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Cutler's Op-Ed Columns SECURING THE AMERICAN DREAM – THE 8% SOLUTION By Glenn Cutler published December 15, 2008 When I was a kid my parents opened up a passbook account for me. It was exciting having my own booklet that showed how much my savings grew. The interest rate was 5.25%. My dad reveled in the joy of teaching me the wonders of compound interest and in showing me how many years it would take to double my money at various contribution levels. This was a valuable lesson, not just in math, but in understanding the value of savings and the importance of interest rates. Of course, not understanding much about banking and finance during my grammar school years, I thought 5.25% interest rates was a permanent thing, an institutionalized number. Building The Dream The dream of success back then, for the baby-boom generation was often capsulated in a notion that one day we would “become millionaires.” That was a universally accepted definition of success. Fast-forward 40 years, and despite living through the troubled economy of the 1970’s, the oil shocks, hyperinflation and the S&L crisis of the 80’s, the American economy found ways to grow and prosper and American ingenuity pioneered new frontiers in science and engineering through technology, communications and biotechnology and a broad expansion into the service sector. Through it all, capitalism thrived, new companies were formed and soon many Americans did reach the dream of wealth, many becoming millionaires. The 2008 World Wealth Report published by Capgemini and Merrill Lynch cites the number of Americans with a net worth of $1 million or more, excluding the value of their primary residence grew 3.7% to 3.028 million people. This growth in the population of millionaires reveals that the percentage of people moving up the economic scale has continually increased. This phenomenon prompted a 1996 book, “The Millionaire Next Door” which discussed the behavior and characteristics of the newly minted millionaires who innocuously assimilated themselves in middle-class communities around the country. Of course we don’t know what the report will show for 2008, but it would not be surprising, given the worldwide collapse in financial assets, that this number may actually shrink for the first time. As interest rates tumbled, investors could no longer produce risk-free income from their capital asset base to meet their annual expense requirements. One would think that having a million bucks in the bank would be enough to provide financial security for life. I’m sure many do believe that to be the case. The math doesn’t bear that out. A 10-Year Treasury at 3% provides safety but not security, as it yields only $30,000 of annual income. Who can live on that? A retired couple in their 50’s or early 60’s with a modest mortgage and annual healthcare premiums can’t live on $30K annually. For the many who spent the presidential campaign screaming about the widening gap in net worth and lambasting the upper 2%, they may have difficulty grasping a conversation about the plight of a millionaire, or perhaps now former millionaires, and the challenges now faced in retirement as their income has declined along with their capital base and therefore confidence in their own ability to manage their long-term financial security has been severely impeded. The Yield Trap As risk-free investment vehicles which generate income have lost their usefulness as interest rates declined, savers have been reluctantly forced to move assets into riskier investments to attempt to secure their future with adequate annual income. This shift lured retirees and other savers into a yield trap. Interest rates typically decline because economic conditions are weak and in declining economies businesses suffer. When the outlook is uncertain and economic data reveals higher unemployment and lower consumption, investors lose confidence in debt securities and prices fall. These are exactly the kinds of investments that perform poorly as questions are raised concerning the ability of corporations to meet debt service obligations and to refinance their short-term balance sheet requirements. With the extreme lock-up in credit markets in this financial hurricane, these concerns have been compounded many times more than observed in recent recessionary periods. The result is that the shift by savers from riskless assets to riskier assets to create livable income caused real shrinkage of personal savings, a diminished capital base and a loss of income as individual companies and bond funds reduced, delayed or eliminated expected dividends and interest payments. Missed Opportunity It is a shortcoming of government and society at large, to not have taken a hard look at how to benefit from the broad spectrum of personal financial success achieved during prosperous times. One would think a mechanism should be in place to provide a safe way for those who achieved their American dream to find a risk free method to secure their own long-term security and not have to fall backwards to become a burden on the system either by seeking financial assistance to get by, or by re-entering the work force when the economy falters. Older people, who have been out of work for years, are not always the most employable and that is additionally magnified at a time when the economy is experiencing accelerating job losses. Wouldn’t it be a reasonable goal for government to hit upon a means to help people who had achieved success to provide a simple way for them to sustain their own futures without having to risk their capital assets? After all, encouraging people to save has always been a mantra yet there is no enabler to encourage those savings, especially in an excessively low interest rate environment when savings cannot produce enough income to make ends meet. Conversely, periods of high inflation, infrequent though they have been, reduce spending power faster than a saver can nurture it. However, certain assets, including commodities and equities are often rising in price and so a balanced portfolio of assets can more readily sustain net worth when there is moderate or even higher inflation. The period of high inflation during the 1970’s and into the ‘80’s was accompanied by high interest rates. Very high. I remember my mom getting a bank CD with a 15% yield in the early 1980’s. And even though the after tax yield was slightly below the then inflation rate of 13% at that moment in time, the overall effect