter. After adjusting for inflation, state income tax revenues declined an average of 14% compared to the first quarter of 2008. South Carolina’s drop was precipitous – over a third. The average decline in sales tax revenue was 7.6% but Georgia saw a drop of over 16%.

Many states start their fiscal year in July and must base their budgets on preliminary data. Personal income tax makes up an average of 40% of state revenues for the 41 states which have personal income tax. The Rockefeller Institute projected an even steeper decline in revenues in April revenues. Since most states must balance their budgets, there will continue to be hotly contested adjustments to state spending to meet the reduced revenue streams.

Gross Domestic Product

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A month after each quarter ends, the Bureau of Economic Analysis (BEA) releases an advance estimate of the nation’s output of good and services, or GDP. As the Bureau receives more specific data, they revise their advance estimate, calling this revision a preliminary estimate.

On 5/29/09, the BEA released their preliminary estimate of first quarter GDP. The good news is that GDP didn’t fall as much as indicated by the advance estimate released at the end of April. It was “only” a decrease of 5.7% from the last quarter of 2008. Defense spending decreased 6.8%. While personal spending was up 1.5%, gross domestic purchases of goods and services declined by 7.5%.

Recent signs indicate that the deceleration in the economy has slowed. New housing permits have seen an increase. The rate of applicants for unemployment is less jaw-dropping. The manufacturing index, while not positive, has turned around from its steep decline. This is a big ship that had lots of momentum in the wrong direction. It will take a while.

Health Care Costs

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On Sesame Street, he’s called the Count. In Washington, it’s called the Congressional Budget Office or CBO. Both are good at counting, but there’s a difference. On Sesame Street, everyone loves the Count. In Washington, many politicians grumble about the CBO’s counting.

On June 15th, the CBO responded to Sen. Edward Kennedy’s draft proposal for health care reform. Estimated increase in federal deficit over the next ten years: $1T. But wait – there’s more. The CBO estimates that 10% of those under 65 would still be uninsured. And there’s still lots more. Kennedy’s proposal had so many blanks and “I dunnos” in it that all the CBO could do was count the holes, acknowledging that it needed more information on a number of issues, many of which the CBO had specified in a paper last December.

On June 16th, the CBO sent a response to Republican Senators Kent Conrad and Judd Gregg about the impact of doing nothing. The short and sweet? The country has to do something to reform the system – and soon – before health care spending in this country becomes the Blob that ate the budget.

You can see a number of links to issues that the CBO considers key to resolving this complex problem at the health care policy page. We’re big kids now. We can figure this out as long as everyone doesn’t expect to get all they want. It’s the principle behind the founding of this country.

Stock Market Returns

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The Depression of the 1930s wiped out the market assets of many investors and all subsequent financial events are compared to that one. After reviewing some historical stock market data, I was surprised to learn that an investor who put $1000 into the large company stocks on Jan 1, 1928 still had about a $1000 ten years later on Dec. 31, 1937. No gain but no loss.

In the past 10 years, from June 1, 1999 to May 31, 2009, a $1000 invested in large company stocks are worth $840 now. More depressing than the depression.

You can investigate a number of historical returns at Index Funds Advisors by clicking on the index calculator at the top of the page. What if, instead of the crooked teeth and allergies your parents bequeathed you at birth, they had invested $1000 for you?

Retirement Calculator

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Retirement planning is for old people. Until then we can merrily skip through life singing that old Roman hit “Carpe Diem”. According to the Center for Retirement Research (CRR) at Boston College, too many people have adopted that happy-go-lucky approach. In a 6/5/09 WSJ op-ed, Janice Nittoli, a vice president at the Rockefeller Foundation, presents some sobering survey data.

The CRR calculates that 61% of workers are not saving adequately. At the end of 2007, the average 401K balance was under $19K. That was before the severe dip in equity prices last September. What about the boomers who will start retiring in the next few years? The median retirement savings for workers aged 55 – 65 was less than $100K. Again, that was before the recent downturn.

Ms. Nittoli writes “A full third of U.S. employers have reduced or eliminated their matching contributions to retirement accounts since January of last year and another 29% plan to do so before [2009] is over.” In a downturn like this, companies reduce employee benefits. This contribution reduction comes at a time when equities are priced at historical lows. In effect, 401K plans can lose the benefits of dollar cost averaging, i.e. buying more when prices are down, buying less when prices are up.

