Life After a 95% Effective Vaccine

Congratulations, you scored your double dose of the Pfizer or Moderna COVID-19 vaccines and you are ready to rock and roll, Baby.

Does it matter that the pandemic is still raging outside your door? For those of us old enough to remember Rowan & Martin’s “Laugh-In” the answer is clear: You bet your sweet bippy it matters.

Ninety-five percent is not 100%. You still have a 1/20 chance of getting the disease given a significant exposure to the virus. Your case may not be as virulent as without the vaccine, but the scientific jury is still out—especially regarding the long-term effects of the disease.

Here’s how to think of your risk. You decide to go to in-person church (or some other super-spreader event). Let’s say for discussion that before your vaccine you had a 50/50 chance of catching the disease. (Even in super-spreader events, not everyone was infected.) With the vaccine, your chances fall to 2.5% for that one event. Life’s for living, right? No more sheltering in place because that doesn’t sound too risky.

Although, on average, if forty of you made that same decision, one of you will come down with the disease.

But okay, you take that chance. Of course, if you are going to chance it once, you’ll chance it twice, three times, ’cause heck, the odds are 39-1 against anything bad happening.

Except that’s not the way probabilities work. To stay healthy, you must win against every encounter with the disease. Your chance of winning each one (based on the assumptions above) is 97.5%. To determine the chances of staying healthy after two events, you multiply the chance of staying healthy for each of those events. 97.5% x 97.5% = about 95%.

After 10 events, your chances of not catching the disease are down to 78%. They become less than 50% after 28 such events. If you are part of a couple who attend the events together, the chances of both of you staying healthy drop to below 50% after only 14 events.

To allow us to get back to normal, we must significantly decrease our chances of being exposed to the disease in gatherings. There are only two ways to do this: Increase effectiveness of the vaccine (nope – it doesn’t work that way) or decrease the chances of being exposed during an outing. That means continuing to make safe decisions until enough people are vaccinated (or have caught the disease and are no longer contagious) so the chances of being exposed in what had been a super-spreader event decline significantly.

The math is powerful. If we can drop the original assumption of 50% to 10%, our chances of staying healthy after 28 events increases from 49% to 87%. If we can reduce the chance of exposure to 5%, the 87% after 28 events increases to 93%. This is the power of herd immunity, but we are a long way from reaching those levels of protection.

Even if you don’t quite understand the math, believe its message: your vaccination improves your odds of staying COVID-19 free, but only if you don’t take unnecessary risks.

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James M. Jackson authors the Seamus McCree series. Full of mystery and suspense, these thrillers explore financial crimes, family relationships, and what happens when they mix. Furthermore, a novella is the most recent addition to the series. You can sign up for his newsletter and find more information about Jim and his books at https://jamesmjackson.com.

Stock Market Volatility in the Time of Covid-19

To believe newscasters, stock markets rise when there are more buyers than sellers and fall with the converse. To consummate a transaction, there must be both a buyer and seller. It is more proper to say that stock markets rise when more people are motivated to buy shares than sell them at a given price. To balance that optimism, sellers require more money to part with their shares. Similarly, price declines reflect that to induce people to purchase shares, they must lower prices. Whatever the motivations, at the point of transaction, both parties have agreed to a price.

General agreement on the prospects for stocks results in little volatility in prices. As what were expected future profits become actualized, current prices rise to reflect the time value of money. As new information becomes available to estimate future profits, individual stocks will increase or decrease—causing what little volatility there is.

Several methods exist to gauge the stock market’s price volatility. The measure I’ll use for this blog is the daily percentage change in prices of the S&P 500 Index[i]. Because we are concerned only with how much the market changed each day, not whether it rose or fell, we use the absolute value[ii] of the percentage price change.

Historical Averages

For the ten-year period ending April 22, 2020, the average absolute value percentage change was .82%. The current S&P 500 Index is ~2,800. Applying the long-term expectation means that, on average, daily prices change by 23 points. Not every day is the same, and standard deviation[iii] measures the variability around that average. The larger the number, the more the variability. For the 10-year period, that was 1.04%.

So, the two key measures for the 10-year period are .82% average change with a standard deviation of 1.04%.

The 2020 Experience

In the beginning of 2020, the stock market was relatively calm. From January 2 through February 19 (the day the S&P 500 reached its all-time high), the average change was .57% and the standard deviation during that time was  .44 (or .50 when comparing those thirty-three daily results to the long-term average change). This calm trading behavior suggests everyone seemed to think they had the temperature of the market.

That stability has changed markedly since the record high. In the forty-four trading days since (from February 20 through April 22, 2020), the average percentage change has exploded to 3.62% with a standard deviation of 2.73 (or 3.91 when comparing those daily results to the long-term average change!). The expected daily change of 23 points has exploded to an actual average of 101. Not only has the daily percentage change more than quadrupled, the variability of the daily change has also skyrocketed.

Meaning What?

Yeah, fascinating for the number geeks, but what does that mean? My interpretation is that until we have clarity on two issues, everyone is shooting in the dark. Each daily statistic shines a penlight worth of knowledge into a mammoth cave worth of unknowns, and yet the markets react: hence massive volatility. Issue number one is how much damage are businesses experiencing? First quarter reports will come out soon. They reflect half a quarter of boom times and the rest of responding to Covid-19 shelters-in-place. Corporations will not be providing forward guidance about the second quarter or later. This data will only partially answer the first question. The Federal Reserve continues to prop upthe economy and Congress continues to throw money (and ballooning deficits beyond anyone’s imagination just two months ago) at the problem.

