Marketplace

Traditional pension and bonds (and stocks)

Question: I am hoping to retire in 5 years at age 62. I've got a three-part retirement plan: a government pension, social security and a 457k. Rather than following John Bogle's advice to invest in bonds at a percentage = to your age, I invest my 457k mostly in stock funds, reasoning that the pension is kind of the equivalent of the more secure bond funds. Also, I expect to be drawing from the 457k for maybe 30 years, which seems like another good idea to keep it in stocks for awhile. What do you think? I've never seen this question addressed before. (I wish I had asked this question before the current financial crisis - I don't mean to gloat over having an actual pension.) Connie, Portland, OR

Answer: Your question illuminates the value of a traditional defined benefit pension plan, the kind that pays out a monthly income to a retiree based on a salary and years of service formula. But fewer and fewer workers are covered by that kind of pension plan. Take this paragraph from a recent research paper by David F. Babbel, finance and insurance professor at the Wharton School and Craig B. Merrill, professor of finance and insurance at the Marriott School of Management.

The economic implications for the average individual are significant. Under a traditional pension program, the retiree receives a set monthly income for as long as he or she lives. Under a defined contribution program, such as a 401(k) or 403(b) program, the amount of income you collect after retirement and how long you continue to receive it is anyone's guess. There are no guarantees. In effect, the risk of retirement has been shifted away from the employer and the PBGC that insures the pension benefits, and placed upon the shoulders of the employee. Put another way, the financial risk of retirement has been transferred from those best able to bear it to those less knowledgeable and least able to bear it.

I think it's a good idea to treat the pension plan as the equivalent of fixed income. Those regular payments make it a bond-like portion of your portfolio. "Too many investors forget that Social Security and pension benefits are fixed-income assets," says Jack Bogle, the legendary founder of the Vanguard mutual fund.

In other words, your overall insight is sound and you can hike the equity portion of your 457 defined contribution pension plan. As an aside, I agree with you that you have time on your side with your equity investments. Brad DeLong, economist at the University of California, Berkeley and former assistant U.S. Treasury secretary during the Clinton Administration, recently made a compelling case for equities. He notes that stocks have been a terrible investment over the past decade, and that the recent 40% or so decline may not be the end of the bad news.

Still, with a time horizon of one to two decades, he argues the math favors stocks. "At the moment, the yield-to-maturity of the 10-year US Treasury bond is 3.76 percent. Subtract 2.5 percent for inflation, and you get a benchmark expected real return of 1.26 percent. Meanwhile, the earnings yield on the stocks that make up the S&P composite is fluctuating around 6 percent: that is how much money the corporations that underpin the stocks are making for their shareholders.... Thus, the expected fundamental real return on diversified US stock portfolios right now is in the range of 6 percent to 7 percent.

The whole article is well worth reading.

As for your traditional pension, a few risks to keep in mind. The insight that it's a bond like part of your portfolio doesn't tell you how much to have in stocks and bonds. For another, inflation can erode the value of that pension. While many government defined benefit plans do increase the payout along with increases in inflation, not all do. Almost all private sector traditional pensions don't take inflation into account. Check out how your pension deals with inflation. I would consider adding Treasury Inflation Protected securities or TIPs to an overall portfolio.

In addition, I wonder if the pension plan should be treated as the equivalent of a corporate bond. After all, many public and private sector pensions are under financial strain and there is always the risk that benefits could be cut into the future.

11/03/08 by Chris Farrell

Permalink

TIPS

Question: With our 401(k) and 403(b) accounts having seriously tanked during October, we're becoming more intrigued with TIPS. But we don't really know how to go about investing in this vehicle -- or if we should even consider this as an option. Can you recommend a good resource to learn more about this and how one can get started? Fred and Dana, Omaha, NE

Answer: As you know, I'm a big fan of investors putting their safe, long-term money into Treasury Inflation Protected Securities or TIPS. I have just the recommendation for you, too. It's "Worry-Free Investing " by Zvi Bodie, a leading finance professor at Boston University and Michael J. Clowes, a long-time journalist and editor.

Several years ago I wrote a book review of Worry-Free Investing. The review came out around the time that the stock market was finally doing better following the false rallies in the fourth quarter of 2001 and 2002. Here's an excerpt:

...Bodie and Clowes' investment advice resonates with the harsh lessons of a three year long bear market. Instead of asking, "How much money will I make?" their fundamental financial question is "How much can I afford to lose?" Stocks, they believe, are too risky for many people to achieve financial security even when held for long periods of time. Instead, their idea is to lock in a long-term standard of living while taking as little risk as possible. Their preferred investment is U.S. government inflation protected securities that preserve the purchasing power of a dollar against the ravages of inflation. Other investments they highlight include the value of Social Security, annuities, and a home. "Worry-Free Investing" is simply written, and well illustrated with examples. The authors walk you through the mathematics of their computations so you can do them on your own with a simple calculator.