There are many online retirement calculators that offer to tell you whether your savings are on track for retirement. Unfortunately, there can be a wide difference of opinion in these calculators. They often seem like black boxes requiring a person to input a few variables, then magically spitting out an answer like “You will need $1.5 million in savings to retire.” Upon hearing this we may be tempted to go down to the nearest karaoke bar, get drunk and sing “Carpe Diem.”

A more concrete way to understand your financial future might be to look at an annuity calculator. For our example, we will use a type of annuity called an immediate fixed annuity, which is a contract with an insurance company, for example, where you give them a certain amount of money and they pay you monthly or annual amounts for a set period of time. This is not a recommendation to buy such a product, only an example to estimate the health of your saving plan.

Let’s say you are at retirement age and you figure you need to net $3000 a month to meet your expenses. You figure that the Social Security Administration (SSA) will take about 10% income tax out of your $1500 a month social security check, leaving you with $1350. In this example, let’s say that any Medicare B or other health insurance premium is already included in the $3000 per month expense figure. I’ll also assume that you don’t have any other fixed pension plan. So, you need an extra $1650 a month, or about $20K annually, to meet your expenses.
The key component in using these calculators is the percentage rate of growth or, in our example, the interest rate of the annuity. Federal Reserve data shows that the rate of return for 10 year Treasury bonds has been 5.4%. Using the calculator at a slightly more conservative 5% growth rate, you find that you would have to have an annuity of about $250K to get the payout you need over the next 20 years. So, is that your answer – $250K? Not quite.

Your $3000 monthly expense will grow larger with inflation, which has averaged 3.1% over the past 80 years. Your social security check will grow with that inflation rate but the “extra” you needed every month won’t. As the cost of living increases, that extra amount of $1650 that you need to cover this year’s monthly expenses will grow to be $3036 per month in 20 years.

A more realistic percentage rate of growth is to subtract the historical rate of inflation, 3.1%, from the historical rate of return on a 10 year Treasury bond, 5.4%. The result is 2.3%. Subtract from that about .4% of the return for the income taxes you’ll pay on the interest your money will earn and the result is about 2%. Putting that percentage into the calculator gives a result of $327K. That’s a more realistic minimum savings goal and one that, given the survey data, a majority of workers will have difficulty meeting.

While $327K sounds like a lot of money, a person aged 25 who saved $200 a month in a savings account paying 5% would have that approximate amount at age 65. When Einstein was asked what was the most powerful force in the universe, he replied “Compound interest.”

Health Care Solutions

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In the search for effective solutions to health care, the grocery chain Safeway has adopted a simple, time tested approach: base premiums on behavior. This is the fundamental model of the the auto insurance industry.

In a 6/12/09 WSJ op-ed, Steven Burd, the CEO of Safeway, details Safeway’s four year long experiment with this model. While American companies have average a 38% increase in health care costs since 2005, Safeway costs have remained flat. Like many large companies, Safeway is self-insured, giving them data on actual medical claims turned in by employees.

Employees who don’t engage in risky behavior, like drivers who don’t speed, pay lower premiums than those who do. The program is voluntary at Safeway but most employees rated the plan good to excellent and the participation rate is 74% for non-union employees. Employees who reduce their weight or give up smoking are rewarded with lower monthly premiums. Safeway is currently negotiating with the union to introduce a similar program for union employees.

This year, the Federal government is likely to step in to the health insurance market to attempt to solve problems so seemingly intractable that the private marketplace and the individual states have failed to address them. Older employees become slaves to their employer. On an individual plan, a woman who had breast cancer 10 years ago may pay four times the premium charged an employer for a plan with the same benefits. How many states have high risk health insurance pools as they do for auto insurance? Year after year small employers, patients and lawmakers have acknowledged that the current system is broken. Suggestions are made. Discussions and arguments follow and little is done.

The Federal government has a poor record of solving problems. That there is enough support for a Federal government solution to the problems in health care insurance says more about the failure of the private marketplace and the state legislatures than an endorsement of the Federal government.