UPDATE: Top 10 U.S. Economic Issues to Monitor

Those who are irresponsible get rewarded.
Those who are responsible get punished.
Since it is irresponsible to be responsible in America today, we cannot rely just upon “In God we Trust.” Our destiny is in our hands, not His. God Bless America.

Click here to read the original article, “Top 10 U.S. Economic Issues to Monitor.”

“It is irresponsible to be responsible.”







Photo: Mehmet Dilsiz















This is the new motto of America as I view it. Indeed, we should replace the motto on our currency from “In God we Trust” with this new motto given the anti-Judeo-Christian orientation of our current leaders. Since my article “The Top 10 U.S. Economic Issues to Monitor” was published in early 2008, we have elected Barack Obama as President of the United States. He is about to close out his current term of office. It is a big disappointment that all of those top 10 economic issues in the study have not been adequately addressed.

We are now, due to length of time and the magnitude of the problems, facing more serious negative repercussions than ever. In the almost four years of his Presidency no economic positives have been accomplished. Many economic indicators have actually deteriorated even further which now makes them a greater concern. We will address here only a few of those concerns to monitor.

Government Expenditures and Deficits

This still remains the most serious concern. Over the past four years, we have seen a rapid deterioration of the country’s finances and record levels of government debt unprecedented in the history of the Republic in this magnitude. The regional debt ceiling will be raised from $11.3 trillion to the requested $16.4 trillion. This is an increase of 45 percent during President Obama’s term. National debt has increased under Mr. Obama faster than any other president, and it increases at a rate of $4.25 billion per day. The U.S. debt as a percent of GDP is second only to Greece!

The Federal Reserve cannot, with its monetary policies, prevent this continued deterioration. It will take a coordinated effort that involves a meaningful fiscal policy. This fiscal policy is predominately the responsibility of the President. The Obama Administration has simply not addressed the situation adequately. Standard and Poor’s has stated that additional credit downgrades on U.S. debt could occur given the magnitude of the debt and continued deficits. The IMF has likewise expressed concern about these issues considering the global implications of a further U.S. credit downgrade along with the deficits since the U.S. dollar is a reserve currency.

Unemployment

Another concern is unemployment. While the Obama Administration will get this number, one way or another, below 8% (at today’s matrix: March 1, 2012) by the election, the real number is more in the neighborhood of 17% (using an historical matrix). Instead of getting America back to work with real jobs, the Obama Administration remains committed to dependency on the Federal Government and Obama. With over 50% of Americans paying no Federal taxes, we have almost slipped beyond traditional capitalistic based recovery.

Social Security and Medicare

There also has been no progress on the solvency issue of Social Security and Medicare. They still remain fiscally unsound. The issue must be faced on this government pension plan and all government pension plans from the Federal level to the state level to the local municipal level. Like Greece, there needs to be a mandated haircut of payments. Many have suggested 35% across the board. Talk has only centered on cutting Social Security, but if it is not accompanied by a similar cut in other governmental pension plans America could face anarchy. Social security recipients will not peacefully take a haircut while bloated government pensions continue. This warfare between the private sector and the public sector must not take place. We most likely will have social breakdown far more serious than we have recently seen in Greece bordering on, if not in fact, a Civil War.

Healthcare

Healthcare will find no solution within Obamacare. The only thing for sure is that senior Americans have seen their Medicare savings transferred (let’s state it correctly: confiscated) to others. The cost functions have already sky-rocked for those on Medicare, and we have yet to see what will be denied (not covered) to the elderly. With physicians rapidly dropping Medicare patients, the end game of forcing them to accept and become government workers is closer. Older Americans will be forced to pay out of their own resources for many medical needs.

Other Concerns

The issues of Concentration of Wealth, the Savings Rate, Consumption Binge, unfunded retirement plans, family debt, and current account deficit all remain. We have not yet had a rational dialog on how to solve these issues. The issue becomes far more complex when it appears that we could be on the verge of a Deflationary-Inflation! Like the Staginflation of the recent past, this should not economically exist with responsible government policy. What we could see is that all asset values deflate (such as homes and savings accounts) while all costs (such as energy, food, and healthcare) increase in cost.

Enlightened Leadership

Photo: Marilyn Nieves

America needs Enlightened Leadership. All that has occurred in the past four years is pointing the blame at someone else, and the creation of an environment of class warfare on multiple levels. Thus, one must seriously question the goals of the Obama Administration. Their failure to address these key economic issues calls into question if, given their Socialist-Communistic orientation, they are not actually intent on pushing America into an economic crisis. Only a true Greek-like or worse meltdown would allow a re-elected Obama to carry out the radical redistribution of wealth, which he and his mentors Reverend Wright and Bill Ayers believe in. The longer these economic issues remain, the more serious and devastating will be the outcome.

The Audacity of Hope appears to be social-economic-political destruction of America as we know it. Certainly, the comments of the Obama Administration about “the flaws of our Colonial document” (The U.S. Constitution and Bill of Rights) must be taken more seriously than in the past. The Obama Administration’s recent attack against Religion is of paramount concern, and the orientation of Attorney General Holder that “he will select what laws to be enforced,” brings into question our American principal of Rule of Law.

Since it is irresponsible to be responsible in America today, we cannot rely just upon “In God we Trust.” Our destiny is in our hands, not His. God Bless America.

For more on this topic, click here to read the original article, “Top 10 U.S. Economic Issues to Monitor.”

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What to Do when Traditional Diversification Strategies Fail – Revisited

Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2010/dilellio-diversification.mp3]

Online investments going down

The market events of 2008 stressed the ability of diversification to protect against loss due to rapidly changing correlation amongst assets. But, as demonstrated in the initial article, “What to Do When Traditional Diversification Strategies Fail,” there is still a simple, repeatable approach based on utilizing previous year correlation coefficients to construct a diversified portfolio that reduces loss of principle.[1] The significant market gains of 2009 further challenge the benefits of diversification. So, the question now is: Does this approach to diversification also provide opportunity for significant positive gains? To answer this question, we revisit the simple diversification strategy featured in the previous article, which exploits correlation to reduce risk, to see if opportunities for gains exist.

Furthermore, a recent competition between brokers has been driving down commissions for online trades. In addition to lower commissions, some brokers have selected a subset of ETFs from a single provider, such as iShares’ affiliation with Fidelity, and waived all commissions when trading these financial products within their online platform. These reduced costs are important and may have a direct influence on the optimal reallocation frequency. So, a new question now is: With the reduction or elimination of trade commissions, is a more active strategy optimal? This article also examines this practical issue, and quantifies the overall benefits from $0 ETF commissions currently in the marketplace.

Hypothesis Revisited

This study revisits many of the hypotheses established in the previous study. The correlation coefficient threshold is validated from an updated illustration containing four asset classes: U.S. Large Caps, U.S. Small Caps, International, and Bonds. As seen in Table 1, correlations observed over 2008 suggest the same allocations against U.S. Large Caps (SPDR S&P 500 fund, symbol: SPY) and Bonds (iShares Aggregate Bond Fund, symbol: AGG) as suggested from correlations observed over 2007.[1] But, because of the continuing trend of lower commission costs, consideration must also be given to volume in the process of identifying uncorrelated assets. Volume is known to be inversely related to costs from bid-ask spreads and is empirically modeled in the following section. So, to provide a preference to higher volume funds that minimize the resulting bid-ask spread, the correlation matrix rows are generated in order of decreasing volume before eliminating highly correlated investment options. The result to the right of the arrow illustrates the result, applying this process to a four-asset class example.


Table 1- DiLellio

Table 1: Correlation Coefficients from Daily Returns Adjusted for Dividends in 2008, sorted by Average Daily Volume.


Table 2 shows the associated 2009 performance, based on holding both the four-asset portfolio as well as the suggested two asset portfolio based on the 80 percent correlation threshold. The diversification effect observed in 2008 reduced the 2009 portfolio gain from 21 percent to 14.3 percent. Reviewing the 2008 portfolio returns (illustrated in the previous article), we observe a loss of 27 percent and 15 percent, respectively, where the smaller loss occurrs when we apply the correlation threshold to portfolio construction. Thus, the two-year cumulative return from this simple illustration is -12 percent when no correlation threshold is applied, versus -3 percent when it is applied.