Still, their basic message is timeless. The economic idea underpinning the book is that most people don't want to get rich, or perhaps more accurately, aren't willing to make the gambles that could just as well lead to bankruptcy as a flush bank account. No, most people want to sustain their standard of living throughout their life. The way to accomplish that goal is to limit downside risk and preserve the value of money set aside today that will be tapped in your golden years. "If you want to sleep nights secure in the knowledge that you will achieve your savings goals, you must invest in a way that eliminates the possibility that inflation will undercut your efforts," say Bodie and Clowes. "If you try to do it by saving less and expecting the stock market to do the heavy lifting, you may not get there at all."

The authors don't dislike stocks. They just think stocks are much riskier than conventional wisdom holds and that it's only sensible to roll the stock market dice after locking in your baseline financial goals...

Check it out. I think you'll find solid financial insight along with plenty of details on how TIPS might work for you.

11/04/08 by Chris Farrell

Permalink

Green investing

Question: Can you suggest some places to search for good environmental/green energy mutual funds? My REIT (PLD) has plummeted to an unbelievable low and I was thinking of riding it back up, but also wonder if a change to renewable energy fund or some other environmental fund would be a better choice. I listen to the show most every week. Thanks Chris, Kathleen, Carmel CA

Answer: Investor interest in putting money into green mutual funds has been growing in recent years. However, the sector has been hit hard along with the rest of the stock market so far this year. What's more, the sharp drop in oil prices has put additional downward pressure on the alternative energy and green universe.

For instance, I just looked up some return figures on a handful of the better known green mutual funds and companies. The total return to investors on the Winslow Green Growth fund is -56%, year-to-date. The comparable figure over the same time period for the Calvert Global Alternative Energy Fund is -54%, the Guinness Atkinson Funds -57% and the New Alternative Funds -45%. A number of small alternative energy companies have cratered recently, especially after Verasun Energy, the large ethanol producer, recently filed for Chapter 11 bankruptcy protection. For example, AE Biofuels is down 52% and Clean Energy by -50%, year to date.

Still, it's an intriguing investment play. I can't imagine that the enthusiasm for green companies and alternative energy will wane over the long haul, especially once global growth picks up and worries about climate change move back to the fore. Indeed, President-elect Barack Obama said his Administration would "invest $15 billion a year over the next decade in renewable energy" in a recent Wall Street Journal Op-Ed piece. .

As an aside, the biggest rap against socially responsible investing is the belief that marrying personal values to an investment portfolio cuts into returns. In other words, doing good and making money don't mix. I don't agree. A number of academic studies suggest there's little difference between pooling money to make money and pooling money to make money and express values. This came home to me in a series of papers by Meir Statman, a finance economist at Santa Clara University. Among his conclusions, the risk-adjusted return on socially conscious index funds (yes, I still favor index funds) is roughly comparable to the Standard & Poor's 500 index. The performance of actively managed socially responsible mutual funds is about equal to their conventional actively managed mutual fund peers.

One note of caution: Socially responsible funds tend to have high fees that cut into returns. For instance, the mutual fund rating service Morningstar says the levy on green mutual funds range from 1.25% to 1.98%. "We're generally wary of pricey funds because high fees are one of the most powerful predictors of future underperformance," writes Michael Herbst, mutual fund analyst with Morningstar.

Two good places for additional research are socialinvest.org and socialfunds.com.

11/05/08 by Chris Farrell

Permalink

Municipal bonds

Question: Would you suggest waiting until the "dust" settles before starting to invest in muni bond funds, as opposed to CDs at this point? We would like to have some more tax exempt investments. I worry that some local govts still have trouble renegotiating insurance on their bonds. We are almost at retirement age, and have our money at this point, in Treasuries and CDs. Beth, Indianapolis, IN

Answer: Tax exempt bond yields are still very attractive relative to taxable fixed income securities like U.S. Treasuries and certificates of deposit. But that higher yield reflects greater risks. State and local government revenues are falling with the economy in recession. There are concerns that the muni bond default rate could be unusually high during the latest downturn. The insurance on tax exempts is essentially worthless. For example, on November 4, Vanguard announced plans to merge its $3.2 billion Insured Long-Term Tax-Exempt Fund into its $2.8 billion Long-Term Tax-Exempt Fund. "The municipal bond market has changed to a point where insured bonds provide little, if any, additional benefit over high-quality uninsured credits. We concluded that a fund focused solely on insured bonds no longer provides tangible benefits," said Gus Sauter, Vanguard's Chief Investment Officer. "Shareholders will be better served by merging the two portfolios to create a single, well-diversified, high-quality fund."

So, part of the answer is whether you want to move your money out of default free securities--U.S. Treasuries and CDs if under the $250,000 FDIC limit--into a slightly riskier investment. My bias is toward conservatism. If you think the extra yield is worth the risk with at least some of your money I would stick to a high-quality broadly diversified tax exempt mutual fund portfolio. Don't reach for even higher yields by investing in the riskier sectors of the muni market.

11/06/08 by Chris Farrell

Permalink

Shut down the stock market?

Question: Dear Marketplace, I have been thinking about this for some time, but could never find an answer on my own, so I am hoping you can help me out. Every weekend and on several holidays, the US Stock Market (and every stock market it seems) closes. During that time, the market doesn't go up or down, and thus while people are not making money they are also not losing money.