And still we do not know what the short-term damage will be.

Worse, we have no certainty about what the longer-term damage will be. Today’s weekly unemployment new claims data are projected to be 4.5 million[iv], yielding 26.5 million new claims during the month. The unemployment rate will exceed 15%.

Initial words from pundits suggested a V-shaped recession: quick decline and rapid recovery because financial imbalances did not cause the problem, and the economy was so strong before the Covid-19 damage. The decline part is correct. I am not optimistic about the quick recovery.

Our chances of screwing things up seem much larger than our opportunity to do it exactly right. The U.S. approach has been to focus primarily on keeping businesses solvent so they can resume operations once governments raise the green flag. It won’t have been enough for some retail operations and many restaurants, which is why there is pressure to reopen as soon as possible. But, reopening businesses too early gives the virus an opportunity to re-accelerate, causing renewed and longer shutdowns. Delaying reopening causes rank-and-file employees to dip further into savings or go further into debt, neither option allowing them to spend at previous levels.

In short, an economy that is 70% driven by consumer spending can’t bounce back to previous record-low unemployment without everything returning to normal. Unless Covid-19 magically disappears or treatments become highly effective, I don’t see a quick restart.

Many supply chains will not seamlessly restart because Covid-19 is affecting various parts of the world in different manners. Most spring events with large gatherings are canceled. Many are already canceling summer events, and planners are already canceling some fall events. Each of these has run-on effects for the hospitality industries and airlines. All this yields more uncertainty.

Which means, volatility will remain high for some time until the economy’s future becomes clearer. That resolution will determine whether the stock market is over-valued or under-valued.

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[i] All data based on information provided by https://www.macrotrends.net/2488/sp500-10-year-daily-chart

[ii] The absolute value of a negative number is determined by changing the negative sign to a positive sign. E.g. the absolute value of -1 is +1

[iii] Standard deviation is the square root of the variance. Variance is defined as the sum of the squares of the difference between each individual value and the mean of values, that total divided by the number of values

[iv] https://www.usatoday.com/story/money/2020/04/22/coronavirus-likely-lead-another-4-5-million-file-jobless-claims/3004023001/

James M. Jackson authors the Seamus McCree series. Full of mystery and suspense, these thrillers explore financial crimes, family relationships, and what happens when they mix. Furthermore, a novella is the most recent addition to the series. You can sign up for his newsletter and find more information about Jim and his books at https://jamesmjackson.com.

Financial Risk for Individuals

Most people don't have a good concept about how to consider financial risk when it applies to them as individuals. Here's a start:

Another word for risk is uncertainty. Financial folks often talk about “risky assets.” By that they mean assets that do not come with a guaranteed return. Investment textbooks contain formulae to measure risk based on volatility of returns, standard deviation of returns, variance of returns, ratios of those statistics relative to expected return and so on and so forth. Lots of measures but they all have to do with how uncertain the return is.

All the mathematical equations in the world miss a very large point about real risk as applied to individuals. You are only one person, and you only get one result, not an array of possible results.

A Simple Illustrates Individual Risk

You have an opportunity to invest in a stock that after one year will be worth either nothing or earn 1,000 times the original investment. Each result has a 50/50 chance. To make this bet, you must put up everything you own up to $10 million. A math guy would tell you that your expected earnings are 500 times your investment—a very positive result. We'd all like a piece of that investment opportunity.

Except . . .

I don’t know about you, but I’m not worth $10 million. This deal requires me to invest everything I have. I’m retired and if I lose it all, I will be in very deep trouble. You could change the 1,000 multiplier to 10,000 or even 1,000,000 and I still could not afford to take the gamble. It is too risky for me because losing wipes me out, and I do not have a viable way to recover any semblance of a decent standard of living.

Bill Gates, however, could hop on this investment with little thought (other than to make sure the deal is as represented.) While he wouldn’t want to lose $10 million, the loss is less than .01% of his reported 100 billion of assets¹ — a drop in the bucket. If you are rich enough that you can easily afford a $10 million loss, this is a great deal.

If I were 23 years-old again with most of my working years remaining, I’d make that bet in a heartbeat. Sure, I only had a net worth of a few thousand bucks, but at that age I’d risk all of it (say $5,000) to earn $5 million.

When we look at financial risk as an individual, we can’t just look at it as a financial wonk would and based our decision on averages or "expected values." We must consider what it means to us if the investment pays off and what happens if it doesn’t.

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James M. Jackson authors the Seamus McCree mystery series. Full of mystery and suspense, these thrillers explore financial crimes, family relationships, and what happens when they mix. False Bottom, the sixth novel in the series—this one set in the Boston area—is now available. You can sign up for his newsletter and find more information about Jim and his books at https://jamesmjackson.com.

¹ Bloomberg Billionaires Index

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James M. Jackson authors the Seamus McCree mystery series. Full of mystery and suspense, these thrillers explore financial crimes, family relationships, and what happens when they mix. False Bottom, the sixth novel in the series—this one set in the Boston area—is now available. You can sign up for his newsletter and find more information about Jim and his books at https://jamesmjackson.com.

¹ Bloomberg Billionaires Index

Parting is Such Sweet Sorrow

Later today I begin the Great Antarctica Adventure. I’ve read all the preparatory material—at least twice. My camera equipment is packed. Batteries charged. Clothing checked against my master list and set aside. Bird books studied. Google translate loaded onto phone (to make up for my nonexistent Spanish skills). Twenty-five days’ worth of medicine set aside. Passport and cash in wallet. Boarding tickets printed out.

