December 2007 Archives

My latest Star Tribune column.

Q: I am one of that pending horde who will be turning 62 in the next year and have a question that I believe may be common to many of our fortunate number. Last year, I was able to leave my management position at a Fortune 500 company after enough years to take a pension WITH health benefits. After giving myself a sabbatical, I began a lifelong dream of full time writing...BUT... From everything that I read, my [Social Security] benefits will be based on the last years of earnings before I begin drawing SSI. Every year that I wait, with zero income or below, doesn't that impact my benefit level adversely? Where can I find someplace where I can calculate the impact of waiting while having minimal earnings? Between my writing and volunteering over 30 hours weekly with Red Cross and some faith- based groups, I really don't want to take a job just to up the SSI, so any input you can provide would be greatly appreciated...Helen

A: Yes, you sure are part of a horde. The leading edge of the 76 million strong Woodstock generation hits 62 in 2008. But unlike some of your peers you're in good financial shape. And I think it's wonderful that you're in a position to pursue your writing interests and volunteering in the community.

I don't think you need to worry about your Social Security income and what you earn in the next few years. The underlying benefit formula is complicated, but it's built on a foundation of your highest inflation-adjusted earnings for 35 years. To put it somewhat differently, Social Security is based on income during your working career, and not just the last three or five years of earnings. The AARP has a write-up of the benefit formula on its website at www.aarp.org/research/socialsecurity/benefits.

I'd encourage you to run some numbers. The Social Security Administration offers three benefit calculators ranging from the quick and dirty to the detailed and comprehensive at www.ssa.gov/planners/calculators.htm. Another place to go is the website www.analyzenow.com. It's run by Henry "Bud" Hebeler, formerly a high ranking executive at Boeing. He has a number of Social Security calculators, including one that will help you decide whether to apply for Social Security at age 62, 66 or 70.

Q: Hi Chris,

I am thinking of transferring some money into a TIAA-CREF money market account because the account has a higher interest rate than the checking account with my bank. After the transfer, the TIAA-CREF account would have $125,000 in it. Given that the FDIC only insures money up to $100,000, would it be unwise of me to transfer this money and go over that limit? Should I consider opening a second money market account at TIAA-CREF or elsewhere? Thanks so much!!

A: The answer involves shades of risk. First, a basic point: The Federal Deposit Insurance Corporation has nothing to do with the TIAA-CREF money market mutual fund. It's a billion dollar-plus mutual fund that invests in commercial paper, U.S. government agency securities, certificates of deposit, and other short-term debt. (All of the funds securities mature in 397 days or less.) Your security comes from diversification and the high quality of the short-term debt the fund invests in.

Now, the mutual fund industry periodically gets roiled by the risk that a money market mutual fund will "break a buck." In other words, the promise of a money market mutual fund is that if you put a dollar into it you will at minimum get a dollar back at withdrawal. As far as I am aware, the value of no major money market mutual fund has fallen so much that withdrawals have been worth less than a buck. However, I am aware that in some cases the parent company has injected cash into the money market mutual fund to preserve its value.

Right now, there are concerns about money market mutual funds that invested in securitized mortgage securities that have gone south in value. That's why I always recommend that investors put their money into a brandname financial institution with the financial resources to support a money market mutual fund if it becomes necessary. TIAA-CREF is a good, sound institution. If you're comfortable with the minimal risk that goes along with a money market mutual fund, then you should be comfortable keeping $125,000 in the account.

If a money market mutual fund is too risky for you and you want the financial security of FDIC insurance, then keep the money at a bank in insured accounts, such as certificates of deposit, a savings account or a bank money market deposit account. All of these types of accounts generally are insured by the FDIC up to the legal limit of $100,000 per depositer per bank. (Retirement accounts where the investments are in bank deposits are insured up to $250,000.) Since accounts at different banks are insured separately, the simplest way to hike your coverage is to keep less than $100,000 at any one bank. The FDIC has a lot of good information at its website www.fdic.gov.