I remember a few months ago that one of the world's stock exchanges was closed, and looking at the history from the NYSE website, it has closed or had part-days hundreds of times in the past for various reasons.

Can the government force the closure of the stock exchange if the stock prices fell too low or too quickly? Is it economically viable, or wise, to keep the exchange closed for more than a day in order to stop the decrease in values of people's mutual funds, stocks, IRA's etc? Would such a period cause stock brokers to want to sell more and faster when the exchange would be re-opened, or would such a closing allow people to "cool down"? (Though the last question is more of a social/psychological question) Thank you for your time. Douglas, New York, NY

Answer: I recently pulled a wonderful book of financial history off my book shelf at work. It's "When Washington Shut Down Wall Street," by William Silber. He's a finance economist at New York University's Stern School of Business. I've only just started it but it's a tale of U.S. Treasury Secretary William Gibbs McAdoo taking dramatic action in the summer of 1914--before the Federal Reserve opened for business. The outbreak of World War I threatened the U. S. with financial disaster. The dollar was falling, and investors feared that the U.S. would go off the gold standard. Gold was flowing out of the country. McAdoo closed the New York Stock Exchange for more than four months "to prevent Europeans from selling their American securities and demanding gold in return. He smothered the country with emergency currency to prevent a replay of the bank runs that swept America in 1907. And he launched the United States as a world monetary power by honoring America's commitment to the gold standard," according to the book's blurb.

The New York Stock Exchange has been periodically shut down, the last time following the tragedy of 9/11. Another notable moment was during the Bank Holiday of 1933. Today, there are also procedures in place to stop trading if the market plunges too far too fast. (See my earlier post on the daily trading downward limits, "Where are the stock market "circuit breakers"?")

Indeed, New York University economist Nouriel Roubini on October 23rd predicted that policy makers might be forced to close financial markets as the panic selling accelerated. They didn't, but the next day the U.S. stock futures market stopped trading. Declines of more than 6% tripped the circuit breakers at the opening. Still, the stock markets circuit breakers are only designed to stem a panic, and at most are imposed for a day.

The President can close the stock markets. Nevertheless, while most economists recognize that stock markets can or should be closed at extraordinary moments, most would argue for keeping the practice a rarity rather than an acceptable tactic. The reason is that it's almost always far better to let buyers and sellers try and figure out where the market is going, and then let the traditional evening close stop trading. (Of course, in a high-tech global capital market the reality is that trading continues in other markets and in different time zones.) The real risk is that a government-mandated shut down for any period of time can make the panic worse. About a decade ago, the late Nobel Laureate Merton Miller told Business Week that ``You want the price to fall, because that will bring buyers out of the woodwork.''

11/07/08 by Chris Farrell

Permalink

Capital losses on home sale

Question: My wife and I were fortunate enough to sell our home in North Minneapolis last May, but we did end up bringing our checkbook to closing. We sold our house for a bit less than we owed. We were told at the time by a couple of professionals (a CPA and an investor) that we cannot write those losses off when we do our 2008 taxes. I was wondering if any of the bailout plan signed by congress and the president changed any of this to favor us, or if you see any chance that someday we could get a kick back for our loss? Thanks! Andy

Answer: The information you got from the CPA and an investor is right: Any loss from the sale of your main residence can't be deducted on your tax form come April 15.

Of course, tax cutting is high on the legislative agenda with a new President and a new Congress confronting a recession that's getting worse by the month. A hodgepodge of ideas is in circulation. The more popular proposals include suspending mandatory distributions from 401(k) plans and the like for those 70½ and older, allowing taxpayers to take out as much as $10,000 penalty- free from their retirement accounts (you'd still pay taxes on the withdrawal), getting rid of income taxes for seniors making less than $50,000 a year and allowing a 10% mortgage tax credit for any homeowner that doesn't itemize.

The notion of allowing homeowners to take into account capital losses on sales usually gets short shrift. It's a concept that gets a hearing every time there's a downturn in the residential real estate market. But homeownership is already such a tax favored investment that even the housing-and mortgage-friendly Congress has rejected this tax initiative in the past.

I can't handicap the odds, but the traditional avoidance of capital losses on home sales could weaken. For one thing, the idea of allowing homeowners to take capital losses has been making the rounds in the blogosphere. For another, there is a growing sense that the federal government needs to direct more aid to homeowners and less to financial institutions. For example, reading the Washington Post this morning I learned that Treasury Secretary Henry Paulson had--with little comment--changed the tax law to eliminate strict limits on the losses banks that take over other banks can deduct from their taxes later on. The restriction had been on the books for more than two decades. It was intended to put an end to an increasingly commonplace tax shelter abuse. Although not directly comparable, I can't help but think: If it's good enough for financial institutions why not for the homeowner?

However, in terms of personal financial planning, I wouldn't bank on the capital gains tax law changing when it comes to housing.