I’m ready to go, already . . . except for one thing. I’m not ready to give up my connection to the internet. We’ll probably have internet access in airports and hotels, but for the nineteen days we are on the ship, it is unavailable—at least at a price I want to think about.

I’ve been working on curbing my obsession to the news of the moment. That’s gone about as well as when I tried to quit smoking by gradually cutting down. Something would happen and poof (or puff), I’d be back at my two-pack a day habit. I’m wondering if constant irritation over the news isn’t as dangerous as my smoking habit was. So, I’m going cold turkey. If there’s a newspaper available at port stops, I’ll catch up, but no more checking eighty-seven times a day to see what . . .well, you fill in the blank; I’d just get upset again.

I’m giving up Facebook, too, but only for the trip. I’ll go missing to my 886 friends (as of this writing), and they will go missing to me. I won’t experience three and a half weeks of their lives, because—and I’m just being honest here—I’m not going to check my friends’ back posts when I return. That admission may even cost me a few friends. You mean I don’t care enough about them and their cat Fluffy that I won’t check out each cat shot, each annoying GIF, each political rant. Yep, and I won’t be able to celebrate your book launch or new grandchild, either. When I return to Facebook, it might be like reading a Russian novel and discovering six pages from the middle are missing. I’ll just plow ahead. I’ll miss about 0.08% of each person’s total life. Sure, some important things will happen, but not many—the effect over my total friends is about 2/3rds of one life.

Admit it—you won’t miss my occasional math-geek or writer-geek post, either. Maybe I’ll schedule one or two, just to remind everyone I’m still alive. I have a Writers Who Kill blog due while I’m traveling, and I turned that in ahead of time.

I won’t waste a second mourning the loss of not having access to my Twitter feed.

Email is something else. I remember when all important communications were delivered by the US Postal Service. Back in those distant times, it might take a week or more for a letter to move from sender to receiver. Only businesses used express mail, and faxes were of low quality, slow (two pages a minute) and were sent over long-distance lines you had to pay for by the minute. Oh, and remember telegrams, with their pre-Twitter form of clipped communication as every letter was expensive. STOP.

I’m a writer – what will happen if an agent or publisher wants to contact me? Or a book club wants to schedule me for a meeting? Or someone wants to buy a signed paperback? I’ll employ an automatic responder: “Sorry, it will take me some time to respond to your email. I’m traveling to Antarctica. Be back on 2/22.” Actually, I won't. Turns out my email program (Thunderbird) doesn't have a way to do that and anyone who writes a message to an account with @jamesmjackson.com will hear nothing from me until I return.

That reminds me of the time my boss insisted he have a way to contact me while I was on vacation. I was whitewater rafting down the canyons of the Green and Colorado rivers. I thought a while and then told him that I supposed he could hire a helicopter rescue company to track down our raft and airlift me from the sandbar or beach we camped at that night.

Today, however, we’re used to being connected 24/7. One might still be forgiven for not answering an email for a day or two if you’d just had quadruple bypass surgery, but otherwise, we expect immediate responses. Well, that just isn’t going to happen. Unlike my days working for corporations where there was someone to back me up, I’m a sole proprietor. It’s me or it’s not.

If that costs me some book sales, so be it. I’m confident the potential loss won’t cause me any sleepless nights or worrisome days. To find out, you’ll have to wait for my return.

A version of this blog first appeared on the Writers Who Kill blog on 1/28/18.

An Open Letter to President-Elect Trump and the Members of the 115th Congress (on repealing Obamacare)

An Open Letter to President-Elect Trump and the Members of the 115^th Congress

RE: Repealing “Obamacare”

Beginning January 20, 2017 with the inauguration of President Trump, a vote to repeal Obamacare moves from political posturing to potential reality as the assured veto of prior bills by President Obama is no longer available. I urge members of the 115^th Congress and President-Elect Trump to consider the real and varied consequences of any changes to the current programs.

Public reports indicate Congressional leaders are considering a sweeping repeal of Obamacare with implementation delayed until a replacement plan is developed. The uncertainty caused by such an approach will result in unintended negative consequences for the individual healthcare market.

Certain aspects of the current law function only because private insurers expect robust risk pools. The Health Practice Council of the American Academy of Actuaries recently sent a letter to House Speaker Ryan and Minority Leader Pelosi, expressing their concerns regarding a deterioration in individual health insurance markets if certain provisions of the Affordable Care Act are repealed without immediate replacement. You may find a copy of the letter at http://actuary.org/files/publications/HPC_letter_ACA_CSR_120716.pdf

I urge you to thoroughly understand the risks outlined in the letter before voting on any repeal measures. Unintended consequences can include significant premium increases by insurance carriers to offset increased uncertainty and reflect adverse selection in which younger and healthier individuals drop coverage. The adverse selection will quickly lead to spiraling premiums and contraction of markets as only high-risk individuals remain in plans and more insurance companies drop coverage. The number of uninsured would rise from current levels, leading to less preventative care and higher use of emergency services with their attendant costs.

I also caution you not to retain certain popular provisions of Obamacare without understanding the incentives necessary to make them work. For example, retaining pre-existing conditions protection without exorbitant costs requires either a very large enrollment base over which to the spread costs of that benefit or direct subsidies. Keeping the provision without providing appropriate incentives to provide one or both mechanisms will rapidly lead to a collapse in the individual healthcare market.