Table 2- DiLellio

Table 2: 2009 Performance of Naïve Allocation with and without use of 2008 Correlation Coefficients.


This updated simple illustration continues to suggest a benefit of multi-asset diversification or wide diversification, consistent with other research.[2][11] While these studies use longer history market indices, we show a more pragmatic view in the following sections, since the ETFs examined are easily traded by individuals, investment advisors, hedge funds, and institutional investors. Furthermore, ETF transaction costs can be accurately modeled, as shown in the next section. Unfortunately, ETFs are still fairly new investment products, so they do not offer the long histories available for many asset allocation studies employing equity, bond, and commodity-based indices used in the aforementioned studies.

Analysis Assumptions and Methodology

Continuing with the nine asset classes identified in the previous article, including the 136 unique ETFs available since January 2004, we have added an analysis of new zero-commission ETFs now being offered by Schwab, Fidelity, and Vanguard. Six of the asset classes are equity-based and consist of large cap domestic, large cap foreign, emerging markets, midcap domestic, small cap domestic, and domestic sectors. The three non-equity classes include commodities, bonds, and real estate. A summary of the nine asset classes represented by these ETFs appears in Table 3, where sector and large cap domestic assets have the largest representation, while bonds and real estate assets have the smallest.


Table 3 - DiLellio

Table 3: Asset Classes represented by 136 Exchange Traded Funds available since January 2004 (values are rounded to the nearest percent).


Based on the updated simple illustration from above, we continue to define uncorrelated assets using a correlation matrix generated by volume. We then eliminate lower volume assets that are more than 80 percent correlated with higher volume assets. All correlation coefficients were calculated based upon 12 months of daily historical returns developed from adjusted closing prices that included dividends and splits. For consistency, volume was also estimated using a 12-month average daily volume. This methodology follows the same rationale established in the initial paper.

Revisiting the existing assumption regarding switching costs, we have updated our methodology to address the practice of investment managers seeking “most liquid” ETFs.[4] To further improve the fidelity of the back-testing, we have also incorporated a nonlinear regression model for a bid-ask spread that grows rapidly with low volume. The model parameters are based on empirical data provided by Pankaj Agrrawal and John M. Clark in their 2009 article, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm.”[3] This data is represented in Figure 1. The value of R2 = 94 percent obtained from the power-law model suggests that a significant amount of the variation has been explained between the bid-ask spread and the trailing volume, providing high confidence in the model’s ability to accurately reflect bid-ask costs based on volume.


Figure 1 - DiLellio

Figure 1: Bid-Ask Spread, in Basis Points (BP) versus Average Volume, with Power Law Regression model and Goodness of Fit Measure.


The model in Figure 1 is applied against hypothetical trades using month-end adjusted closing price and volume. Returns were calculated based on a naïve allocation approach that evenly spreads assets across uncorrelated ETFs. The purpose is to examine the data’s sensitivity to annual, biannual, and quarterly rebalances. To reflect the latest updates in commissions from discount brokerages such as Vanguard, trade commission are reduced from $10 to $5 per trade against a portfolio starting with $100,000 in a tax-free account.[7]

Empirical Results

Figure 2 appears to have a very similar downward trend, but contains a full five years of history. Once again, the increased correlation amongst assets classes increases over time, yielding fewer uncorrelated funds. Also note that including volume as part of the process to determine uncorrelated funds has had a marginal effect on the total number of uncorrelated funds, but the downward trend from 2005-2009 remains.


Figure 2 - DiLellio

Figure 2: Number of ETFs that are less than 80 percent correlated over previous year with higher volume ETFs (2005 – 2009).


Tables 4, 5, and 6 list the portfolio allocations against each of the nine asset classes for the annual, biannual, and quarterly rebalancing periods. In each case, the allocations begin in 2005 with a majority of holdings in large foreign equities, emerging markets, and domestic sectors. By 2009, large domestic equity increases significantly, while large foreign equities and emerging market allocations shrink drastically, as highlighted in orange. Highlighted in yellow, bond funds continue to grow to become 43 percent of the allocation, one of the largest percentages seen over the five-year study. Lastly, domestic sectors remain a significant percentage of the allocation throughout the five-year study, suggesting a cyclical pattern between the range of approximately 25 percent and 45 percent. In summary, these results indicate that the naïve allocation strategy appears to be achieving wide diversification, based on the portfolio containing between five and eight asset classes throughout the five-year testing period.[2] Furthermore, the strategy appears to have a dynamic component that, in times such as early 2009, approaches the classic allocation of 50/50 bond-equity allocation.


Table 4 - DiLellio

Table 4: Annual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold



Table 5 - DiLellio

Table 5: Biannual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.



Table 6 - DiLellio

Table 6: Quarterly Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.


Table 7 summarizes the net returns based on the three reallocation intervals and includes the effect of modified and new positions incurring a bid-ask spread cost and the flat-rate $5 commission cost. Once again, the annual reallocation period appears optimal. Also, the commission costs do not appear to be driving the lower performance. When set to $0, returns increase by 0.6 percent, 1 percent, and 1.9 percent over the five-year period for annual, bi-annual, and quarterly reallocations, respectively. But, this increase is not sufficient to offset the larger gross returns provided by the annual reallocation frequency.


Table 7 - DiLellio

Table 7: Net Returns with Naïve Allocation



Table 8 - DiLellio

Table 8: Sharpe Ratio with Naïve Allocation


Alternatively, Table 8 shows the risk adjusted returns using data from Ibbotson & Associates’ one-month T-bill for the risk-free rate and William F. Sharpe’s methodology based on excess return and standard deviations.[5] Once again, annual reallocation provides the greatest risk-adjusted returns.

The cost impact on the portfolio due to the bid-ask spread is somewhat more complex than the flat-rate commission discussed above. While the the aim was to select higher volume uncorrelated funds, it is likely that a few of the uncorrelated funds had significantly lower volume. To examine the relative effect of the portfolio’s bid-ask spread against number of positions in the allocation, a scatter plot appears in Figure 3 from the quarterly allocation data. Interestingly, the lowest bid-ask spread cost incurred for a given allocation is achieved when 20 to 30 uncorrelated funds are identified. Alternatively, when only a dozen or so funds are available, the resulting bid-ask spread becomes significant. The larger bid-ask spread is also seen for portfolios with more than 40 uncorrelated funds, but to a lesser degree. The larger portfolio bid-ask spread is the result of a few low-volume ETFs needed to provide portfolio diversification, which were not available from higher volume alternatives. And because of the rapid growth of the bid-ask spread for low volume, a small fraction of the allocation towards low-volume ETFs can increase the portfolio bid-ask spread substantially.


Figure 3 - DiLellio

Figure 3: Portfolio Bid-ask spread (basis points) vs. number of uncorrelated funds is nonlinear.


Observations and Current Market Offerings

Revisiting the simple methodology previously established, we see that using correlation coefficients continues to provide a practical approach to obtaining the benefits of diversification. Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio. Furthermore, based on a correlation threshold, the methodology applied here can include these low-volume ETFs in portfolios with smaller and larger numbers of uncorrelated funds.

These are important observations because, as of May 2010, Fidelity, Vanguard, and Schwab all offer $0 commissions on trades. These brokerage firms appear to be using this offer along with lower expense ratios, better exposure to asset classes, and lower tracking error as a discriminator.[8][9] But, expense ratios and bid-ask spreads are important costs to consider, particularly for lower volume $0 commission ETFs.[10] Table 9 summarizes the median cost for the 6 ETFs from Schwab, 26 from Fidelity, and 46 from Vanguard that are currently offered with $0 commissions when traded online. The costs are based on buying and selling the median ETF over a one-year holding period, and the bid-ask spread is based on the model in Figure 1 using average volume from February to April 2010.

Table 9 suggests that annual transaction costs associated with buying and selling $0 commission ETFs can quickly exceed 100 basis points, or 1 percent, when traded quarterly. While such evidence still may not deter day-trading of ETFs, one broker has announced limitations on trading their $0 commission ETFs. Vanguard incorporates a limit of 25 buys/sells of its $0 commission ETFs per year.[6] This announcement is clearly associated with Vanguard’s founder, John Bogle, and his belief in keeping costs low for long-term investments. Investors would be wise to consider this fundamental philosophy.