11/10/08 by Chris Farrell

Permalink

Life insurance for a young military family

Question: I am the 22 year-old mother of a 6 month-old daughter. I am currently unemployed while I take classes to complete my college education and my Husband is deployed with the National Guard overseas. I am concerned about my family's financial future if anything should happen to either myself or my husband. I would like more information about various life insurance options. What kinds are there? What is the difference between the types? How do I pick what one is right for my family? Are there any books or online resources with accurate and easy to understand information? Thank you for your time and help. Sincerely, Jodi, Jonesboro AR

Answer: This is a fittiing question for Veterans Day. First of all, since your husband is on active duty with the military you should be automatically covered for $400,000 in life insurance benefits through Servicemembers' & Veterans' Group Life Insurance. Here's what the handbook says: "Members on active duty, active duty for training or inactive duty for training and members of the Ready Reserve or National Guard are automatically covered for $400,000, the maximum amount of coverage."

He can also purchase up to $100,000 of SGLI coverage for you, in increments of $10,000.

The policy offered by the government is a "term" life insurance policy. Term life insurance is a pure death benefit. It doesn't pay dividends and there isn't any cash savings attached to the policy.

The section of the U.S. Department of Veteran's Affairs website that describes the life insurance benefit offers good information, including details on the policy, a calculator for figuring out how much life insurance you should carry, a life insurance glossary, and a description of the basic types of life insurance.

The differences between life policies matter a lot if you and your husband decide your family needs more life insurance--especially adding more coverage for you in case something happened to you.

Life insurance comes in two basic flavors. The first I've already mentioned, term insurance. Term insurance is a simple product, easy to understand, and it allows for competitive comparison-shopping for the best mix of price and coverage. You'll want a low cost, plain vanilla policy from a blue chip, financially strong life insurance company. Term insurance is ideal for most families with insurance needs, like you.

Cash value is the other major kind of insurance. Cash value insurance always comes with a tax sheltered savings component as well as a life insurance policy. Cash value life insurance can be complicated. There are all kinds of policies, from whole-life, universal-life, variable-life, variable-universal life, and so forth. Depending on the type of cash value policy, the insurance company may invest the savings for you or you may choose from a menu of investment options. The premium may be stable for the life of the policy or you may vary your payments. In general these policies are expensive.

11/11/08 by Chris Farrell

Permalink

Co-sign a loan?

Question: My daughter and son-in-law have an empty "underwater" condo. We all shudder at the thought of renting it out! It's hurting them to be paying a mortgage and other expenses while not living there, so they hope to sell it in 2009. They will owe around $25,000 more at closing than they will receive. I am considering either loaning them the money at a rate about what I can earn on a CD or other savings, OR co-signing a loan from their bank or credit union. I trust them to make payments either way. What are the advantages and disadvantages of either of these plans - for them AND for me? Carol, St. Cloud, MN

Answer: I am not a fan of anyone co-signing a loan from a bank or credit union no matter how much you trust the person. You know them, and you know that they are trustworthy people. But sometimes even very good people can't pay a loan because of a lost job or big medical bills. And then you are on the hook to make the loan payments if you co-signed the loan.

I have been getting more questions lately about co-signing. It's a reflection of tough economic times. Although the circumstances are very different from yours, I want to highlight another email I recently received from a listener. It's from Gregory in Irvine, CA, and it offers a grim reminder of the risks of co-signing:

I co-signed a car loan for a friend and right now there is about 4,000 owed to it. This was a mistake that I regret a great deal because it turns out my friend is not responsible with money and I have just learned he lost his job a few weeks back. I no longer talk to this friend of mine and I do not want any communication. Last week Wachovia, the loaning business, called me and told me that this last months car payment is 15 days over due and they will report the late payment in another 15 days. Please help. I do not want to bail out my former friend for a car he never should have bought in the first place, yet I do not want my credit to be destroyed. Can I refinance the car in his name alone? If the car gets repossessed will it really upset my credit that much? What should I do? What would you do?

Greg is legally obliged to pay up. The only solution I can see is Greg needs to swallow his distaste and approach his former friend and see if they can negotiate some kind of solution.

Since family relations are strong in your case, and everyone wants to avoid the renting option, I would lend the money with an interest rate to your daughter and son-in-law. Then if they fall on hard times the three of you can renegotiate the loan without the involvement of credit reporting bureaus, credit scores, or an impersonal financial institution.

11/12/08 by Chris Farrell

Permalink

From India: what to do?

Question: We are currently relocated for a year in Bangalore, India with a July 2009 date to come home. My husband is an IT consultant who has a retailer for a client so in naturally worried about a job when we return to America. The company gave no raises this year but we did receive a $7-8,000 bonus. My husband and I have started to discuss what to do with it--pay down the mortgage or invest in non-ira stocks to have some cash savings?

We have no other debt except a home mortgage and a vacation home mortgage and we have solid retirement investments (although these economic times are hard on the mutual funds and blood pressure!) plus a non-retirement money market account. We will save money by being an expat as many of our costs in India are picked up by the company. We have three children, the oldest is 13 and youngest is 9 so there will be some college costs coming up in the next 5 years.

We have discussed other forms of investment--do you invest in a business, or buy more property? Is there a more creative way to invest the money or is it better to "keep it simple stupid" approach? We have always valued you advice and was wondering what your thoughts are. Thank you, Monica, Bangalore, India

Answer: It must be a fascinating to live in India at this time. The economies of the U.S. and India are closely intertwined, and American companies have spent billions in investment dollars expanding in India since 2000, transforming urban centers. More recently, a number of Indian companies went on a global corporate buying spree. But now the global economic crisis is hitting the Asian giant hard.