If you do not have sufficient experience with the actuarial and underwriting principles that underpin the individual insurance marketplace, I urge you to work with the American Academy of Actuaries to understand how those principles relate to any proposed legislation before casting your vote.

Sincerely,

James M. Jackson

Retired Actuary

“Bitcoin is Still in Beta”

So says Bitcoin’s executive director, Jon Matonis as reported by CNN. Now, I’m sure that bit of information, combined with Matonis’s further advice that “You should only invest in trade what you can afford to lose,” is very comforting to people who used Mt. Gox to store their investment.

In other words, the executive director classifies bitcoin as an extremely risky investment, not a monetary store of value. I suppose that’s obvious for anything which has had its value jump to over $1,000 and subsequently slump to under $600. Notice from the chart below that this is not the first slump since Bitcoin went stratospheric. Also notice since Mt. Gox’s demise that bitcoins have been trading higher. I suppose you could attribute that to classical economics: since the supply of bitcoins has decreased, all other things equal, the price should go up. Alternatively, you could view it as whistling past the graveyard.

Mt. Gox has filed for bankruptcy protection in Hong Kong, so perhaps their account holders will receive pennies on the dollars for their accounts when the debacle is finally resolved. Apparently even before Mt. Gox was hacked and “lost” 1.5 million bitcoins, they were under financial pressures that should have been sufficient to alert investors that the exchange was unsustainable. Again, according to CNN it appears Mt. Gox’s 2012 revenue was less than $400,000 and its expenses included $5 million seized by the U.S. government for alleged false answers on bank documents.

All of that was news to me because I had no reason to follow Mt. Gox. However, those with bitcoin “investments” are now surely warned (if they weren’t before) to perform careful due diligence of the organization holding their bitcoins.

Bitcoin’s Jon Matonis thinks in five years bitcoins will be mainstream, with apps that are as easy to use as Skype. That comparison is not fully reassuring to me. In the meantime, may the Force be with you and your bitcoins. I’ll continue to enjoy the action from the outside looking in.

~ Jim

Bitcoin Exchange Goes Missing

Timing is everything, as the saying goes. On Tuesday, February 25, exactly one week after I ran my blog about the risks of Bitcoins,  Mt. Gox, one of the larger worldwide exchanges, turned off the lights on its website exchange. For those who kept their electronic accounts with Mt. Gox, this is equivalent to me wandering over to my local Wells Fargo Office ATM and discovering it and the bank were no longer there and there is no FDIC insuring my savings.

Here’s an article from Reuters with a bit more information, but by the time you read this, it may be out of date.

This may be a temporary situation done to protect the website from hackers. Or it may be something worse. I have not a clue. Regardless of the final outcome, my conclusion from the earlier article stands: “While I’m waiting to see how that turns out, I won’t be holding bitcoins. Too much risk.”

~ Jim

A Skeptic Looks at Bitcoins

One of my rules for evaluating potential investments is how well I understand them. Unless I have developed a basic understanding of the investment and its attendant risks, I’m not willing to invest in it. No amount of written and verbal advice given by “experts,” is sufficient to overcome my need to understand. After all, these selfsame experts are the ones who have missed numerous bubbles.

The value of Bitcoins is market-based, determined by supply and demand. Supply is purportedly regulated by the software. There are currently approximately 12.4 million bitcoins, and the programming calls for a maximum of 21 million. That means the currency is designed to inflate almost 70%, but at ever-slower rates until finally reaching the 21 million maximum.

Bitcoins, unlike gold or silver for example, have no industrial use; they have no intrinsic value. They are like wampum: they are only worth what two people in a transaction agree they are worth. Humans do not have a great record at determining monetary worth when something has no intrinsic value. This is not a 21^st century problem, as evidenced by the tulip bulb craze in the early 17^th century. Even when something has intrinsic value (gold, silver, real estate), we humans often go hog wild—or conversely can’t see the value in the dirt below our feet.

To summarize, bitcoins have no intrinsic value and are programmed to inflate. That does not sound like a winner to me. But wait, there’s more! In addition to the inherent risks of buying with no intrinsic value, bitcoins contain exogenous risks as well.

Unfortunately, I have very little clue—and, if they are honest, no one else does either—what the exact characteristics of those risks are.

For example, what prevents those “in charge” of the open source coding from deciding to increase the number of available bitcoins past the current 21 million limit, continuing to inflate the currency? I’m sure those in charge insist it can’t happen. But it is certainly a real risk, and I can’t quantify it.

How secure is the system from hackers? I have a firm belief that if humans made it, other humans can break it. This theory applies to more than just the system that creates new bitcoins according to a predetermined schedule. How safe is your bitcoin account? If someone raids your bank your loss is covered (up to certain limits) by the bank or their insurance. Will the same hold true for your digital bitcoin wallet? Who pays those insurance costs? How secure is the insurer? I have no clue.

If the value of bitcoins stabilizes so that its conversion to traditional currencies is primarily determined by inflation in the traditional currency, it would make bitcoins a perfect inflation hedge. That would have utility. However, with a maximum of 21 million of the little critters—and at a recent price of $628—total currency in circulation will max out at a bit over $13 billion. The world’s annual output of goods and services is something north of $70 trillion. US Debt—the world’s “safe” place for parking money—is over $17 trillion.