Table 9 - DiLellio

Table 9: Annual Median Transaction Cost of Reallocation using $0 Commission ETFs


DISCLAIMER: The exchange trade products analyzed in this article were chosen from those publicly available. They do not represent the author’s recommendations and were only used to support observations. Investment advice is neither implied, nor suggested.


[1] DiLellio, James, “What to Do When Traditional Diversification Strategies Fail,” The Graziadio Business Report, 12, no. 4 (2009).

[2] Mulvey, John M., Cenk Ural and Zhoujuan Zhang. “Improving Performance for Long-Term Investors: Wide Diversification, Leverage, and Overlay Strategies,” Quantitative Finance, 7.2 (2007): 175-187.

[3] Agrrawal, Pankaj and John M. Clark, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm,” Institutional Investor Journals. Fall: 59-66.

[4] Hight, Gregory N., “Diversification Effect: Isolating the Effect of Correlationon Portfolio Risk,” Journal of Financial Planning, October (2010).

[5] Sharpe, William F. “The Sharpe Ratio,” Journal of Portfolio Management, Fall (1994): 49-59.

[6] Wiener, Dan, “Free Trading Vanguard’s Shotguns,” Forbes.com, May 4, 2010.

[7] Maxey, Daisy, “Vanguard Joins Cuts of ETF-Trading Fees,” The Wall Street Journal, May 5, 2010.

[8] Spence, John, “BlackRock, Vanguard Battle for ETF Assets – Being First Mover isn’t So Advantageous,” The Wall Street Journal, April 27, 2010.

[9] Kapadia, Reshma, “Identical Twins? Nope.” WSJ.com, April 5, 2010.

[10] Randall, David K., “Why Bargain Trades Are No Bargain“, Forbes, March 15, 2010.

[11] Gibson, Roger C., “The Rewards of Multiple-Asset-Class Investing,” Journal of Financial Planning, July (2004):58-71.

[14] Vanguard.com, Vanguard ETFs® https://personal.vanguard.com/us/funds/etf.



[i]Expense ratios and volumes were obtained from Brokerage Web sites in April 2010, including Fidelity.com, Vanguard.com, ishares.com, as well as finance.yahoo.com, SeekingAlpha.com, and are subject to change.

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The Top 10 U.S. Economic Issues to Monitor

Exit polls from the 2008 New Hampshire primary confirmed that 97 percent of Democrats and 80 percent of Republicans are worried about where the economy is headed.[1]





Photo: Mehmet Dilsiz





Forecasting economics is one of the more dangerous endeavors of life. The reason is actually quite simple: “History is economics in action,” as Karl Marx noted.

Marx, who got almost everything else wrong but most likely got this right, connected economics to everyday reality.

In their famous book The Lessons of History, Will and Ariel Durant explain that economics in action is the contest among individuals, groups, classes, and states for food, fuel, materials, and economic power.[2] Economics is a very dynamic system that changes quickly due to the shifting causes and directions of individuals, and is therefore a very difficult system to forecast.

Most individuals are unaware of the economics underway that could seriously erode their retirement plans and could very well cause them to modify their investment choices.

This article will not forecast, but rather will address what many believe to be “The Top 10 U.S. Economic Issues to Monitor.” They were chosen by the author, and are not listed in order of importance.

Number One: Government Expenditures and Deficits

In The Lessons of History, the Durants wrote:

The experience of the past leaves little doubt that every economic system must sooner or later rely upon some form of the profit motive to stir individuals and groups to productivity.[3]

Hence, the U.S. form of capitalism should be embraced. Indeed, virtually all corporate retirement investment choices assume this notion as a given. A commitment to capitalism suggests a major commitment of resources to individuals and limits on the power and resources of government. One of the most disturbing economic trends is the ever increasing percentage of government expenditure in the U.S. Gross Domestic Product (GDP).

GDP is the sum of consumption (C), investment (I), and government (G) expenditures in a closed (no goods in or out) economy. That is, GDP=C+I+G. In the United States, the government is taking an increasing share of resources and this has trended sharply upward since 1947. Federal defense spending is running at a rate of about 5 percent of GDP; federal non-defense spending is at 7 percent; and state and local government is approximately 12 percent-a total of 24 percent of the U.S. GDP. This number does not include transfer payments like Social Security.

If the trend continues, the amount of government expenditure could have a very negative impact on the nation’s ability to consume goods and build plants and equipment for future economic growth. Former U.S. Federal Reserve Chairman Alan Greenspan gave a clear warning of this threat when he stated before Congress, “Unless we do something to ameliorate it [federal budget deficits] in a very significant manner, we will be in a state of stagnation.”[4]

In addition, the size of federal government debt has increased from $2.13 trillion in 1986 to $9 trillion today.[5] In 2006, the federal government reported a deficit of 1.8 percent, a statistic that did not take into account the surplus money spent from Social Security. The actual deficit number used by the Comptroller General David Walker is -3.3 percent.[6] Even he says the stated government number is wrong! This number is simply unacceptable and unsustainable, especially in light of the forthcoming Social Security and Medicare funding problems. The key question is: “As a society, are we deriving value for all of our taxes?”

Number Two: Social Security

There is no such thing as a Social Security[7] savings account. Social Security takes in enough taxes today to remain viable until 2017 (depending on who you speak with and on what day). Unfortunately, these funds are not in a piggy-bank. They are invested in special government securities (IOUs). The borrower (the U.S. federal government), according to both former Secretary of the Treasury Paul O’Neil and now Comptroller General David Walker of the Government Accountability Office (GAO), is in serious financial difficulty that needs to be addressed immediately. Walker has said it is necessary to balance the budget within the next five years, make a down payment on the $50 trillion imbalance, and begin reforming government programs. “Time,” he said, “is working against us.”[8]

Many believe that there will be little return from Social Security and/or Medicare unless substantial changes are made very soon. These changes might include:

  1. Raising or eliminating the maximum payroll ceiling for Social Security and/or Medicare;
  2. Raising the payroll tax rate(s);
  3. Raising the retirement age;
  4. Adjusting Cost-of-Living Adjustments (COLA) to reflect true inflation;
  5. Investing some funds held by Social Security in domestic and foreign bonds and stocks;
  6. Taxing social security benefits for very wealthy Americans;
  7. Reducing benefits for retirees in the very distant future (perhaps affecting those now in their 20s); and
  8. Establishing a proper estate tax.[9]

Currently, the anticipated benefits of Social Security and Medicare to individuals are greater than their contributions. Adding to the complexity of this problem are: the graying of America (the growing aging population of America and the industrial world), and the fact that American workers simply face higher taxes and lower wages. This does not take into account the decline in consumption (other than healthcare) that will result from the ageing American population. The end result is a further decline in the standard of living for the average American.

Number Three: Concentration of Wealth

The Durants also noted: “Since practical ability differs from person to person, the majority of such abilities, in nearly all societies, is gathered in a minority of men. The concentration of wealth is a natural result of the concentration of ability and regularly occurs in history.”[10]

One of the major trends that must be monitored is the increasing concentration of wealth in America. Capitalism and democracy accelerate this problem. This can be seen clearly in the following data, which shows entrepreneurship rewards, as well as-unfortunately-an increased concentration of wealth.

The richest, or top 1 percent of the country, now own 34.3 percent of the nation’s private wealth and 36.9 percent of all corporate stock. These numbers are growing. In 2005, this group received 21.8 percent of all pre-tax income-just 30 years ago, in 1976, they only accounted for 8.9 percent of U.S. income. The total inflation-adjusted net worth of the Forbes 400 rose from $470 billion in 1995 to $1.25 trillion in 2006.[11]

This concentration may reach a point, as the Durants state, “…where there is an unstable equilibrium which results in redistribution of wealth through taxation or redistribution of poverty through revolution.”[12] In the past, the United States has chosen taxation, for example, during the periods of 1933 to 1952 and 1960 to 1965, but it is unclear whether the government will follow this peaceful path yet again.