Anyway, on to your personal finance question. Yes, as you know, I am a big believer in the KISS approach--keep it simple, stupid. I also believe in seizing an opportunity when it comes along. Right now, as you say, you have a unique opportunity to truly build up savings because you're living the ex-pat life. Take advantage of it. If it were me, I would stash away as much money as possible into safe investments that would preserve the value of your capital while making you a bit of money. Of course, none of these investments, such as Treasury bills and FDIC insured CDs, are very exciting.

Your new-found savings stash can do double duty when you come back. First, it's your safety money in case it is hard to find a job. It buys you or your husband or both of you time to look for a good job. But, let's say that you come back with jobs waiting for you. Then the savings is your opportunity fund. It's a safe bet that over the next several years those households with cash will have the ability to snap up bargains. You can also use the money to help out with college if that turns out to be the best use of the savings.

That's why I would recommend primarily focusing on increasing your cash savings. I think you are in a wonderful position. If you want to have some fun, put a slice of money into an equity index fund on the theory that the stock market will rebound at some point. Or you could take that slice of money and put it into a 529 college savings plan.

11/13/08 by Chris Farrell

Permalink

If a mutual fund company fails?

Question: If you own mutual funds through a company such as Vanguard or Fidelity, what happens if the company goes bankrupt. Do you still own the underlying equities or is your investment lost? If it varies by fund or institution, how do you distinguish between them? Stephen, Berkeley CA

Answer: What a long way we've come over the past year, and not for the better. Questions like this used to be highly abstract, but now we need to take them seriously.

In essence, mutual fund investors don't have to worry. Your investment isn't lost.

The money you've invested in the mutual fund is safe even if the fund company goes belly-up (like Lehman) or needs a federal bailout (like AIG). There are several lines of safety. For one thing, you're a shareholder in a mutual fund. Your money isn't an asset of the fund company itself. For another, you and all the other shareholders in the fund actually own the securities, not the mutual fund company.

What's more, the securities--stocks, bond, and the like--are held in a segregated custodial account, which is typically managed by a bank or trust. Mutual fund companies carry mandatory insurance. If it has a brokerage business, any accounts there will be covered by the SIPC. Another financial institution would likely swoop in and manage the mutual funds, too.

Of course, these layers of protection that ensure the money is yours do not affect the value of that money. And for most of us that means portfolios are off anywhere from 20% to 40%.

11/14/08 by Chris Farrell

Permalink

Emergency savings

Question: This is a basic question, but with everything that is going on I am confused. I am starting a job and I want to begin setting aside an emergency fund of three to six months of living expenses. This money is only for emergencies, so my primary interest is having access to it. What are the types of accounts or institutions I should consider for this emergency money, and what can I expect in terms of fees and returns? John, Palo Alto

Answer: You're not the only one that's confused at this time, and we're all asking very basic questions about our money. They're usually the best questions. The legendary investor Benjamin Graham once wrote that when challenged "to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Very simple. Very basic. Very wise words for all seasons, but especially at an unsettled time like this.

Now, stuffing our money into a couch--however tempting--isn't a good idea. I'd do nothing more glamorous that putting the money--or at least most of it--into a bank savings account, a money market deposit account, a short-term certificate of deposit and the like in an FDIC insured institution. (Credit unions have a comparable federal insurer.) Your money is completely safe up to $250,000 even if the bank fails, and you have easy access to it if you need it.

As for fees, a number of banks are hiking fees and penalties in an attempt to shore up their crumbling finances. And I thought fees and charges were already to high. It pays to shop around, and I'd look into community banks and credit unions. Here's is an email we got over the weekend about credit unions from Dana in Federal Way, WA.

I just got finished listening to your segment on interest bearing bank accounts. Minimum balance of $3500? Nope! My account is completely free. My checking account is through a credit union.

As a general rule the trade-off for safety is a very low interest rate on savings. But so what? The money will be there if you need it.

11/17/08 by Chris Farrell

Permalink

Buy a home?

Question: My fiancé and I are trying to decide whether or not it is a good time for us to buy a house. I am a PhD candidate earning a stipend and have savings for a down payment. He has a full time job as an analyst with a large aerospace manufacturer. We will definitely be in the Seattle area for another 2 years but aren't certain where we will go after that (once I graduate). We have heard mixed things about how long you have to live in an area for buying a house to be worth it and whether or not now is a good time to buy a house. Do you have any advice? Amanda, Seattle State: WA

Answer: Many people are wondering when it makes sense to get into the housing market again. After all, there have been double-digit price declines in most major markets. For instance, over the past year ending in August home prices are down 31% in Las Vegas and 27% in Los Angeles, according to figures compiled by the S&P/Case-Shiller Home Price Index. In comparison, Seattle has held up relatively well with a mere 8.8% decline over the same time period.

That said, I think there are more price declines to come. We're in a recession, and it took a turn for the worse in October. As far as I can see the economy in November is certainly no better than last month and probably worse. I can't imagine many people will extend their finances to buy homes until the scale and scope of the recession is clearer.