So there we have it: an entity with no intrinsic value, a currency guaranteed to inflate 70%, with lots of potential risks for which there are no guarantees. Investing in bitcoins sounds to me like making a bet based on the greater fool theory.

Does that mean we should ignore bitcoins all together?

No. They might soon have transactional value. Right now if someone in the U.S. buys one of my novels or my bridge book and uses a credit card, I pay the transaction costs. Using my Square credit card reader, the fees are 2.75% if I swipe a credit card and 3.5% if I enter the transaction manually. Square doesn’t work for foreign transactions.

If someone comes up with a methodology that reduces my transaction fees and allows for instant conversion of bitcoins back to U.S. dollars so I don’t have a currency risk, I’ll adopt in a flash. And since bitcoins are not individual country centric, I could use them abroad without the foreign transaction fees charged by most credit cards.

Bitcoins may be the opening salvo over banks’ and credit card companies’ bows. Technology continues to attack the value of intermediaries—those people and corporations that stand between buyer and seller. If entrepreneurs find a way to reduce the necessity of intermediaries and their attendant transaction costs, it will have major ramifications.

When people first used the internet to exchange messages, most had no clue how dramatically the internet would change the way we do business. The same may be true with bitcoins, and venture capitalists are already making their bets. It is too early to tell how this will all turn out, but it’s too important to ignore.

While I’m waiting to see how that turns out, I won’t be holding bitcoins. Too much risk.

~ Jim

Delaying the Start of Social Security Benefits

I was one of the youngest in my 1968 high school graduating class, which means I’m one of the last of those who have already retired to face the decision of starting Social Security payments at our earliest eligibility, age 62. This decision involves many considerations; I advise talking with an experienced financial advisor to help make sure you understand all the ramifications of early retirement.

I was an actuary and understand the mathematics involved in determining the exact retirement age to maximize the present value of Social Security payments. However, that calculation does not include a crucial perspective: reflecting your risk profile relating to outliving your money.

Unfortunately, because you are a single individual the actuarial mathematics of optimizing when to start Social Security doesn’t apply. It relies on the law of large numbers to provide rational results. You and I are single numbers. We only get to die once (reincarnation is not reflected in Social Security earnings records) and you will either die before or after the actuarially expected time—throwing off the results.

A factor people who have significant retirement assets other than Social Security should give significant weight to is the financial effect if you die “too early” compared to the results if you live much longer than anticipated.

Unless you are already living month-to-month (in which case you probably didn’t have significant retirement assets), if you die “too early” you probably didn’t spend all the money you had available. Your beneficiaries will get more than you hoped they would (you hoped you would spend it not your children or church or whatever). You could have lived a bit higher off the hog. That’s your loss.

If you live “too long,” at some point your standard of living takes a rapid decline. In determining how much you can spend each year, you include Social Security, retirement plan payments and dipping into savings based on a reasonable expectation of how long your savings must last. Unless you are lucky enough to have retired from government, your defined benefit plan payments (if any) are not linked to inflation so over time their purchasing power decreases in value. With good planning, you took that into consideration when you determined how much you could pull out of savings each year.

All of which works fine until you live longer than your plan allowed. Savings can no longer hold up its end of the bargain; the pension plan payments buy less and less each year. Only Social Security keeps up with living costs.

By deferring the Social Security payment start until normal retirement age (66-67 depending on your year of birth) you maximize the portion of your assets indexed to inflation. Let’s say your Social Security normal retirement benefit starting at age 66 is $1,000 a month. If you begin payments at age 62, you will receive only $750 a month. Assume inflation runs at 3% every year (that won’t happen, but it could average out to about that). Here’s what you would get at various ages:

Age	With Age 62 Retirement	With Age 66 Retirement		Age	With Age 62 Retirement	With Age 66 Retirement
62	750	0		80	1,277	1,702
65	820	0		85	1,480	1,941
66	844	1,126		90	1,716	2,288
70	950	1,267		95	1,989	2,652
75	1,101	1,469		100	2,306	3,074

During the first four years you are unambiguously better off if you start your Social Security benefits at age 62. Over those four years you will receive around $37,500 in benefits. Assuming a risk-free return equal to the inflation rate, those payments would have an accumulated value of approximately $39,000. You’ll need that money to reimburse yourself for the greater normal retirement benefits you could have been receiving had you delayed your Social Security retirement. Your accumulated pot of money (continuing to grow with interest but shrinking with the make-up payouts) runs out around age 77. From then on you are less well off compared to deferring Social Security retirement.

From a risk standpoint, these later years are just the time you’ll need the extra money because your chances of outliving your life expectancy are now much greater.

For me the choice is easy. I can afford to die “too early” and I won’t be living to regret my decision. However, if I live longer than expected, I’ll have to suffer (or not) the consequences of that decision. Having a larger guaranteed income will be a welcome cushion.

I’m not sure most baby boomers will agree with my logic. The majority of my generation has preferred purchasing perishable consumer goods over saving for retirement. I suspect these people will start collecting Social Security as soon as they can. Many will rue their decision after they’ve run out of money and all they have left are their toys that no longer work.

~ Jim

Is the Multi-year Bond Rally Over?

Back a month ago, I needed to rebalance my portfolio by selling some equities. I’ve dithered around reinvesting those proceeds in the fixed income portion of my portfolio, but when a CD matured this month, I simply had too much money sitting in a money market fund earning a walloping .03% a year. (That’s $30 per $100,000.)