Number Four: Median Family Income

One of the most illuminating ways to view any economic problem is through the status of the middle class of a population. In general, the middle class has determined the political outcomes of almost every modern nation since the French Revolution. In the minds of many, the middle class will determine America’s fate.

To discuss the middle class, one must establish a standard. Many believe that the middle class standard is best described as an educated group (actually, this would be upper middle) with upward economic mobility, that is: safe homes and workplaces, worthwhile jobs with compensations that advance above inflation and are in line with demonstrated increased productivity, acceptable levels of healthcare, comfortable retirements, and acceptable amounts of debt. This is the standard that America has worked to achieve since World War II. If the number of people within this category begins to decline, many believe that all is lost.

Using median economic data, the middle class is under siege. Statistics show that the median family income (inflation adjusted) sharply increased from 1947 to 1970, due in part to sharp increases in productivity. Since then, however, incomes have been stagnant; 2000 to 2005 actually showed a decline of 0.5 percent in median family incomes.[13] One should also note that these numbers are derived before, not after, taxes.

The expectation that each generation will do better than their parents has become a fundamental part of what we call “The American Dream.” In a recent article the Brookings Institute stated, “New data suggested that this once solid ground may well be shifting. This raises provocative questions about the continuing ability of all Americans to move up the economic ladder and calls into question whether the American economic meritocracy is still alive and well.”[14]

Number Five: The Savings Rate

Already noted is that the median family savings rate has substantially declined. (One should be aware that in our GDP equation, all savings equal, investment by definition).

From 1960 to 1990, the personal savings rate in the United States was 8 to 10 percent. As family incomes have stagnated, this rate has collapsed and in 2006-for the first time since the Great Depression (when many individuals spent their last nickel for food)-the personal savings rate was negative. When the dire outlook for Social Security is taken into account along with this statistic, an alarming picture of the future of the United States is painted.

Given the status of Social Security/Medicare (discussed in Number Eight), if America is going to have long-term viability, the personal savings rate must move upward to a more realistic positive level-not only to provide for retirement, but also to provide capital for long-term investment [In the U.S. GDP equation, savings equal investment (S=I).][15]

Number Six: Consumption Binge

One of the reasons that personal savings are so low is that individuals have gone on a consumption binge, even in the face of stagnate incomes. Normally, market forces would correct this binge in part by increasing the costs of consumable goods. But recent times have been different. There are groups out there (especially one-China) willing to trade consumable goods for America’s seed stocks by financing federal budget deficits through the purchase of federal debt, thus enabling the funding of higher mortgages on consumer’s homes. So, the consumption binge continues. It is, however, moderating as the dollar declines in value and home values decrease.

Number Seven: No Retirement Funds

A recent Wall Street Journal article reported that most baby boomers under 65 have less than $150,000 saved for retirement; those under 50 have saved less than $50,000.[16] Such low savings are clearly not sufficient for a comfortable retirement and may force retirees back into a lifetime of work.

Many times, the funds that are invested in the stock market are invested more as a gamble in an effort to “catch up.” Apparently, the relationship between savings and the time value of money is unclear to most employees. From early debt repayment to life cycle decisions, the burden is on individuals to fend for themselves. A long-term plan with adequate contributions is needed in order to prepare for retirement, particularly in light of the Social Security dilemma.





Photo: Steve Woods





Number Eight: High Family Debt

The median family has never had so much debt. It has been far too easy to obtain home credit and personal credit, especially through credit cards. Perhaps the best way to describe it is in terms of total liabilities as a percentage of total assets. In 1999, the average (not median) was 19.7 percent per median family. In 2004, that percentage rose to 29.3 percent. Almost everyone believes the percentage is well above that today. These statistics are “mark to the market”-in other words, actual market values of both real estate and stocks are used. (Remember debt is fixed, but asset values are variable.) If we see a decline in values in the housing market and/or the stock market, these total liability percentages will jump dramatically. A solid recession would wreak havoc on these asset categories, in addition to bringing on the threat of unemployment.

Number Nine: Healthcare

Most economists simply do not know what to say about this extremely important and looming issue. There is already pressure on the system, as baby boomers require more healthcare as they age. America also has an increasing immigrant population that has had little or no medical care in the past and is therefore likely to be more expensive to care for in the future. This means that healthcare costs should continue increasing well above the inflation rate.

The only viable solution for most employees is to fund any and all healthcare savings options as rapidly as possible. Assume there is no Medicare. If one receives it, the retirement years will even be that much more pleasurable.

Number Ten: The Current Account Deficit

It has already been mentioned that there are groups willing to lend to us so we can continue our consumption binge. This dilemma adds a new economic concept to our equation. A country can now have imports and exports (NE) into our economy, that is, GDP=C+I+G+NE. It becomes a little more complex when one takes into account the federal government’s borrowing of funds to operate, which also falls into this current account category.

The current account deficit is about 7 percent of our GDP-more than double the previous modern record of 3.4 percent in the middle 1980s. Back then, the value of the U.S. dollar dropped by 50 percent against the other major currencies over a three-year period from 1985 to 1987 as a result. The Euro could go as high as US$2.00 from the approximate US$1.47 of early 2008.

Many, however, including our current Federal Reserve Chairman Ben Bernanke, do not believe that this high current account deficit will be that harmful,[17] largely because of the capital account (see explanation below).[18] In economic reality, the capital account is more interesting than the current account since it is the account that takes down economies. Since trade deficits (current accounts) are traditionally balanced with surplus capital accounts, the scales will tip against everyone if the capital account collapses. This is even more difficult to forecast since capital markets are the result of expectations, not realities.

Nonetheless, most agree that this high deficit level is unsustainable. Further, economists agree that it is possible that the current account deficit could be the single greatest threat to the continued prosperity and stability of the United States and world economies.

Lou Jiwei, Chief Investment Officer of China, is perhaps the most influential person in the U.S. economy today. He oversees the $1,250 trillion or so Chinese investment fund, which mostly consists of U.S. treasuries. Because he is investing heavily in the U.S. government (about two-thirds of the fund), we have very low interest rates. This is good for the U.S. as long as the positive economic party continues. But what happens if the music stops?[19]

Many do not believe the Chinese will cause a major disruption to the world financial markets. The author expects very little from them until after the Beijing 2007 Olympic Games. After the Olympics, many anticipate changes more in line with their recent $3 billion investment in the Blackstone Group, which purchases U.S public companies and privatizes them. The Chinese see this as a logical first step considering the xenophobic view from America when the Chinese tried to buy Union Oil Company of California directly.[20]

It is possible that the Chinese will economically squeeze America. However, if China is economically rational, they will force the point over the long run until America becomes of little importance to the world while China ascends.[21] Two centuries ago, Napoleon Bonaparte stated it so well: “When China awakens the whole world will tremble.”[22]

Epilogue

The Durants defined civilization as “social order promoting cultural creation.” Yet history is littered with the ruins of civilizations. These looming economic issues seem to indicate that America is on its deathbed. Most Americans will refuse to believe that this nation must suffer Shelley’s Ozymandias,[23]-that death is the destiny of all. Unfortunately, the disturbing fact is that nations do die. One only has to look back to the early years of the Great Depression to see that we have experienced all of this before.

America is not yet on its deathbed.

In the post-World War II years, America enjoyed a substantial increase in its standard of living. The question is: Will it continue under the new world realities? It will not, in the opinion of the author, unless there is a change in social and economic behavior. America and the world are undergoing fundamental and signal social and economic shifts. The world has not seen, perhaps, such a major shift since the pre-dawn morning of July 16, 1945, in the desert near Alamogordo, New Mexico.[24] In many respects, this new shift and the rise of the age of globalization is even more daunting than the ascendancy of the nuclear age due to globalization’s personal impact on so many individuals.

As Hedrick Smith stated, “In this restless new world, what is needed above all is a new mind set, if America is going to sustain a high standard of living into the 21st century and to prevail as a global economic power in the long-run.”[25] This mind set-to make America work better for more Americans-must change or our retirement portfolios are in jeopardy.


[1] PBS Online. “Candidates Strive to Address Voter Concerns on Economy,” Online News Hour, http://www.pbs.org/newshour/bb/business/jan-june08/economy_01-10.html

[2] Will and Ariel Durant. The Lessons of History, (New York: Simon and Schuster, 1968).