What's more, as a recent post on the Business Week Hot Property blog points out, by two common measures the housing market is still overvalued. Comparing the median cost of a new home to median income suggests that home prices nationwide could drop another 15% to 20%. The home prices to average rent ratio is predicting a 20% to 25% decline.

But here's the main reason I wouldn't buy a home right now: You say you might move out of town in two years. I wouldn't buy unless I knew I was going to live somewhere for at least 3 years and preferably 5 years. Even with prices down, a home is an expensive investment. The down payment will absorb savings. Then there are all the closing costs associated with taking out a mortgage. Closing costs can include points, taxes, appraisals, credit reports, title insurance, survey's underwriting fees, and document preparation. The price-tag for all this stuff can range somewhere between 3% and 6% of the mortgage amount. What's more, anyone who has bought a home could tell you that the money spigot doesn't end with ownership. I would save my money and wait to buy a home. That is, until you know where you'll be putting down roots.

11/18/08 by Chris Farrell

Permalink

Credit problems

Question: I have been working to eliminate my personal revolving debt for more than five years by paying the minimum monthly or more. It is evident that I'm not really making any headway and may be going in the opposite direction with creditors raising my interest rates to well above 25%. As you know, creditors check credit scores regularly and arbitrarily raise their rates and charges.

Now that my income has unfortunately dropped, I'm wondering if under the new bankruptcy law I'm better off negotiating a settlement with each credit card creditor. I'm not looking for a write-off, but a negotiated settlement with payment terms.

My question is should I take this course, suffer the consequences on my credit score, and rebound down the road? Ron, Escondido CA

Answer: It's outrageous that banks are hiking credit card interest rates when the economy is in recession, job losses are mounting and taxpayers are bailing out the financial system with at least $1 trillion dollars. It seems to me that raising credit card rates now is bad for households and the economy. (Longer term tighter credit terms might be good, but in the short-run it looks bad.)

For instance, both American Express and Citigroup have said they're raising rates by 2 to 3 percentage points on some customers. I expect we will also see many people get hit by "universal default" and the default rate of around 30%. About half of all credit card issuers have a universal default policy hidden in the fine print of a credit card agreement. Late on any payment to any creditor, and the rate on the card could automatically jump to the default rate--even though you're up to date on the credit card payments. I don't see how anyone ever gets out of debt at a 25% to 30% interest rate. That's loan sharking.

Here are three practical suggestions. First, get a copy of Gerri Detweiler's "The Ultimate Credit Handbook: How to Cut Your Debt and Have a Lifetime of Great Credit." It's in its third edition, and is very helpful. However, my guess is that your way past the kind of advice she gives since you've been working on paying down your debts for 5 years. (But it's worth a look for anyone worried that they're carrying too much debt and trying to pay it down.) I am also a fan of the credit advice at the non-profit organization Nolo.com. Its web address is www.nolo.com.

Second, contact the National Foundation for Credit Counseling (NFCC). It's the largest and oldest national nonprofit credit counseling service. You can find a branch near you at www.nfcc.org. I'd set up a meeting with a debt counselor, and see what can be done with their help and guidance.

Third, consult with a bankruptcy lawyer to what are your options for wiping the debt slate clean.

You'll then be able to make a reasoned decision.

I wouldn't worry about your credit score right now. The key is to figure out the best, most practical way to eliminate your financial burden and, at the same time, to make sure you won't end up in the same place 5 years from now.

11/19/08 by Chris Farrell

Permalink

Stay the course?

Question: Hi, Chris. Like everyone else, my company retirement savings plan is way way down--56% off, to be exact. I'm 38 so I don't need the money right now, but it is incredibly painful to keep shoveling money into this hole. Through a generous company match, I'm investing almost 30% of my income into an target date (and therefore aggressive) mutual fund. I've heard you say that we should all just keep investing through the ups and downs but is that still true in this prolonged crisis? Won't it take these funds years and years to recover from losing half of their value? I'm not going to sell anything--that would be locking in the losses--but I'd sleep a lot better at night if a much bigger chunk of my future retirement savings was going into bonds or a money-market. What do you say? Thanks for all your help in this crisis. Erin New York, NY

Answer: Uncertainty is the overarching concept that rules our lives. We may have hunches and even mathematical probabilities, but we never know for sure what the future holds. Peter Bernstein.

Your portfolio is down even more after today's carnage, with the Dow Jones Industrial average plummeting by 445 points, or 5.6%. Citigroup shares lost 26% and J.P. Morgan Chase fell by 19%. Month after month, week after week, day after day it seems that the stock market falls ever lower. We keep hearing that this is the worst financial crisis since the Great Depression. Does that mean an 89% decline is in our future, which is what happened to the blue chip index in the early 1930s? Or, even though the timing is uncertain, is this a once-in-a-lifetime buying opportunity?

Like soothsayers of old, working people of all ages are struggling to peer into the future. That's because, over the past three decades, the 401(k) has become the mainstay retirement savings plan for private sector workers. Their nonprofit peers save in 403(b)s and government workers in 457 plans. Whatever the label, workers throughout the economy are confronting difficult investment choices. And the answers matter since investment decisions made today will influence whether a worker enjoys caviar or roe two-to-three decades from now.