Thinking about fixed income forced me to ask this question: is the multi-year bond rally over? My conclusion is that it is, but I have no clue how long rates will continue to stay at their current low levels. As I am writing this, 1-year treasuries have a yield of about .18%; 10-year treasuries yield 2.21%. For TIPs the real rates of return are -.11% for 10-year bonds and only .89% for 30-year TIPs.

Think about that for a second. If you buy 10-year TIPs you pretty much guarantee that after ten years you can buy less with the results of your investment than you can buy right now, and that’s before you pay taxes on your “gains.” Such a deal!

The Federal Reserve has committed to keeping short-term rates close to zero through 2014 in order to stimulate economic growth. They have also worked to flatten out the yield curve, which is part of the reason 30-year TIPs have real rates of return under 1%. (And 30-year mortgages are again under 4.00%)

Another reason for the current low interest rates is that with the instability of global economics, the US economy still looks like a good bet to those worried about their money. Despite the massive budget deficits the US runs, whenever there is a spike in economic uncertainty, money continues to plow into US treasuries.

Short-term we can have more uncertainty. The Fed can institute QE3 (quantitative easing round 3) and interest rates will again decline. Or Congress can do something stupid (alright, even more stupid than what they have been doing) and cause confidence in the dollar to drop. If I could prognosticate short-term bond moves, I’d be raking in 8 figures a year—and I’m not.

But looking at the long-term I think we must be very near to the end of the multi-year bond rally.

1. Very short-term rates cannot go much lower on a long-term basis than the virtual zero currently in effect. Yes, if there is a scare people may be willing to accept negative short-term nominal rates, but not for long.

2. Although we know bond buyers are willing to buy “safety” at the price of real value retention (witness the 10-year real TIP yield of -.11%), even as the Fed tries to flatten the yield curve, how much more real return are investors willing to give up for safety? And for how long a period—surely not for  30 years? This phenomenon cannot last forever.

3. US Inflation is running around 3% in an environment of 8% unemployment and the Fed holding down interest rates. If the Fed is successful at stimulating the economy, at some point wages will again start to rise and inflationary pressures will increase. Not only will bond yields will have to increase in order to maintain the same real rate of return, but the Fed may switch from worrying about unemployment to worrying about inflation and start to actively increase interest rates itself.

4. Money continues to move away from bonds, seeking higher returns. Corporate bonds have had a very strong run, with high-yield corporate bonds doing even better. As even these riskier investments are priced higher and higher, people will turn away from fixed-income securities and chase commodities (even more than they have.) Eventually the housing stock will rebalance and housing prices will start to rise, attracting new money.

5. Once the Fed either (a) no longer pumps money into the system because they think the employment market is healed or (b) starts to worry about inflation, their massive support of low interest rates will wane. At that point, there will be a very rapid rise in interest rates with the consequential large capital loss—largest in high-duration fixed income instruments.

I don’t know when this will happen, but I do think it will. And when it does, unless one can quickly liquidate one’s position, the capital losses will be massive. Unlike other fixed income bear markets where coupons offset much of the capital decline, now we have almost no coupon interest and so there is no cushion.

My personal conclusion is to keep in money markets only that amount I will need for expenses in the next year. Because of the Fed’s low rates, banks have little current need for investor funds so CD rates are pitiful. However, even those pitifully low rates are better than the equivalent duration treasuries, so CDs are preferable given that their principal is guaranteed (with limits) by the FDIC.

However, to even match inflation, I’ll need to put the rest of my bond allocation in short-term corporates. Doing so, I am taking on more risk, but I do not see corporate debt quality declining much in the next 24-months (and I’ll stay away from junk.) I’ll ladder a few securities, giving a bit of diversification in both company and duration. As bonds mature, I can decide how to redeploy those funds.

If I am wrong, I’ve given up a bit of yield to long-term bonds I could have purchased instead. If I’m right, I’ll save a lot in capital losses I have avoided. That sounds like a good trade-off to me.

~ Jim

Annuity or Lump Sum Payment? (Part IV)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In the third post we discussed alternatives for investing a lump sum. In this post we’ll consider how much money you can safely withdraw each year.

Deciding how much you can withdraw leads right back to this question: how long are you going to live? The shorter your life span, the more you can “pay yourself” each year. With one year, all the money is yours to do as you wish. If you want to keep the inflation adjusted principal to give to your favorite charity (which may be your kids) you can only spend the real return each year. With long TIP real returns less than 1.75%, you need a huge pile of money to live off the income. For example, to pay yourself $50,000 a year that will increase with inflation, a 1.75% real rate of return means you need to have $2,857,000. Those are the extremes; what about the rest of us?

Okay, so no one has given you a look into their crystal ball to determine your date of death. You are going to have to guess. If you guess too many years, you didn’t use your money wisely—some will be left over. If you guess too few years, you are penniless when you live past the date you guessed.

Let’s say you have a nest egg of $1,000,000. With a real rate of return of 1.75%, if you only expected to live ten years, the first year you can take out $108,000. Planning to live twenty years? You can withdraw only $59,000. Thirty years? Only $42,000. Forty years? Then $34,000 for you in year one. The next year you get an increase to cover inflation during the year.

Taking on more risk (add equities, corporate bonds, etc. to your portfolio) in order to increase your expected real rate of return works well if you start when markets are low; poorly if markets are at their top. How do you know which is which? You don’t, except in retrospect. We all know trying to time the markets doesn’t work well for most of us.