[3] Ibid, 54.

[4] Edmund L. Andrews. “Greenspan Says Federal Budget Deficits Are ‘Unsustainable’,” New York Times, March 3, 2005. http://www.nytimes.com/2005/03/03/politics/03deficit.html.

[5] Kyle Almond. “One Man’s Campaign Against Federal Debt,” CNN.com, March 30, 2007, http://www.cnn.com/2007/US/03/28/federal.debt/.

[6] David J. Walker. “Long-Term Budget Outlooks: Deficits Matter-Saving Our Future Requires Tough Choices Today,” testimony before the U.S. Committee on the Budget, House of Representatives, U.S. Government Accountability Office, Tuesday, January 23, 2007. http://www.gao.gov/new.items/d07389t.pdf.

[7] Established in 1935, Social Security is a U.S. government program to provide benefits to retirees and some other individuals, based on required contributions made during the individual’s working years.

[8] Almond.

[9] A proper estate tax would involve putting a cap on the non-taxed portion of the estate and taxing the remainder at a very high progressive rate with the proceeds going directly to Social Security.

[10] Durant, 55.

[11] There are a number of websites dealing with these economic statistics. See: Michael Hodges. Grandfather Economic Report, http://mwhodges.home.att.net. (no longer accessible).

[12] Durant, 57.

[13] Barry Bluestone. “Household Incomes and Housing Costs: A New Squeeze for American Families,” testimony before the U.S. House of Representatives Committee on Financial Services, April 4, 2007. http://www.house.gov/apps/list/hearing/financialsvcs_dem/htbluestone040407.pdf. (no longer accessible).

[14] Isabel V. Sawhill, John E. Morton. “Economic Mobility: Is the American Dream Alive and Well?” Economic Monthly, Brookings Institute, May 2007. http://www.brookings.edu/papers/2007/05useconomics_morton.aspx.

[15] It should be noted that, in the real world, savings has three macroeconomic components: (1) personal savings, (2) government savings, and (3) foreign investment (with an open economy coming from foreign savings). It is the foreign investment that is fueling our economic engine and keeping this country afloat.

[16] Maria Bartiromo. Weekend Wall Street Journal Report with Maria Bartiromo, CNBC, The Wall Street Journal, March 27, 2007.

[17] Ben S. Bernanke. “The Global Saving Glut and the U.S. Current Account Deficit,” remarks at the Homer Jones Lecture, St. Louis, Missouri, U.S. Federal Reserve Board, April 14, 2005. http://federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm.

[18] In economics, the capital account is one of two primary components of the balance of payments, the other being the current account. The capital account records all transactions between a domestic and foreign individual that involves a change in the ownership of an asset. It is the net result of public and private international investment flowing in and out of a country.

[19] While China is not the only investor in the United States, they are the most dominant. The world, unlike the United States, has a savings glut.

[20] James Kynge. China Shakes the World, (Massachusetts: Houghton Mifflin, 2006).

[21] One caution about China is that many have noted that the Chinese people do not like the Communist Party and the vast majority wishes for a less corrupt, more equitable regime. An infinitesimal number of people have benefited from economic development. For most Chinese, the feeling of deep-seated injustice is far greater than the hope for a better tomorrow. Hence, the cautionary comment about equilibrium is warranted for China as well; their redistribution could bring poverty yet again, with their importance vastly diminished. Finally, it is quite possible that the Chinese will themselves face economic problems that will bring a major downturn.

[22] Kynge.

[23] A sonnet written by Percy Bysshe Shelley in 1817 with the central theme of mankind’s hubris. Many believe that Shelley condenses the history of not only Ozymandias’ rise, peak, and fall, but also that of an entire civilization. See: Percy Bysshe Shelley, Ozymandias, http://www.rc.umd.edu/rchs/reader/ozymandias.html.

[24] The first atomic bomb was tested.

[25] Hedrich Smith. Rethinking America, (New York: Avon Books, 1996): XVII.

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Preserving Family & Business Assets

Save $10,000 for every hour of strategic estate planning.

Death and taxes are an undeniable reality. Understandably, most attempt to postpone each as long as possible, but ultimately there is a conclusion. The purpose of this article is to highlight the preparation that is necessary to best manage the consequences.

As each of us moves closer to the aforementioned, the tension caused by the need to put our financial house in order creates its own resistance and sometimes paralysis. Indeed, my observation is that 75 percent of the professional community have failed, and will continue to fail, in their estate planning obligations. The result of this inaction is confiscatory taxation and a potentially crippling probate (either with a will or worse, intestate), both of which unnecessarily burden families and lay waste to hard-won estate assets. Deferred maintenance as to estate planning, just as with a business operation, trades short-term comfort for eroded resources later.

To illustrate the point, a fictitious Mary and John Doe can be used as an example. Assume that the couple has two million dollars in assets. So as to make the following analysis more relevant for the reader, dividing or multiplying the monetary amounts to fit individual family wealth circumstances will provide a rough personal picture. Do consider insurance and inconspicuous assets in your compilations.

Assuming a failure to set up a credible estate plan, it makes little difference which of the Does dies first. There will be probate and, excluding court costs, there will be approximately $42,000 in fees (See the following table). Upon the death of the surviving spouse, additional probate fees will be in the area of $62,000 for a grand total of $104,000 in probate fees needlessly removed from the estate. As sobering as this might be, there is a vastly greater assault from federal estate taxes.

PROBATE REPRESENTATION FEES
The combined statutory commission of the personal representative and of the attorney of record (California Probate Code Section 10800 as an example) is based on the total amount of asset inventory without reference to encumbrances or other obligations on property in the estate, and is computed as follows:
The first $15,000 @ 8% $1,200
The next $85,000 @ 6% $5,100
The next $900,000 @ 4% $36,000
The next $9,000,000 @ 2% $180,000

Although the surviving spouse can generally avoid paying state and federal estate taxes upon the death of his or her spouse because of the Marital Deduction, without a strategic plan, the second death unleashes a taxation juggernaut. Despite the Unified Credit that protects the first $650,000 of the estate from federal tax, the estate of John and Mary Doe nevertheless faces federal estate taxation that will consume up to $345,000 of the family wealth (See the following table).

FEDERAL ESTATE TAX RATES

The Unified Credit is now $211,300 which is the exemption equivalent of the first $650,000 of an estate.

Amount is
Over:

0
$ 10,000
20,000
40,000
60,000
80,000
100,000
150,000
250,000
500,000
750,000
1,000,000
1,250,000
1,500,000
2,000,000
2,500,000
3,000,000
But Not
Over:

$10,000
20,000
40,000
60,000
80,000
100,000
150,000
250,000
500,000
750,000
1,000,000
1,250,000
1,500,000
2,000,000
2,500,000
3,000,000
————
Tax
on:

0
$ 1,800
3,800
8,200
13,000
18,200
23,800
38,800
70,800
155,800
248,300
345,800
448,300
555,800
780,800
1,025,800
1,290,800
Rate on
Excess of:

18%
20
22
24
26
28
30
32
34
37
39
41
43
45
49
53
55

In addition to the federal tax is the estate tax levied by the domicile state. Fortunately for Californians, voters long ago removed the state death tax, but observers have noted a subtle change in the political winds and there is no guarantee for the future. Most states have an estate tax but it is not imposed unless federal estate tax is due. The state estate tax is designated to pick up the amount of the allowable federal credit, resulting in no net increase in tax payable. Those states with an inheritance tax, as opposed to an estate tax, present additional challenges that may outflank the unwary.

As we return to the matter of John and Mary Doe’s two million dollar estate, it becomes clear that without basic estate planning, the death of the surviving spouse will culminate in the largely unnecessary loss of $104,000 to probate and a staggering $345,000 to federal death taxes. The bottom line is that nearly $450,000 will be stripped from the estate. Not included herein are additional, but avoidable, income taxes paid upon sale of appreciated marriage assets during the survivor’s lifetime.

The picture becomes even more grim for larger estates. By way of comparison, an unprotected estate of $10,000,000 will pay $4,664,500 in federal estate taxes and $340,000 in probate fees for a loss in excess of $5,000,000 to the estate.