This is no way to run a retirement system. But it's the one we got and it's the one you're invested in. My judgment is that you have time on your side so I would stay the course. I essentially agree with what Zvi Bodie, finance professor at Boston University, recently told me: "I would characterize my approach to investing as cautious optimism with the emphasis on cautious and the optimism faith in the progress of the U.S. economy," he said. "Another way of saying this, we have to be careful of wishful thinking, the belief that we can get high returns without higher risks, and on the other hand catastrophyzing, if that's a word."

In a recent article for the Wall Street Journal, University of Chicago finance professor John Cochrane made a compelling case for taking a more positive slant on the stock market's future, without going overboard. It's a cautious, well-grounded argument. (You can read it at his website. It's a good website for learning and researching finance, too.) Here's the kernel of Cochrane's position:

In a recession, or following losses, many investors become more averse to holding risks. They want to sell. But we can't all sell -- a fact routinely ignored in much financial advice and commentary. Instead, prices must fall and prospective returns rise until some investors are willing to buy. Unsurprisingly, upward spikes in the dividend yield came in bad economic times.

History is not a guarantee -- this time could be different. Rather than a higher return going forward, this price decline could reflect a consensus opinion that a massive depression is coming -- a 34% permanent decline in earnings and dividends and a massive wave of bankruptcies.

But as I read the news, the "risk aversion" story seems more plausible. We are in, or headed for, a recession. Anyone whose job or business will be impacted can't take stock-market risks, and should be selling despite low prices. We are seeing lots of "deleveraging," "disintermediation" and "forced selling." As losses mount, investors or institutions that have borrowed money must sell to avoid bankruptcy. Others, such as some university endowments or defined-benefit pension funds, have backstop commitments that must be honored, and they too must "capitulate" at some point. Still others may just be less willing to take risks after suffering a huge loss, a sensible "once burned, twice shy" mentality.

All of these actors become more averse to holding risks as the market declines, so they sell. This increasing risk aversion amplifies an initial price decline -- coming from bad earnings news or the huge rise in credit spreads -- into a rout.

If this is indeed what's going on, it also means that unleveraged, long-term investors should be buying, since prospective returns are better. They must be able to suffer through further mark-to-market losses, and not have recession-sensitive jobs or businesses. They must still have some money left to invest, so they can exchange some of their valuable Treasurys for assets that the suddenly risk-averse are trying to unload. The more these investors can understand and digest slightly exotic securities being dumped by leveraged intermediaries, the better. Warren Buffett is in the news, and he should be.

That said, you are putting a lot of money into the fund. If it were me, I'd be okay with it. (But I haven't changed my retirement asset allocation at all during this time; all the shifts have come outside the tax-sheltered retirement accounts.) You clearly want to take full advantage of your company's match. But you also said you aren't at the sleeping point. Why not direct future contributions into the high quality bonds and money market fund? This way you don't lock in any losses in the Target fund, but you build up a more conservative overall portfolio. Rather than selling down to the sleeping point, its more like redirecting your savings to the sleeping point.

11/21/08 by Chris Farrell

Permalink

Bank trouble and a credit card

Question: I have a Citi Bank credit card as my primary credit card. The account is in good standing with no debt, but what happens if Citi Bank collapses, files for bankruptcy, or merges with another company? Also, what about my interest rate, credit card benefits (such as cash back, airline mileage, etc.), and terms of use if something happens to Citi Bank? Sincerely, Andrew, PA

Answer: Citigroup's stock is getting pounded again today. Like GM, investors are losing faith in another icon of Corporate America. The mammoth banking conglomerate has lost 60% of its market value since last Friday and now trades at a 15 year low. Citi hasn't posted a profit in four quarters--unlike several of its major rivals--and the outlook is steadily worsening with the sinking economy and deteriorating credit.

I suspect central bankers and finance ministers worldwide will hold non-stop transatlantic meetings over the weekend about how to deal with the recent precipitous decline in Citi and other financial services stocks. After all, Goldman Sachs is now trading below its initial public offering price. Goldman is no longer the financial services industry's gold standard but a tarnished benchmark.

Citi is one of the biggest issuers of credit cards in the country with some 54 million cardholders. Although the bank has announced it's raising credit card rates on substantial portion of its credit card accounts by 2 to 3 percentage points--supposedly less than 20% of the total--the credit card portfolio is still one of its most valuable franchises.

How will you fare if yet one more unthinkable happens, that Citi sells off assets, gets acquired or the government buys an even bigger stake in the financial services institution? My bottom line: You're fine. Put it this way: If Citi really got into trouble your credit card account would be considered an asset worth owning. And if the past is any guide your credit card will work and you won't be left stranded.

However, a couple of cautions or safeguards. If Citi does get deeper into trouble, read your credit card mail carefully. The new owner might have information for you. For instance, a new owner may change the size of your line of credit. But the typical experience is for a new owner to honor most of the terms of your existing deal. Over time it may bring about changes so that there is only one interest rate, fee, penalty and other policies for all its credit cards.