Wait, you say, I Googled it and depending on my age websites tell me I’m safe to take out 4%, 5%, 6% a year. Do they guarantee you won’t run out of money? No, they don’t. The more sophisticated models give you a percentage chance that you’ll be okay. Which is great if your life is a Monte Carlo simulation where there are hundreds of thousands of you who live to various ages and get various results on their investments. But you are only one person.

Yeah, you say, but I like that 95% probability from the simulation.

And I say the only way you are going to do that is if a very large part of your portfolio is made up of annuities where you have no mortality risk and you’ve minimized the inflation risk as much as you can (see post 2).

I’m glad we have that settled!

~ Jim

Annuity or Lump Sum Payment? (Part III)

In the first post I asked you to consider the risk you should be trying to mitigate as you choose between a lump sum and an annuity. In the second post I discussed considerations if you choose the annuity. In this post we’ll consider how to mitigate your risks when you choose a lump sum.

Many investment advisors recommend taking a lump sum instead of an annuity because of the annuity’s lack of inflation protection. That concern is legitimate (and discussed in the second post), but advisors commonly fail to mention the issue of your longevity. So what are their recommendations?

Variable annuities: The idea here is that the increase in the underlying value of the assets will fund ever increasing annuity payments. There is, of course, no direct link between inflation and equity prices. In the long run, equities have outpaced inflation, but in the long run we are also dead. The issue if you are retiring is all about the relatively short run of the next 30, 40 or 50 years.

Buying a variable annuity right before the most recent stock declines would put you in a very large hole that your annuity might not recover from. Fortunately, inflation is currently low, but it might not stay low. If you purchase a variable annuity, the payments will decline if the underlying assets decline, meaning you may end up with less than that fuddy-duddy annuity you cashed out of.

Also of note are the fees attached to many variable annuities. Those fees (going to your broker who suggested you take the lump sum—he gets nothing if you choose to stay with the company’s annuity) and the profit the insurance company thinks they should get for providing you the product and maintaining it over the decades, also mean there is less going into your pocket. Remember: the more for them, the less for you.

You can purchase variable annuities with certain levels of guaranteed benefits, which lessen the risk of a decline in the nominal benefit. Those annuities limit your upside potential in order to pay for covering the downside.

Alternatively, you might purchase a traditional annuity, without the equity element – but wait a minute, that’s what we had to start with. Years ago interest rates used by some pension plans to determine lump sums were lower than those used by insurance companies to determine annuities, so even with the commissions, fees, insurance company profits and the like you could make out on that kind of deal. Today, except under unusual circumstances (when interest rates have rapidly increased), no such a deal will be worthwhile.

How about TIPs? Treasury Inflation Protection bonds provide a floor in the case of deflation and match the CPI for inflation. The current real rate of return for long-term TIPs is less than 2%. Not going to get rich that way, but it at least provides protection.

Your advisor could suggest some mix of stocks, bonds and cash – and we know there are no guarantees with any mix, other than cash and its equivalents and those leave us subject to inflation.

But let’s say you’ve made your choice. Some combination of equities, TIPs, REITs, some foreign securities—a nice balanced portfolio. You know it can go up and down and you’re prepared for that. Now, how much are you going to take out each year?

We’ll discuss that question in Part IV.

~ Jim

Annuity or Lump Sum Payment? (Part II)

In the previous post I asked you to think about the risk you should be trying to mitigate as you consider the lump sum vs. annuity issue.

Most people’s greatest risk is outliving their money and relying on Social Security. Annuities can mitigate that risk, but not eliminate it. Life annuities will continue for as long as you live, but most pensions do not adjust benefits for increases in cost-of-living. You've lessened, but not eliminated your risk of outliving your money when you choose an annuity over a lump sum. This risk of outliving assets applies not only to the person receiving the annuity or lump sum, but also to a spouse or partner.

If you are married, you can take your annuity as a joint and survivor form to allow continuation of some or all of your pension after your death. The payments will continue as long as your spouse lives. Your benefit is reduced to pay for this insurance. All other things equal (although they rarely are), I suggest the joint and 75% or 66-2/3% options because one person cannot live well on half the income two had. For example, if you own a house or rent an apartment, you’ll need more than half the space if you decide to move and if you don’t move, your rent or real estate taxes stay the same.

If you have an unmarried partner, you have the same considerations, except many corporate pension plans will not allow joint and survivor benefits. Then you need to look carefully at what happens when you die, and how much income needs to be continued. Perhaps a life annuity will be fine because the partner has sufficient retirement assets to take care of himself. If not, then either you can take the lump sum (see the third blog in the series for problems with lump sums) or some portion of the monthly benefits will need to be set aside to take care of the partner.

Let’s say the partner needs to have the equivalent of a 50% of the pension annuity income continued after the annuitant dies. To use an example, let’s say the annuity is $2,000/month and if you were allowed to take a joint and 50% survivor benefit, your benefit would be reduced to $1,800 to cover the cost of the survivorship benefits. Actual reductions depend on the age differences between the partners and pension plan specifics. If that option isn’t available, you can look at how much life insurance you can purchase on your life for $200 a month. (To simplify I am ignoring taxes here.)

Purchasing guaranteed renewable term insurance might be a good way to fill in the gap, essentially buying the survivor benefits from an insurance company instead of from the pension plan. It’s not as efficient, but it can work.

