The Savers’ [of the bubble] Budget, by UK Conservatives

Let the campaign begin. Source: Google Images.

I’m a bit late to the UK Budget commentary – I wanted to hear more experienced/knowledgable opinions before setting out my own.  Anyway, here are some quick thoughts that came to mind while watching the source material + reading summaries of those commentators:

• The UK actually has a budget.  Not well-known among UK folks, but the US is utterly incapable of passing a budget.  Perhaps a triumph of separation of powers, or perhaps a prime example of how sensible things can’t pass Congress, but idiotic things can.
• A clear campaign tool.  It seemed to me there were a few programs/expenditures selected for budget inclusion purely to make snide comments about the opposition.  Still, if I were in the ‘internet of things’, I’d be happy with the new subsidies nonetheless.
• Savers win…I think.  A few items that were interesting to me:
  • Lower income taxes.  Yup, still a Conservative government, even if the policy was a Liberal Democrat policy.  The increase in tax-free allowance will mainly help middle-class folks; those who should be saving more.
  • Tax-free interest.  WOO HOO!  Middle-class earners now get £1,000 of tax-free interest a year; higher earners now get £500 tax-free.  With today’s average savings account rates of about 1%, that means accumulated cash savings about about £50-100k will earn tax-free.  Sweet – this is basically a 20% subsidy on bank interest.  Hopefully an incentive to save more.
  • More flexible ISAs.  For the non-UK’ers out there, one of my favourite programs in the UK is the Individual Savings Account (ISA).  They are tax-free investment/savings wrappers which can be used by any UK resident.  Like a US Roth IRA, but you can withdrawal funds at any time.  The new rules mean you can withdraw from an ISA, then put back the money in the same tax year.  Previously the withdrawals couldn’t be put back.
  • The Help to Buy ISA.  Ugh.  Continuing my rant on UK housing, the next ruse to prop up house prices is a 25% savings subsidy for those saving for a house down-payment.  The saver puts in £200/month; the government puts in £50/month, until a maximum £3,000 subsidy (so £15,000 total in the account).  Great – again using demand subsidies to treat a supply issue.  <humph>
  • Sell-back your annuity.  I see this as a big problem down the road, but one I hope doesn’t hurt too many folks.  I’ve written before about the new pension rules in the UK; now those who have recently been forced to buy an annuity can resell for cash.  Given annuities are basically individual insurance contracts, I can’t see a very liquid secondary market being setup.  That will lead to poor prices for pensioners, who in turn will be easy to scam.  Hopefully I’m wrong.
  • Pensioners – less savings for you.  Despite the above, the lifetime maximum allowance for tax benefit (i.e. tax-deferral) has been further decreased to £1m from £1.25m.  Given today’s annuity rates, the lower cap allows for a lifetime income of about £2,000/month (assumptions: retire at 60, joint, inflation-indexed, no guarantee, no tax-free lump sum).  That’s a bit lower than UK median income.  So seems a bit stingy to me – it’s a cap which many ordinary savers will probably hit.
• What I didn’t hear enough of: infrastructure investment.  I’ve written before how I view the situation: use record-low government borrowing rates to build infrastructure (and more social housing, while we’re at it).

In sum: I’m looking forward to tax-free interest (even with peer-to-peer lending, apparently), and the lower taxes.  The rest is kinda ‘meh’, aside from my bad thoughts on HTB ISA and new pension rules.

Social Security Works (or not?)

You tell ’em, tea-bagger. Source: Google Images.

This morning I read a Huffington Post article by Nancy Altman, which piqued my interest.  It advocates shifting away from privatising Social Security, or indeed advocating 401(k)s or IRAs, and applying additional taxation towards extra funding and benefits from the existing Social Security system.