Most importantly, continue to pay your bill on time.

by Chris Farrell

Permalink

A lay-off and the 401(k)

Question: I am getting laid off at the end of this year. I have been at the company for 12 years and have a decent nest egg in my 401k. What is the best way to preserve the value of my retirement savings as I make the transition from 401k to IRA? Max, Dalton, MA

Answer: Sad to say, your story is far from unique and it will become increasingly common in the months ahead. It's a tough situation. The first thing anyone in your position needs to do is contact human resources and see if you can keep the 401(k) intact at the company while you look for a new job. So long as you have $5,000 or more in the plan--and it sounds as if you have much more than that--federal law says in most cases fired and laid off workers can keep the money in place. That will defer the day of retirement savings reckoning for you in light of today's volatile market. When you do get a new job, you can either have the money rolled over into your new 401(k) plan or into a rollover IRA. (Make sure it's an institution-to-institution transfer so that there are no implications with the shift.)

Two words of caution: First, don't touch the money. Leave it alone. Second, be wary of any so-called financial advisors that might solicit your business when you lose your job. It seems that a number of financial services companies with high fees and poor products troll for victims among laid-off workers with an eye toward tapping into their retirement money.

Good luck finding a new job.

11/24/08 by Chris Farrell

Permalink

Closed credit card account

Question: I just received a letter from Chase informing me that they had closed one of my credit card accounts (I have two Chase cards) due to lack of use. I had this account for almost six years (in fact, the first credit card I ever had) and I have not used it for quite some time. The only reason I didn't ask for it to be closed sooner was my understanding that keeping it open was more beneficial to my credit rating than closing it. Taking that into account, doesn't this amount to Chase damaging my credit rating with no cause? Solon, Albany, NY.

Answer: It's remarkable how fast we've gone from a credit card world defined by billions in solicitations and offers of 0% financing to one defined by slashed credit limits and closed accounts. Yes, your credit score has been dinged somewhat. It doesn't really matter if you close an account or it's closed by your creditor. The main impact typically comes if closing the account affects your ratio of total credit balances to total credit limits. Closing an account lowers your overall credit limit and raises the ratio. But with good credit card habits--such as paying off the balance every month--your credit score will bounce back. It reads that you manage your money well.

I believe that consumers should control their own credit habits and not follow the formulas of Fair Isaac, the main credit scoring company. I know that's a bit naive, but in an era of identity theft and too-easy-credit it's better for most people to close unused accounts than keep them open. (I realize in your case it wasn't a choice. This is as a general approach.) The big exception is if a major purchase, such as a home or car, lies in your immediate future. In that case, it pays to wait to close the accounts until after the deal is done. But I would still close them.

11/25/08 by Chris Farrell

Permalink

Student loans

Question: No one has yet commented on how the credit crisis is going to affect the availability of college loans. Likely, since it's still early in the educational year, no problems have been noticed...but what about later? Drew, Carlisle PA

Answer: The credit crunch is having a dramatic impact on the student loan market, although it does appear that most students are getting the money they need at the moment. Companies that lent to students relied heavily on securitizing those loans and selling them into the global capital markets. That business is largely shut down with the credit crunch. Sallie Mae and other student loan companies are struggling. Many financial institutions have stopped making private student loans or consolidating student loans. Compounding the financial pressures on lenders is a recent law that limits federal subsidies to them. Parents are also feeling the pressure since it's estimated that about a quarter of tuition costs were paid with home equity loans, and that market is drying up too.

I think the Department of Education has been a government backwater during the credit crisis. Still, it has enacted several initiatives to bolster the market. Most recently, it said it will support the market by buying up to $6.5 billion in federally guaranteed loans from the 2007-2008 academic year. The Dept. of Ed. is focusing on shoring up the Federal Family Education Loan Program, which accounts for most of the loans banks and other financial institutions make to students. The government also makes loans directly to students. (I expect that this latter program will expand under the new Administration.) A number of universities are dipping into their funds to make loans available.

So far, it looks as if the stopgap measures are mostly working. But there are genuine concerns going forward. The Dept. of Ed is working on a bigger program announced Nov. 8 to buy up more loans, but it will be awhile before it is up and running. It may not be enough, either.

More fundamentally, I think that the student loan boom has gone bust. Government policy, as well as colleges and universities, have come to rely too much on student loans. It's anecdotal, but I find it fascinating that - judging from the emails we get at Marketplace Money - student loans have replaced credit cards as the main debt worry of young adults. It's also sinking in that the student loan default rate is much higher than the 4% to 5% level the Department of Education has officially announced for years. For example, reaching back into the 1990s and following student experience over the subsequent years, students with loans totaling $15,000 or more had nearly triple the default rate of those with loans of $5,000 or less--19% versus 7%, according to researcher Erin Dillon of Education Sector, an independent think tank based in Washington D.C.

Finally, if you look at the wages of college graduates in the 2000s they're either flat or down, after adjusting for inflation, while the real cost of student borrowing has gone up. The college market needs to change: Too much debt, a high default rate, and low wages at graduation don't add up.

11/26/08 by Chris Farrell

Permalink

Happy Thanksgiving

To all our listeners and readers, a warm and happy Thanksgiving.

11/27/08 by Chris Farrell

Permalink