Despite the bleak picture, with proper estate planning it is possible to drastically reduce death taxes and to completely sidestep probate. A business person must take time out of his or her busy schedule, while there is opportunity and legal capacity, to skillfully formulate an estate plan. It has often been said that if each of us gave as much attention to estate planning as we do to buying a new computer, we would shield our beneficiaries from debilitating probate paperwork and delay, and effectively protect the product of our life’s work. It is fair to say that a modestly-positioned businessperson can easily save his or her estate $10,000 for every hour given to strategic estate planning.

Listed below are some options that vary from a default position to sophisticated asset reconfigurations. A coordination of these and other strategies could virtually remove taxation and probate fees as a threat and vastly increase the efficiency of asset transfer.

INTESTACY

If we make no effort toward planning, the state will create one for us through intestacy proceedings in probate, without regard to our preferences or tax avoidance opportunities. Added to the chaos is the delay in settling the estate that can take years to complete.

WILL

This tool effectively employs strategies for directing assets and may utilize sophisticated trusts and other tax avoidance measures. Included in the use of a will, however, are the resulting probate fees and delay in asset transfer.

TRUSTS

Living Trusts provide a great opportunity for achieving the long-term intent of an estate plan, while at the same time avoiding the costs and delay of probate and, in some cases, of a significant portion of estate taxes. The Irrevocable Life Insurance Trust, the ever-popular Bypass and QTIP trusts, and other testamentary trusts, provide additional opportunity for tax minimization and other estate goals.

FAMILY LIMITED PARTNERSHIP

Under this structure, assets can be transferred to the partnership and thus provide opportunity to gift a percentage of ownership to family members each year. This achieves the need to reduce the size of estates for death tax avoidance and to reduce income tax exposure. Of additional importance is the fact that grantors can exercise leadership over the donated assets for an extended period.

FAMILY CORPORATIONS

This vehicle achieves similar objectives as the Family Limited Partnership. Unfortunately, without careful attention, families may invoke harmful tax consequences should they improperly make corporate property division or remove corporate assets.

LIMITED LIABILITY COMPANY

The recent advent of this option appears to provide opportunity, in the same way as the Family Limited Partnership, to gift ownership to others in order to achieve savings on income and estate taxes.

CHILDRENS’ TRUSTS

Most business people have heard of Section 2503 of the Internal Revenue Code, but are unsure as to how it might benefit them. The Section is complex, but among other features, allows diversion of income over to children. This is accomplished by gifting an asset and then renting it back as a business expense. The rental amount over the lease period may ultimately dwarf the initial gift value, achieving income tax benefits to the grantor. Further appreciation in the value of the gifted asset remains outside of the grantor’s estate and thus avoids estate taxation. An Educational Trust is a variation under the Section that sets aside funds for the future education of the grantor’s children. Regardless of title and objectives, there are unified credit, Crummey powers and other issues that will have to be carefully navigated.

CHARITABLE TRUSTS

There are three common versions of charitable trusts which are the Charitable Remainder Annuity, Charitable Remainder Unitrust and the Lead Trust. These trusts are used in conjunction with a Life Insurance Replacement Trust to provide for the maker’s needs during life and for the minimization of estate tax exposure upon death.

PRIVATE FOUNDATION

Individuals can reduce the size of their estate and thereby reduce income and estate taxes by donating to their own Charitable Foundation. An added benefit is that, provided the Foundation is in compliance with Internal Revenue Code Section 501 and IRS regulations, any income earned by the Foundation as the result of donated assets is tax free to the Foundation. Furthermore, the family and others involved can receive reasonable salaries for Foundation responsibilities. The Foundation may lose its tax-exempt status, however, should activities stray from its exclusively charitable purpose. The result of a properly created and run Private Foundation is the ability to apply learned business management skills to charitable giving, spread income from the assets donated, lower the donor’s income tax exposure and decrease the size of the estate so as to limit estate taxes upon death.

Conclusion

As shown in the partial and broad-brushed list above, there are abundant alternatives and combinations of strategies available to the businessperson. These strategies benefit those who are financially successful, those who expect to be, and those of even modest means who wish to achieve the same effective, purposeful management of their resources.

A poor use of valuable time is the do-it-yourself approach. Businesspersons need to identify objectives and engage in discussion with experts in estate planning to help develop and implement a strategic plan that, in a legally compliant way, achieves those objectives. Since death and taxes are certain, the business of living requires due diligence with the development of a strategic estate plan that provides efficiency and comfort to the wealth creator while living, and maximizes the benefit of a lifetime’s productivity for charitable and other family objectives upon death.

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Retirement Call to Action

The responsibility for retirement planning now rests more squarely on the individual than at any other time in recent history, and studies suggest that baby boomers are not prepared. Are you?

Editor’s Note: Clicking on the studies referenced here will open a new browser and take you to that paper. At the end of this article are links to a quiz that will test your investment IQ and to several retirement planning calculators.

The widely-accepted estimate is that it will take 70 percent of pre-retirement income during retirement to maintain one’s pre-retirement standard of living. That income will need to come from some combination of social security, a company pension, personal savings, and continued work. The question is, what percentage will come from which source, and what will it take in the way of savings to meet that goal.

Fortune Magazine recently did a study in which it estimated the percentages of income from each of these sources for 1992 retirees and for those who will retire in 2029. For 1992 retirees, in aggregate, 8% of their income comes from traditional Defined Benefit Pension plans that guarantee a particular amount of income, 19% comes from Social Security, 27% from continued employment income, and 46% from investment income, including Defined Contribution pension plans such as 401(k) and personal savings. For the 2029 cohort, they estimate that only 4% of the income will come from traditional Defined Benefit plans. They further assume a 50% cut in Social Security and Medicare benefits for purposes of the study, dropping the total percentage of income from that source to 7%. Investment income rises to 48%. But because investment income has not risen fast enough, more people will have to work longer and more hours if their model is correct. They estimate that two-fifths of aggregate income (41%) will have to come from continued employment.

A recent study conducted for Merrill Lynch by Douglas Bernheim supports the Fortune position. Bernheim’s study indicates that boomers should be saving, on average, three times as much as they currently are in order to avoid a precipitous decline in their standard-of-living in retirement. He agrees that without fundamental changes in patterns of saving, many boomers will be forced to keep on working during the “retirement” years or accept a significant reduction in their standard of living at that time.

According to the Employee Benefits Research Institute, “A consistent 20 – 25% of working Americans are very confident that they will have enough money to live comfortably through their retirement years.” Data from a recent study by the authors that is reported below suggests that some of this confidence may be misplaced. Even if correct, however, the other “three out of four American workers have no idea about how much money they need for retirement” (Office of Investor Education and Assistance). When asked in a recent survey by this department of the US Securities & Exchange Commission how much they thought they would need, “most respondents said they were afraid of the answer, considered the process too complicated, or didn’t have the time” to think about it. If people don’t even know how much money they will need, it is fairly certain that they are not adequately addressing the question of what they need to do now to remedy the situation.

The problem of anticipated shortages of retirement funds due to the lack of proper retirement planning and saving is compounded by the inability of the government to guarantee sufficient funds to make up the difference. Social Security has been one of the landmark social programs of the New Deal, but the program was never intended to be a total retirement fund, only a social safety net. Nevertheless, Americans have come to rely heavily on Social Security payments to provide the necessary funding for retirement. According to a 1994 survey by the Bureau of the Census, 16% of the over-65 population currently relies on Social Security for 100% of their income, and a full two-thirds of those over 65 receive half of their income from Social Security (Congressional Research Office).

There is good reason to believe that if coming generations rely this heavily on Social Security, their standard of living will indeed fall. A recently completed a study by the Heritage Foundation on Social Security found that while workers close to retirement have experienced relatively good returns on their contributions, workers in their 20’s and 30’s will receive a far smaller return on their social security taxes. The realities of demographics and politics means that even Baby Boomers cannot expect to receive the same relative level of benefits that current retirees receive because there will be fewer workers to pay the taxes to support this type of pay-as-you-go retirement system. Generation X faces serious problems associated with what is now viewed by some as a government Ponzi Scheme. Interestingly enough, however, a recent poll commissioned by the “Gen X” organization 2030 found that young people do want Social Security to survive and believe it is possible to reform it.