Q: I recently heard that Credit Scores are lowered each time a request for a score is made. This seems incredible to me so I wondered if Chris could clarify this for me... thanks, Ernie

A: This is an area with a lot of confusion. Here's what you can do without impacting your credit score. You can check your own credit report as often as you want with no implications for your overall score. The industry understands that in an era of identity theft and rampant credit errors it makes sense for you to check your credit report at the three major reporting agencies at least once a year--and preferably more often than that. In addition, for two categories of purchases, the industry provides a safe harbor. When you buy a house or a car, the credit scoring business knows that consumers shop around for the best financing deal possible. However, if you drag out the process over several months and lenders keep making requests to view your credit report your credit score will take a hit.

Now, there is an impact when credit card companies and other lenders make a "hard inquiry" on your credit history. (There's no impact from a "soft inquiry" when lenders ask for your credit report to make a preapproved offer.) So, if you already have a handful of credit cards (a subject for another column) I'd think twice before applying for another.

The latest market review is out for the month of November from money managers Aronson + Johnson + Ortiz.

The highlights:

Worst monthly stock market performance since 2002

No bright spots--except for bonds and cash

Growth and size relatively strong--large growth on top, small value on bottom

International, though down, is solid for the year; emerging markets, though sharply down, are spectacular for the year!

Here are some total return equity market figures for November:

S&P 500 -4.18
S&P Reit -9.24
Russell 2000 -7.18
Dow Jones Industrial Average -3.63
MSCI ex-U.S. (international index) -3.89
MSCI emerging markets -7.14

The comparable figures for cash equivalents and bonds:

Vestek 90 day Treasury bills +0.57
Vestek Long Treasury Index +4.40
Vestek Broad Bond Index +2.18

Having criticized U.S. Treasury Secretary Henry Paulson for not taking a leadership role with the subprime crisis, it's good to see that he is adopting an idea put forward by the head of the FDIC and adopted by Governor Arnold Schwartzenegger in California: A rate freeze on the adjustable rate subprime mortgages that will reset at a higher rate in 2008. Estimates are that there are more than $350 billion in such mortgages nationwide that will reset in 2008.

From the news reports he is negotiating a temporary reprieve (and it's unclear how long the freeze will last; my guess is up to five years, a long enough period of time for the real estate market to revive.) I'd prefer a permanent freeze. Nevertheless, for those that are able to make payments on their adjustable rate subprime mortgages at current rates (typically between 7% and 9%) but won't be able to stay current on their payments when their mortgage adjusts to 11% to 13%--or higher--this is good news. It's also a boon to the economy.

To be sure, the plan will bail out some speculators and wealthy homeowners that gambled with a subprime loan. But that's always the case with a comprehensive solution. But these folks are also in the minority. And all the evidence we have in recent months is that the case-by-case loan modification attempts between lending institutions and homeowners wasn't working out. As Federal Reserve Board vice-chairman Donald Kohn said in a recent speech, there's "no need to hold the economy hostage to teach a very small minority of the population a lesson."

With the freeze, homeowners are still obligated to pay their mortgage. By the way, let's be clear: These homeowners aren't paying "cheap" rates. Certainly, that the message of recent Congressional testimony by Michael Krimminger, a special advisor to the head of the FDIC. "The typical structure of these loans is to provide for a starter rate (typically between 7 and 9 percent), followed in 24 or 36 months by a series of steep increases in the interest rate (often totaling 5 percent or more) and a commensurate rise in the monthly payment," said Krimminger. He went on to say that " Almost three quarters of subprime mortgages securitized in 2004 and 2005 were structured in this manner, as were over half the subprime loans made in 2006. Most of these loans also imposed a prepayment penalty if the loan was repaid while the starter rate was still in effect."

This is a disgrace. Lenders should be ashamed of themselves. I don't mind teaching lenders a lesson. It doesn't bother me in the least that the balance sheets of banks and other lenders that wrote these loans take a hit. I just wish it was permanent rather than temporary.

Thanks to economist and blogger Greg Mankiw. A great send-up by two British comics of financiers and the subprime crisis. Enjoy.

"Moral hazard" is a major economic and financial concern of recent years, especially among conservatives.

Here's how the Economist dictionary defines moral hazard: "One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE..... Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for."

