Tuesday, February 3, 2009

If You Are a Boomer, You Can Retire—Here’s How

The 202 million Americans born between 1940 and 1994 look forward to retirement, but to retire they will need financial stability. The assets required for retirement amount to roughly $540,000 for a middle-class professional who wishes to retire at age 67 on $70,000 per year including social security benefits. Unfortunately, though, 401-k, pension plans, annuities and other financial arrangements fail to protect retirees from a trio of financial risks—inflation, stock market volatility and deflation. These risks reduce Americans’ prospects for a comfortable retirement.

The steps that the Federal Reserve Bank has taken recently to eliminate deflation and depression may prove to weaken the dollar and cause inflation. In the 1970s, stagflation, the combination of unemployment and inflation, saw inflation rates of 13.3% in 1979 and 12.5% in 1980. That could happen again—and worse.

This past year, according to the Federal Reserve Bank, M1, currency and demand deposits, increased at a seasonally adjusted rate of 37.6% in the three months from August to November 2008. M2, which includes savings deposits, increased 13.9%. In comparison, in the five years that preceded the 1979-80 inflation, from November 1973to December 1978, M1 increased about 37%. In other words, since last summer the Fed has increased the money supply by an amount equivalent to the amount it increased the money supply during several years preceding the 1979-1980 inflation. More ominously, according to the St. Louis Fed, the monetary base grew from $873.8 billion on September 10 to $1,671 billion on December 17, an increase of better than 90%. These fluctuations suggest inflation risk.

Moreover, the recent panic in the financial markets reminds us that 40 or 50 percent fluctuations in stock market prices are to be expected over any twenty year period. No matter what, retirees face the risk of stock market declines.

Those facing retirement also face a third risk: fluctuating commodity and house prices. For instance, oil has descended from $145 to $37 and now back to the $40s per barrel over the past few months. Someone who purchased a year’s worth of heating oil last July suffered losses. Dollar depreciation, stock price depreciation and commodity price depreciation all threaten retirees, but of the three, the least threatening risk is depreciating commodity and house prices. Many retirees would benefit from deflation because deflation would stretch their consumption budgets. But the federal government has made prevention of deflation a key objective. Monetary policy is at loggerheads with retirement policy. Yet, none of the interest groups associated with retirees has emphasized this crucial issue.

Potential retirees thus face three risks. First, they face the risk of inflation, which would significantly erode the value of dollars that they hold and so devalue traditional annuity, savings and money market accounts. Second, they face the risk of stock market fluctuation. Third, they face the risk of price depreciation in commodities and real estate.

Dollar-Based Retirement

Much has been written about retirement in financial terms. Many experts argue that an annuity that replaces 60 to 80 percent of final average income is necessary to retire. In private industry, the old fashioned defined benefit pension plan used to accrue benefits of one to two percent of final average salary per year of service. That would mean that an employee with 35 years of service would get about 50% of pay, often partially reduced for primary social security benefits upon normal retirement age. When social security was added to the pension the result was about 70% of pay. With respect to today’s more popular 401(k) plans, an employee who earns $100,000 and aims to retire at 67 with 70% of pay including social security would need roughly $540,000. But what if the $540,000 is eroded to $400,000, $300,000 or less in real dollar terms over a 2-3 year period? In the late 1970s there were accounts of retirees forced to sell their homes or eat pet food in order to make ends meet because of governmentally-induced inflation.

Commodity-Based Retirement

It is time to rethink dollar-based retirement. Retirees need to pay for a stream of goods and services whose dollar value fluctuates. The most important risk that they face is diminution of the stream of goods and services, not their fluctuating dollar value. A steady dollar income in an inflationary environment poses a greater risk to retirees’ well being than a stream of commodities that meets retirees’ needs in a deflationary environment, even if the dollar value of the commodities is declining.

Retirees need to consider the commodity value of retirement income rather than its dollar value. That is, retirees need to compute their budgets, translate the budgets into commodity equivalents, and then annuitize a stream of commodity consumption into a flow of forward commodity futures contracts. Then, they need to fund the stream. Today, this can be conveniently done with exchange traded funds. Excess assets over and above the required commodity stream could be invested in traditional financial instruments, CD’s, precious metals or other hedges.

The reason this is necessary is the Federal Reserve Bank’s risky, potentially inflationary monetary policy.

In 2003, the average white retiree’s budget was $26,341. Social security, which is indexed for inflation, covered roughly half of this amount. The average retiree spent 15 to 17% of this budget on food, eight to 13% on utilities, 17% on transportation, 2.6% on gasoline 30-35% on rent, and 9-10% on healthcare.* Were inflation to escalate, the average retiree would face risk over and above social security. Commodity contracts could insure this risk.

But if a retiree earns twice the average wage, or about $80,000, and wants to retire at age 67 with an annuity of $56,000, then at today’s low interest rates he needs a pool of goods and services (net of social security) of at least $360,000 upon retirement. At a median October home price of $218,000, home ownership would account for 60% of this fund unless house prices continue to fall. If the retiree wishes to avoid a reverse mortgage or borrowing to fund his retirement (which would create yet an additional risk), he would need the full $360,000.

The $360,000 would need to be allocated as something like $56,000 for food (agricultural futures), $56,000 for energy (energy futures), about $50,000 in materials for home repair and new car costs (materials futures), with the remaining amount in cash, precious metals or other hedges against deflation and inflation to purchase a range of other items. It would be easy to develop more refined budgets that could be annuitized with forward commodities futures using exchange traded funds.

Retirees should not have to fear deprivation. However, for millions of Baby Boomers, the Federal Reserve Bank is creating that very risk. In order to sidestep the financial system’s uncertainties, Boomers need to stop thinking in dollar terms and start thinking in consumption terms. They need to re-conceptualize their retirement planning in terms of a commodity rather than a dollar stream. There is no reason why insurance companies and pension funds cannot furnish such arrangements.

Theoretically, money provides a store of value as well as a unit of account and medium of exchange. Our monetary system’s inability to do so deserves re-consideration. In 1913, when the Federal Reserve Bank was founded, life expectancy was only 52 years for males and females combined and planning for retirement was not an important issue for the average American. To this day retirement planning is not one of the Federal Reserve Bank's priorities. Americans continue to hope for retirement, but recent events suggest that Fed policy and the monetary system may encumber rather than facilitate their goals. Today’s economic theories were developed at a point in time when erosion of fixed incomes affected the wealthy and helped debtors. Today, inflation primarily harms the middle class and poor elderly.

*Pierre Bahtzi, “Retirement Expenditures for Whites, Blacks and Persons of Hispanic Origin. Monthly Labor Review, June 2003, pp. 20-22.

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