Social Security has been a political winner until now. But the simple truth of the matter is that future benefits will need to be cut by some mechanism, or the entire system will fail. By the government’s own projections, Social Security trust funds will be depleted by the year 2032 unless there are changes in the system. This projection includes the gradual increase in the age at which one can obtain full benefits from the current age 65 to 67 that is already written into law. There are numerous proposals being debated about ways to save the system, and it is likely that Social Security will remain in some fashion. It is very clear, however, that those who want a comfortable retirement should not count on this program to fund it. Personal savings will be more important in the future than they have been for current retirees.

Another compounding problem is the previously-mentioned shift in employee retirement programs. Retirement funds are disproportionately being shifted away from Defined Benefit Plans (DBPs) to Defined Contribution Plans (DCPs). Typically, the DCPs do not include retirement health care, a frequent component of DBP’s. As health care is a major expense of older people, this is a significant shift from employer to employee. Furthermore, the worker has the added responsibility of managing and monitoring the investment decisions of retirement accounts.

Not only is the responsibility and risk for retirement planning shifting away from corporate America to the worker, increasing percentages of workers are doing freelance work, are working for small companies that do not offer retirement plans at all, or are shifting jobs frequently and therefore not getting vested in retirement plans that may exist. Clearly we are in a period where the individual is going to be much more responsible for his or her own future than has been true before.

The Problem

There have been numerous studies that question the ability of Americans to actively manage not only their financial affairs in general, but their retirement affairs in particular. The later point is emphasized by the oft-cited fact that the United States has the lowest savings rate of the G-7 nations at 4.1%. Japan (15.3%) and Italy (14.3%) experience savings rates over three times higher. This relatively low and stable US savings rate reinforces the argument that the lack of savings is a serious long-term problem with particularly grave consequences for retirement planning.

Problems stemming from the deficiency of retirement monies are complicated by the lack of knowledge and skills necessary to manage retirement account funds. Savers could earn more on investments and pension benefits if they understood the basics of investing and the behavior of financial markets. These additional funds, benefited by compounding, would alleviate the looming shortfall and subsequent decline in the standard-of-living.

The Institute of Certified Financial Planners noted in a 1993 study that 53 percent of planners surveyed indicated that their clients had great difficulty with retirement planning and implementing investment strategies. It should be noted that the very act of contacting planners suggests that these clients are already ahead of most Americans. They have recognized the problem and sought a pragmatic solution to it.

The problem is serious enough that the Office of Investor Education of the Securities and Exchange Commission, along with a number of other organizations has organized a “Facts on Saving and Investing Campaign.” Noting that “at a time when more Americans than ever before are investing in our securities markets directly through the purchase and sale of stocks and bonds, numerous studies show they lack the financial basics.”

These findings are verified by a survey recently conducted by the authors. Using a questionnaire designed to test individual participant knowledge on diverse topics such as risk, diversification, financial advisor qualifications, taxes, stocks, valuation, business math, the impact of changes in interest rates, exchange rate risk and global investing and mutual fund performance, a sample of 264 college-educated adults were tested on their investment knowledge. A perfect score on the quiz is ten points, with seven points or higher suggesting that one has mastered the investment basics. A score of five to seven suggests that one must do some reviewing prior to making any big investment decisions, while less than five indicates a serious deficiency of basic investing knowledge.

The majority of those taking the test were currently employed (84%), about half were married (45%), about half were home-owners (49%), and most were optimistic about America’s future (83%). Only 12% did not have retirement accounts, and most owned stock (70%) through IRAs (40%), 401Ks (68%), other pension plans (17%) and/or participation in investment clubs (25%). Most were covered by life insurance (67%) and 24% owned annuities.

Seventy-seven percent of the respondents reported that they felt adequately prepared for retirement. This optimism exists despite the fact that only a third of them anticipate receiving any benefits from social security and Medicare.

Results

The results suggest that these respondents are overly-optimistic about their abilities to handle their investments. The overall average response was slightly over five correct answers out of the ten. It would appear that they may well be participating in financial investment vehicles and markets they do not understand, even at an elementary level.

When broken down, the results suggest that those who are actively involved in investing tend to have a better grasp of investment basics than do others. Therefore, participation in pension plans at work may be one way of becoming knowledgable. Firms can provide information and encouragement to employees about investing, and may well benefit by instilling a sense of loyalty and trust. KPMG employed Merrill Lynch to educate its employees and the initial results were an increase in salary deferred to almost 9% compared to KPMG’s 5 to 6% historical average.

Retirement Calculators

How much will you need to invest or save to maintain 70% of your pre-retirement income in your golden years? These calculators are similar in many ways, but each has some special features and you may want to review them all before deciding which to use. The last two contain features that suggest the types of asset allocations that may be appropriate based on the information provided.

Read the assumptions on these calculators carefully however, particularly those about the rate at which investments will be compounded. Historically, the overall stock market has risen at an annual rate of less than 10% over the long-term, not the 17%-20% that people have experienced in the past two or three years. A difference of even one or two percent (e.g., 8% vs. 7%) can make a sizeable difference in the estimated value of a portfolio over a period of 30–40 years.

The American Savings Education Council’s “Ballpark Estimate” Planner
http://www.asec.org/ballpark/index.htm

The Motley Fools Retirement Calculator
http://www.fool.com/calcs/retcalcs/ret2.htm

Vanguard Retirement Resource Center
https://personal.vanguard.com/us/planningeducation/retirement

Fidelity Retirement website
https://401k.fidelity.com

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Guide to Personal Investment Software

The selection of an appropriate software package can have a significant impact on the overall success of a small investor.

The selection of an appropriate software package can have a significant impact on the overall success of a small investor. The purpose of this paper is to evaluate the cost-effectiveness of ten financial planning software packages for individual investors. Details of these programs and information concerning their manufacturers are provided in Appendix A.

Typically, investment software has been organized into three general categories: tracking; trading; and selection or screening. Tracking involves the process of charting specific investments over time, trading consists of designing optimal portfolios, and screening entails sorting investment data based on a set of criteria. None of the examined packages incorporates all three categories. Instead, they tend to focus on either tracking and screening or tracking and trading. This made direct comparisons between the software more difficult.

Comparisons were based on the following attributes: user interface, charting capabilities, program manual/tutorial, research capabilities, output features, data input, customization, and comprehensive value. Each attribute was weighted in importance as shown in Table 1. These evaluations were performed on either a full-featured program or a demonstration program which highlighted the pertinent features and characteristics. User manuals were evaluated based on the presence of hardcopy support literature, ease of use, troubleshooting index, and examples. Each financial package was assessed by three evaluators and the average of the scores was used in the analysis.

The output features were assessed in terms of the extent of graphical and table data presentation. The level of customization was measured in terms of the user’s ability to modify the standard screens, charts and reports. The research capability was judged in terms of the user’s ability to modify the data set using formulated decision criteria and to interpret specific trends and indicators. This interpretation capability represents an important framework for helping the user gain a better understanding of market fundamentals. The data input feature was assessed primarily on the sophistication of the data file transfer process. The comprehensive value was defined as the program’s overall technical coverage and effectiveness.

The results show that the Windows On Wall Street program has the highest weighted score of 4.8. This is not surprising since it showed excellent performance in all evaluation categories. Wall Street Analyst was second with a score of 4.5 and AIQ was third at 4.3. There is very little difference in the weighted scores of the top rated programs. Also, the first two programs focus on tracking and screening while the third emphasizes tracking and trading. In cases where the ratings are close, costs can be a deciding factor.

Table 2 shows a benefit-cost analysis based on the initial cost of the program and the estimated annual online charges. These results show that the Reuters Money Network program emerges with the largest benefit-cost ratio with Wall Street Analyst in second place. These ratios can be somewhat misleading since the online charges can vary considerably depending on use. In many cases, the annual online charge can exceed the initial cost for the software.