Now, moral hazard is frequently invoked by conservative commentators to complain about any proposal for universal health insurance. The same goes for attempts by the Federal Reserve Board to use monetary policy to offset recessionary forces (the Fed ends up encouarging greater risk taking as people decide the Fed will bail them out when times turn bad, or so we are told). And now I'm reading plenty of commentary complaining about moral hazard with the federal government's negotiated subprime mortgage bailout. All it will do, we're told, is encourage future reckless behavior when it comes to real estate.

The commentary has a tone reminiscent of U.S. Treasury Secretary Andrew Mellon's infamous declaration during the Great Depression: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Of course, we now know that his proposal was exactly wrong. Worse yet, Mellon went on to proclaim that panics (read recession) weren't all that bad: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people”...

Right. Yes, moral hazard can be an issue, but it seems to be greatly exaggerated at the moment, especially when it comes to Fed actions and the mortgage bailout. Look, we are losing appreciation of a unique and powerful aspect of our capitalist culture: The second or third chance. Giving workers a second or even third chance unleashes energy into the economy. The notion of another chance lies at the core of our creative and entrepreneurial economy. It's part and parcel of capitalist optimism.

A very sour mood is settling over public policy discussions today--a mean-spirited, zero sum game approach. I don't buy it. Capitalism isn't a zero-sum game. Moral hazard isn't a big worry. Let's not lose sight that a second and third chance, maybe even more--matters to individual risk-taking and wealth creation.

Banks are 'fessing up. Here's Bank of America chief executive officer Ken Lewis: "A number of participants--including Bank of America--have forecast sizeable writedowns, particularly in Collateralised Debt Obligations (CDOs). Based on conditions today, we expect those writedowns to be larger than have already been reported--although obviously we won't know our final numbers until we close the fourth quarter."

Remember last quarter when banks and Wall Street firms announced major write-offs, but tried to put a glossy spin on the news? They suggested that they had pursued the "kitchen sink" approach toward earnings--get all the bad news out at once.

But that wasn't the case. Instead, a much better metaphor is the the cockroach theory of finance. There's no such thing as one cockroach. And like cockroaches, bad financial news tends to scurry out over time.

Stay tuned.

The economists and market-watchers at UBS have come up with their annual list of 10 potential financial and economic surprises for 2008. Here is their list of possible outcomes that go against the grain of current conventional investing wisdom:

1) Global growth surprises on the upside

2) Oil prices: Is 50 the new 20?

3) The dollar appreciates

4) World trade clouds

5) Developed deflation, developing inflation

6) Financials outperform

7) Emerging equity markets under-perform

8) Japanese equities outperform

9) Equity volatility settles at lower levels

10) Chinese inflation falls sharply

If you want to read their reasoning, click here. Download file

This is an important number, courtesy of the Urban Institute. People in the bottom 20% of lifetime earners can hike their retirement income by 98% if they work five more years instead of retiring.

And people are working longer. Specifically, between 1988 and 2007 the labor participation rates of women rose by about 20 percentage points for those age 55-64 and doubled for women age 65-69. When it comes to men, between 1992 and 2007 participation rates for those age 62–64 increased from 41 to 51 percent, a hike of 24 percent over the 15-year period. Over the same time frame, male participation rates at age 65–69 increased from 22 to 34 percent, an increase of about 55 percent.

The Urban Institute also notes that traditional retirements--meaning a direct transition from full-time work to no work--is not the norm. For instance, about 60% of older people work after retiring from career jobs; about one-third of workers change occupations after age 51; and about one-quarter of older adults "unretire," returning to work after leaving the labor force.

Problem is, employers aren't very interested in hiring older workers. We all know that. I think this will change with time, but it's the reality faced by many aging workers who still have a major contribution to make at the workplace.

To delve farther into the issue, check out these two papers from the Urban Institute: Download file and Download file

Arnold Kling, entrepreneur, Othello tournement player, blogger, and economics professor at George Mason University--among other things-- has a chilling post on his blog. Well, chilling if you live in California, New York, or Miami.

Commenter Jim M. points to Housing Tracker as a source for data on house price to income ratios. Here is a list of the top cities in terms of median house price relative to median income.

Overall, it looks as if prices may have to fall almost 50 percent in the top 7 markets, but in many other markets they don't have to fall at all.

However, I wouldn't take too much comfort from this if you live in a non-coastal metropolitan area. Considering the historic surge in real prices by 44% between 1995 and 2005, even in those markets where the price/income ratio is more reasonable it's likely that residential real estate prices will stagnate for years.