I should mention that if the need for post-mortem income is limited to a fixed period of time, plans often allow optional benefit forms of 5-, 10- or 15-years certain. Under those annuity forms, if you die before the end of the certain period, the benefits will continue for the remainder of the guaranteed 5, 10 or 15 years, as elected. Note: these forms of benefit are only useful if there is some need of finite years (for example a child’s education) that you are trying to protect. Do not use a years-certain option in lieu of joint and survivor options for a life-income need.

How can you handle the issue that most annuities do not have inflation protection? It takes discipline, but here’s one approach: Determine (you can do this online or have your friendly insurance agent or financial advisor get the information for you) how much your annuity would need to be reduced to get inflation protection. It’s rare for an insurance company to provide full protection, so you may need to settle for a proxy to determine an estimated cost – such as using an annuity that automatically increases benefits 3% or 4% a year.

Let’s just say your original $2,000 per month annuity must be decreased to $1,333 per month in order to provide full COLA protection. In year one, you will need to invest the $667 monthly difference between your standard annuity and what it would be with future COLA adjustments. In year two, the annuity will continue to pay you $2000, but let’s say there was some inflation and the $1,333 would have grown to $1,375. In year two, that’s the amount of your pension you can spend and the rest ($625/mo.) you will invest. (Again, I’m ignoring taxes.)

At some point the $1,333 increased by cumulative COLA differences will exceed the $2,000; let’s say it is $2,025. Then you are taking the entire annuity and making up the $25 difference by dipping into your savings.

Will it work perfectly? Not at all. On average, for a very large number of people it might work out well, but some people will die before they exhaust the savings made up of “scrimping” in the early years. For some, inflation will be less than expected and they too could have spent more in their earlier years. For others the opposite will be the case. Perhaps inflation runs higher than expected – or you live much longer than average. In both cases you should have spent even more in the very early retirement years, and now you will have to cut back in your later years.

Not a perfect solution by any extent, but at least with the life annuity, the nominal payment is guaranteed for as long as you live. For lump sums, the issue is even worse.

Next up in Part III, what happens when you take the lump sum instead of an annuity.

~ Jim

Annuity or Lump Sum Payment? (Part I)

For me, the choice was easy. My defined benefit pension plan didn’t allow for lump sum payments, so the only question I needed to answer was the form of the annuity. My defined contribution pension plan didn’t allow an annuity, so lump sum it was. In this discussion I will use generalities regarding taking a lump sum from a defined benefit pension plan.

Lump sums are determined based on the defined benefit otherwise payable, interest rates and mortality assumptions. The law defines minimum and maximum lump sums; the pension plan itself contains the rules for determining your specific lump sum. I could regale you with atrocities plan sponsors and financial advisors perpetrated on plan participants in the bad old days; but the law was changed and those abuses are no more.

If you are going to die the day after you receive the distribution, taking a lump sum is a great idea for your estate. Clearly, if your expected mortality is significantly worse than assumed in determining the lump sum you are better off taking the cash now.

If you don’t expect to get personally acquainted with the grim reaper in the near future, then a lump sum is not a clear winner—even with historically low interest rates. Before the next post, I want you to think about what risk you should be trying to mitigate. (Here’s a hint: it’s not about dying too soon.)

The next blog will explore the risk that should be paramount in your decision-making and what that means.

~ Jim

Shoot the Messenger (Germany style)

Haven’t we heard this before? The causes of the Greek debt crisis and the subsequent decline of the euro’s value are the actions of speculators – hedge fund operators, short-sellers and the like.

Folks, the causes of the Greek debt crisis are too much debt, too little income and few prospects of that changing. The euro took a beating because it is only as strong as its weakest member’s finances. To blame speculators for this mess is akin to chastising the little boy who called out, “The King has no clothes on.”

Should the euro fall as much as it has against the dollar? I have no clue; currency evaluation is beyond my ken. However, Germany’s response of banning naked short sales does not solve any problem and will perhaps cause more.

Short selling is the process of borrowing a security and then selling it. Legally, you must at some point buy it back, hopefully at a lower price. As the nineteenth century financier Daniel Drew is quoted as saying, “He who sells what isn’t his’n must buy it back or go to prison.” If you already own the security (but don’t want to or can’t, for whatever reason, sell it) and borrow shares from someone else to sell, that is called a covered short sale. Naked short selling occurs when you borrow and then sell a security you don't already own. The purported idea behind banning naked short selling is that those sales are putting undue pressure on the euro.

All Germany will accomplish is to drive the small percentage of European naked short-selling business transacted in Germany to London, where most is done already. Consequently, the German response will have little economic effect and is merely political grandstanding.

The problem is not short selling. Short sales can help make markets efficient since those who think current prices are too high have a mechanism of backing up their opinion with money. What governments should manage is the level of margin (or leverage) firms can use when they sell short. Leverage got the US investment banks in trouble, not per se the investments they made; they had too little capital when the markets went against them.

So too with short selling. If world-wide regulators set standard margin requirements to assure firms cannot become overly leveraged, we get the best of all worlds. The hedge funds can do what they claim to do best (find mispriced securities and take contrary positions), the markets remain liquid and efficient through multitudes of buyers and sellers and the rest of us are protected against financial calamities when firms take on too much risk.

The lesson governments and regulators should be learning from the most recent financial meltdown (and the one before that and the one before that, ad infinitum) is to manage risk levels. The German action to ban naked short sales does nothing of the kind. If the public lets them off the hook of addressing the real issues, it will only be a matter of time before we have another worldwide economic crises brought on by unmanaged risk.

~ Jim