of a long-term CD at those rates would have provided a total return well in excess of inflation, which gradually fell. Creating financial vehicles is a by-product of capitalism. There are pros and cons to this creativity. Recently, we’ve experienced one of the hardest lessons of financial creativity as some financial products, derivatives and derivatives of derivatives, have become so complex and so intermingled as to create a jigsaw puzzle so large it cannot be fully understood by any one individual, nor regulated even by those who insist upon stringent oversight and regulation. Historically, however, there are examples of simpler financial products created to serve specific purposes. To raise money to support World War I the US government created Liberty Bonds, which eventually evolved into Series E Bonds or what we call Savings Bonds. Today we have I Bonds which are indexed to inflation and Series EE Bonds. The 8% Solution What the government should consider is to offer a new type of product which is tailored toward those who have accomplished their financial goals and whose primary focus has shifted to figuring out how to secure themselves financially for the rest of their lives without taking unacceptable risk. These government issuances might be called Security Notes or S-Notes. Or R-Notes as in, Retirement Notes. Unlike the old War Bonds which are purchased at a discount and increase toward their face value over a defined time period when they can be redeemed, Notes are treated as an interest based loan with coupon payments on a specific schedule, usually twice per year. A fixed rate of 8% would be the coupon. This would be a reasonable rate of return on $1 million, and produce annual income of $80,000. They should be exempt from state and local taxes. There would be no public trading market, the underlying value would never change and the yield would be pegged. This 8% solution offers any retired family with enough guaranteed annual income to provide a modest lifestyle. Enough to take care of their basic needs, but not so much that it invites excessive spending behavior. If 3 million people invested $1 million each in S-Notes, this would equate to $3 trillion in purchased S-Notes. There are many positive effects from this that can reach beyond the initial concept of helping successful people manage their own long-term financial security and create a much needed incentive for savers. The $3 trillion could be a much higher number, since many successful people have well north of $1 million. As an economy grows, which one day again it will, more people will experience an increase in wealth. Growing economies attract many things including investment capital, entrepreneurialship, increased employment and higher consumer spending, all good things. But along with that always comes the fear of inflation. When prices spiral ever higher, inflation becomes a factor that weakens purchasing power. Thus, inflation is the enemy of expansion and rising GDP. Of course, as the current environment illustrates, deflation may be the greater enemy. Inflation would be a much friendlier guest today. Simply put, we’d prefer to spend $5 a gallon for gasoline and see our net worth double, rather than experience the devastation of a 50% haircut in our investments and net worth, even though we get to enjoy gas at the pump for $1.65. That’s a current lesson in real economics that everyone needs to grasp. There is a certain economic eloquence to the S-Note concept. As the economy improves the number of people attaining wealth increases. As personal wealth increases the incentive to reduce risk and establish financial security for the family becomes a higher priority. The availability of the 8% solution, the S-Note, is an enabler to that goal. As these people shift their assets out of riskier investments into the S-Note, three interesting things happen. First, the S-Note enables individuals to automatically reallocate their assets based upon changing risk profiles as they seek safer long-term security. This incentivizes people to trim back their assets at times when markets are high and more vulnerable, thus minimizing the tendency for rising markets to accelerate into excessive bubble conditions, and encouraging people not to keep fully invested in riskier vehicles, especially when risk/reward ratios are no longer optimal. Second, the movement of capital into S-Notes removes money from the system. This would be a positive factor to limit inflation during periods of economic growth, something the Federal Reserve is always striving to achieve. Third, the removal of capital from the system would have a positive impact on the underlying currency and be a force of stability and stronger underpinning for the Dollar, which weakens when new money is aggressively created. So here with one vehicle -- we can create a savings incentive for the population -- enable successful people to better support themselves in retirement while reducing their exposure to events and circumstances that may cause them to lose their financial independence and force them to either re-enter the workforce at an older age or lean on government programs for assistance because they lost their wealth – and have an investment process that contributes to regulating inflation during periods of economic expansion through a mechanism that removes capital from the system and in addition, supports the underlying currency. Couldn’t something like this 8% Solution be implemented as either a substitute, adjunct or as an alternate form of Social Security for those who did manage to achieve their American dream? Certainly the potential tradeoffs open up a range of interesting possibilities, including a transfer of part or all of one’s Social Security entitlements back to the system in exchange for the guarantee of the 8% solution. No solution to any large and complex issue can ever be perfect and finite details need to be hashed out. For instance, what consideration may be required for the S-Note holder if inflation rises above 8%? Certain restrictions as to who can purchase S-Notes would be necessary, since they are geared specifically to help individuals sustain themselves through retirement, and not to attract institutional investment capital earmarked for capital formation and economic investment. Perhaps my original notion that a Passbook Saving Account was set at a fixed interest rate is the kernel for a solution to a significantly large problem.
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