That's still a much better outcome than the 30% to 50% drop that some coastal cities might face. Those percentages are extreme, but they aren't outlandish, either. For instance, LA home prices declined by about a third in real terms in the early '90s with the "peace-dividend" induced real estate bust.

I find this troubling. Disdain at overweight and obese women is an increasingly acceptable prejudice. "The stigma of obesity has actually worsened in the past 40 years with the increase in prevalence of obesity. The bias [has become] more socially acceptable," says Rebecca Puhl of the Rudd Center for Food Policy and Obesity at Yale University.

That quote comes from a new paper that shows the pejudice has real world financial consequences. It's a report from the Bureau of Labor Statistics: "Women's Increasing Wage Penalties from Being Overweight and Obese."

The paper looks at annual surveys between the 1981 and 2000 of the National Longitudinal Survey of Youth--as well as other data sets--to estimate the effect of being overweight on hourly wages. Previous studies, say the authors, have shown that white women are the only race-gender group for which weight has a statistically significant effect on wages. Their paper finds a statistically significant continual increase in the wage penalty for overweight and obese white women followed throughout two decades.

Here's the scholars' conclusion: "The increasing wage penalty corresponds to current psychological research that demonstrates increased weight stigmatization in the United States. Further, as larger women age, their wages incur the effects of years of cumulative discrimination. With other factors controlled, their starting wages are lower.... This paper has shown that an obese 43 year-old woman received a larger wage penalty in 2004 than she received at 20 in 1981. This paper also provides some evidence that an obese 20 year-old woman receives a larger wage penalty today than she would have in 1981 at age 20.... It can be concluded that increased body weight has drastic economic consequences that have grown over time."

In the 1980s, there was a lot of concern about foreign companies and investors snapping up U.S. assets. Most of the worry was concentrated on the Japanese, although British companies and European companies were also active buyers. With the benefit of hindsight, American companies got the better end of the deal, with Japanese corporate investors paying top dollar. And in a number of cases U.S. investors and companies bought back the assets at a much cheaper price.

This time appears to be different. The sovereign wealth funds are purchasing stakes in leading U.S. financial institutions on the cheap. They're getting a good deal, smartly taking advantage of the turmoil in the credit markets. I also think that we should encourage more investments from the sovereign wealth funds as they will knit closer ties between the U.S. economy and much of Asia and the Middle East.

The National Foundation for Credit Counseling (NFCC) has a tongue-in-cheek list of resolutions for the New Year. These are resolutions you can enjoy breaking--don't feel guilty!

*Apply for every credit card offer you receive in the mail. (Makes your credit score lower.)

*Charge everything, even those items that you could easily pay for with cash. (Runs up a large debt load.)

*Don't open the monthly statements from your creditors in a timely manner. Instead, wait until it's convenient for you. (Equals late charges.)

*Don't pay any attention to your credit card limit, just keep charging. (Results in over limit fees.)

*Open store charge accounts simply because they'll give you 10 percent off of today's purchases. (These accounts usually carry a higher interest rate than a general-purpose card, and one more charge card is one more temptation to spend.)

*Take advantage of all "buy now and pay later" offers, and then ignore the due dates. (The zero percent interest will probably skyrocket to double digits if you don't comply exactly with the fine print. Further, the interest will likely be applied all the way back to the date of purchase.)

*Take out cash advances through your credit cards. (These are at a much higher interest rate than normal charges.)

*Use the convenience checks that come in the mail. (They're a come-on to add to your debt load.)

*Transfer balances to a new credit card with a low interest rate, and then charge, charge, charge. After all, it's a low rate, so what will it hurt? (The rate will likely go up in a few months. Then you'll owe the balance you originally transferred, plus all the new charges. You're worse off than when you started.)

*File for bankruptcy. After all, your neighbor did this and lives like a king. (He's not telling you the whole story. What interest rate is he paying? Yes, you'll be extended credit after bankruptcy, but you'll pay for it.)

*Buy a new car and finance it for the maximum number of months. (Your debt may outlive your car.)

*Never save a dime. Hey, tomorrow will be better. (Tomorrow probably holds as many bumps in the road as today.)