Conclusions

This study revealed the following:

  • Windows on Wall Street (Tracking and screening) package is the top ranked program.
  • Reuters (Tracking and screening) program has the best benefit-cost ratio.
  • >Windows on Wall Street, Wall Street Analyst, and Reuters are all on or near the efficient frontier.
  • Online charges can exceed the initial cost of the financial software.
  • The top-ranked programs are very user-friendly and are easy to learn.

The current inventory of financial planning software can assist the individual investor in improving his/her performance in the market. Additionally, software packages like the ones examined in this study can be used by the employer as training systems for both employees and retirees in designing their own financial investment plan. Obviously, both the initial cost as well as the recurring online charges must be taken into account before deciding whether to purchase a financial planning system.

Several of the relatively low-cost systems identified in this paper, e.g., Reuters, may serve as a starting point. Corporations may wish to consider purchasing one or more of the investment planning packages for use by employees and retirees. This could include the establishment of financial investment clubs where the company helps underwrite the online data transfer charges.

The capabilities of stand-alone investment software will continue to grow over the next several years. In many ways, they will serve as a bridge to virtual financial software support via the Internet. Here, the individual investor will be able to access a wide range of software support tools, data bases, and online technical support on an as-needed basis.

Recommended Reading

Boucher, T. O. (1993), “Multicriteria Evaluation Automated Filling Systems: A Case Study,” Journal of Manufacturing Systems, v. 13, no. 5, pg. 357-378.

Edwards, W. (1977), “How to Use Multiattribute Utility Measurement for Social Decision Making,” IEEE Transactions on Systems, Man and Cybernetics, v. 7 pg. 326-340.

England, C. (1995), “Taking Care of Business: A Review of 21 Accounting Packages,” MacUser, v11, n4, pg. 92-100.

Deloughry, T.J. (1994), “Pushing the Envelope,” Chronicle of Higher Education, v. 41, iss. 9. pg. A36-A38.

Green, P. E. & Kim, J. S. (1991), “Beyond the Quadrant Chart: Designing Effective Benefit Bundle Strategies” Journal of Advertising Research, v. 31, pg. 56-63.

Gianturco, M. (1994), “Cyber-Investing: Try It,” Forbes, v. 153, pg. 162-166.

Kirkwood, C.W. & Corner, J.L. (1993), “The Effectiveness of Partial Information about Attribute Weights for Ranking Alternatives in Multiattribute Decision Making,” Organizational Behavior and Human Decision Processes, v.54, pg. 456-476.

Kopalle, P.K., and Hoffman, D.L. (1992), “Generalizing the Sensitivity Conditions in an Overall Index of Product Quality,” Journal of Consumer Research, v. 8.

Maynes, E.S. (1976), Decision-Making: An Introduction to Consumer Economics, MacMillan, New York, NY.

Wilding, R.E. & Talarzky, W. W. (1993), “Electronic Information Systems for Consumers: An Evaluation of Computer Assisted Formats in Multiple Decision Environments,” Journal of Marketing Research, v. 30, pg. 125-141.

Appendix A

Financial Services Software Specifications

1) Analyzer (Ver 1.2) & Prosearch (Ver 5.0) – (800) 324-8246

Telescan, 10550 Richmond Avenue, Suite 250, Houston, TX 7704

COST: $295 plus $50/mo.

BASIC FEATURES: Tracking and screening (60% to 70% of program useful)

EVALUATION VERSION: Demonstration program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Limited analytical features (Algebraic)

OVERALL ASSESSMENT: Good

WEB SITE: http://gbr.pepperdine.edu/981/ (no longer accessible)

2) Meta Stock (V 6.5) – (800) 882-3040

Equis International, 3950 S. 700 E, Suite 100, Salt Lake, UT 84107

COST: $349 plus $20/mo.

BASIC FEATURES: Tracking and screening (60 to 70% of program useful)

EVALUATION VERSION: Demonstration program

USER INTERFACE: Pull down menus

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Limited analytical features (Algebraic)

OVERALL ASSESSMENT: Good

WEB SITE: www.equis.com

3) Fundmaster – (508) 663-3330

FundVest, Inc., 337 Boston Road, Billerica, MA 01821

COST: $295 plus $20/mo.

BASIC FEATURES: Tracking and trading which includes testing trading strategies

EVALUATION VERSION: Full feature program

USER INTERFACE: DOS with keystroke commands

USER MANUAL/TUTORIAL: Inconvenient; difficult to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Portfolio Optimize used to help identify trends based on historical price data (Inferential)

OVERALL ASSESSMENT: Poor

4) Captool Professional Investor (Ver 5.1) – (800) 826-8082

Techserve, P.O. Box 9, Issaquah WA 98027

COST: $499 plus $20/mo.

BASIC FEATURES: Tracking and trading helps to identify asset class performance. Updates on latest tax laws

EVALUATION VERSION: Demo disk

USER INTERFACE: DOS with pull down menu bars

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: File transfer. Compatible with online databases

COMPUTATIONAL SUPPORT: Optimizes a portfolio based on financial position of investor

using Sharpe ratios and Markowitz model

OVERALL ASSESSMENT: Good

WEB SITE: www.captools.com

5) AIQ Trading Expert (Ver 4.0 ) – (702) 831-2999

AIQ, Inc., Box 7530, Incline Village, NV 89452

COST: $695 plus $50/mo.

BASIC FEATURES: Tracking and trading (70% useful, 30% very advanced)

EVALUATION VERSION: Full feature program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Charting and analysis capabilities (Inferential)

OVERALL ASSESSMENT: Good

WEB SITE: aiq.com

6) RAMCAP (Optimizer) – (800) 480-3888

Wilson Associates International, 7535 East Hampden Ave, Suite 101, Denver, CO 80231

COST: $595 plus $100 per quarter or $399 per year

BASIC FEATURES: Tracking and trading

EVALUATION VERSION: Demo disk

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: File transfer. Updates provided through subscription

COMPUTATIONAL SUPPORT: Optimizes a portfolio based on financial position of investor using Sharpe ratios and Markowitz model

OVERALL ASSESSMENT: Fair

7) Windows on Wall Street (Ver 5.0) – (972) 235-9594

MarketArts, Inc., P.O. Box 850992 Richardson, TX 75855

COST: $130 plus $20/mo.

BASIC FEATURES: Tracking and screening (80 to 90% of this program useful)

EVALUATION VERSION: Full feature program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Excellent charting and analysis capabilities

OVERALL ASSESSMENT: Good

WEB SITE: www.wallstreet.net (no longer accessible)

8) Principia for Mutual Funds – (312) 424-4288

Morningstar, Inc., 225 W. Wacker Dr. Chicago, IL 60606

COST: $495/year with monthly updates via CD

BASIC FEATURES: Screening which utilizes comprehensive mutual fund database

EVALUATION VERSION: Full feature program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient; easy to assimilate

DATA INPUT: Data base & updates provided through subscription

COMPUTATIONAL SUPPORT: Criteria based screening process (Descriptive stats)

OVERALL ASSESSMENT: Fair

WEB SITE: http://gbr.pepperdine.edu/981/ (no longer accessible)

9) Reuters Money Network (v2.5) – (800) 521-2471

Reality online, 2200 Renaissance Blvd., King of Prussia, PA 19406

COST: $20 plus $20/mo.

BASIC FEATURES: Tracking and screening (60% to 70% of program useful)

EVALUATION VERSION: Full feature program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Convenient, easy to assimilate

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Limited analytical features

OVERALL ASSESSMENT: Fair

WEB SITE: http://gbr.pepperdine.edu/981/ (no longer accessible)

10) Wall Street Analyst (Ver 3.0) – (800) 556-2022

9200 Sunset Drive, Miami, Fl 33173

COST: $70 plus $20/mo.

BASIC FEATURES: Tracking and screening using candlesticks & tick bar charts

EVALUATION VERSION: Full Feature Program

USER INTERFACE: Windows

USER MANUAL/TUTORIAL: Two in-depth manuals but no tutorials or indexes

DATA INPUT: Built-in downloading features & database compatible

COMPUTATIONAL SUPPORT: Provides standard statistical measures and calculates moving averages, momentum, volatility and related indicators

OVERALL ASSESSMENT: Good

WEB SITE: http://gbr.pepperdine.edu/981/ (no longer accessible)

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