*If you get in a bind, rely on money from payday loan companies. (Interest can range into the triple digits.)

*Carry your Social Security card in your wallet. (This is the gateway to your identity and will be a real bonanza to the thief who steals your purse.)

*Count on someone else to make your financial future secure. (There is little job loyalty, divorce is rampant, Social Security is uncertain, and baby boomers are the first generation to retire without a pension.)

Q: My employer will be offering the option to switch all or some of my 401(k) contributions to a Roth 401(k) starting 2008. So the question is; all, some, or none?... As I understand it, the question comes down to paying the taxes now or later. Anonymous

A: First, a quick definition for our readers. The big difference between a traditional 401(k) from a Roth-401(k) is taxes. Your contributions to a 401(k) are made with pretax dollars. You pay taxes on the savings when it's withdrawn during retirement. With a Roth-401(k), your contributions are made with aftertax dollars. But the money comes out tax free at withdrawal.

Both plans are good. The bottom line is that you can't go wrong. Which one is better for you comes down to a combination of math and tax assumptions, although I think for most people the Roth-401(k) holds an edge. The higher your tax bracket in your old age the better the Roth-401(k) looks. For instance, young workers in a low tax brackets should look closely at a Roth 401(k). The odds are that their incomes will rise during the course of their career, putting them in a higher tax bracket. A traditional 401(k) becomes more attractive if you think your tax bracket will drop during retirement. There are a number of calculators on the web that will run some numbers for you. I've played with one offered by Smart Money at www.smartmoney.com/retirement and another by Bloomberg at www.bloomberg.com/invest/calculators.

One other thought: Doing both isn't a bad idea. You'll pick up tax diversification. After all, who knows what tax brackets will be 10 to 30 years from now?

Q: Would it ever be a good idea to forego an employer's 401k in favor of a Roth? I'm 46, single and have been saving 15% of my income in a 401k since I was 22 resulting in about 500K in savings. My current employer doesn't match my 401k, that is, they're not profitable enough to match it... John

A: I get variations on this question a lot. The answer is easy when there's an employer match. Everyone should at least fund their 401(k) up to the match. It's the match that truly boosts your return on savings. Then if you have the money and qualify you can also fund a Roth-IRA.

But what about circumstances like yours where there is no match? I'm assuming your company offers a good mix of mutual fund options coupled with low fees. If that's the case, next year you'll be able to set aside a maximum of $15,500 in your 401(k) ($20,500 if you are over 50). The limits on a Roth are $5,000 ($6,000 if you're over 50). You can set aside a lot more money every year with the 401(k), and that's certainly attractive. So, I wouldn't stop taking full advantage of it. Rather than forego the 401(k), how about a mix of both?

By the way, to make a full contribution to a Roth-IRA for 2008 your income must be under $159,000 if you file jointly and below $101,000 for a single filer.

The only reason to abandon your 401(k) is if your employer's plan is a high-fee bad-choice menu of investment options.

Q: My husband's sister has 4 kids. We have been looking into opening 529s for each of them and putting money in the accounts for them for Christmas gifts, Birthdays, etc... We were concerned that opening accounts for them would affect the later opportunities for applying for financial aid, whether in terms of grant money, loans and scholarships. But it seems to us that the money found in a 529 is not totally considered against them for these types of programs. Is that true? I guess I would like to know what the pitfalls are for opening a 529 versus doing some other type of investment for their education. Leanne

I like 529 college savings plans. The plan is funded with aftertax dollars, but the money compounds tax free. It's also tax-free money if it's withdrawn to pay for qualified educational expenses. In most cases, there are no income or age limits, and the money that can be set aside is substantial, up to $300,000 in a number of plans. Anyone can contribute the child's account, including parents, grandparents, relatives, and friends. The savings plan also gets favorable treatment under the current financial aid formula. When it comes to paying for college, parent-owned accounts are assessed at 5.6% and by law 529 accounts are considered parental assets.

By the way, the plan beneficiaries are not locked into attending school in their state. The accumulated savings are available for college--public or private--and in any state. A good place to research 529 plans is www.savingforcollege.com.

The biggest disadvantage is that the government imposes steep penalties if the money isn't used for education expenses.