I see that Ms Altman has a book out, as well as a lobbying group named Social Security Works.  In lieu of buying the book – which I may yet do, given the thesis is far from my understanding of the status quo – I read a few of the lobbying group’s memos.  My thoughts:

• Isn’t Social Security going broke?  Well, yes and no.
  • Social Security’s income comes from (source: the lobbying group)
    • Current taxation: around 85%
    • Investment returns: around 15%.  FYI, ‘investments’ are 100% US Treasury notes and bonds.
  • So what?  Well, lower yields for Treasuries means lower future returns for Social Security.  So that item will need to be supplemented by additional tax, or else benefits will come down.  Also, the large cohort of (working) baby boomers leaving behind a smaller workforce will lower the current taxation component.
  • And… that leads to projected deficits, and loss of benefits, beginning around 2033 under status quo.  Technically, the loss of any benefit would be a default – therefore bankruptcy or ‘going broke’.  The group claims this isn’t the case, as taxation will still be coming in.  If only personal bankruptcy worked that way, right?
  • How to fix this?  The group suggests abolishing the cap on income subject to Social Security tax – right now income over $117k isn’t subject to SS tax.  No mention of removing the cap on SS benefits however – those remain.  The progressive in me thinks this is generally OK: maybe the US can follow the UK National Insurance scheme, and tax the extra income by a lesser rate, like 2%.
• Why not privatise and/or encourage IRAs and 401(k)s?  
  • Cost differential?  Your run of the mill IRA + fund management charge is probably around 1-2% of assets in the retirement account, per year.  Social Security spends about 0.5% of trust fund assets in Administration costs, per year.  So one can plausibly argue that Social Security is a more cost-efficient way to save for retirement – though I wonder what is the administrative cost of collecting SS taxes.
  • Return differential?  I’ve written before about how good a deal Social Security can be for current retirees, particularly against expectations for future generations.  So here’s a thought, keeping in mind where the money for SS payments comes from (see above): given a slowdown in demography (i.e. fewer workers paying in) and investment returns explicitly limited to US Treasury returns, how can there be enough money to go around in future?
    • For example, 30-year Treasury bonds currently yield 2.63% per year.  That means $100 of Bonds purchased today will be worth around $220 in 30 years.  If we assume the Fed can achieve 2% long-term inflation, and SS benefits continue to rise in line with inflation, that’s hardly any real return at all.  And that’s the maximum investment return allowed by Social Security.
• How to fix it?  
  • Sadly, the mathematics just don’t add up unless taxes are raised – hence I absolutely see why the group wants to remove the cap on earnings subject to SS tax.
  • I suppose the amounts sent to ‘auto-enrolled’ 401(k) plans could just be reframed as additional SS tax to help keep up the program, and possibly increase benefits?
  • The only other method I can think of would be to massively increase population through either more lax immigration policy or through discouraging the use of contraception.

In sum: I was absolutely intrigued by the idea that, instead of thinking of Social Security as a slowly fading institution of old-time, New Deal America, we should consider the program as a better option for our future pensions.  The cold mathematics, however, means pretty unpalatable choices to make this happen.  But, as I’ve written before, the millennial generation faces stark mathematics regardless of how pensions are handled – there just isn’t enough money to go around.

On government (mis)intervention

So we’re in week 2 of the European Central Bank’s (ECB) quantitative easing.  Among the effects:

• Bond bubble: some commentators have spoken phrases such as ‘bubbles are only obvious in hindsight’.  Well, despite articles justifying the purchase of negative medium-term bond yields, I hope it’s obvious to most that these 10-year bond yields are unsustainable:
• 

  Let’s lock in 1% for 10 years, shall we? Source: Bloomberg

  Anybody notice in the above that countries such as Italy, Spain and France can borrow for 50% or less of the US Treasury?  Does that make sense to anyone?

• Stocks flying: the S&P 500 is more or less even in 2015, despite tepid company results.  European stock indices are flying: the German Dax is up 23% YTD, for example.  While Germany is growing, that’s a big flier. (Side note: I’m happy I did that little bit of rebalancing a couple months ago).
• UK house bubble keeps going: as written before, this market defies logic.  The UK government’s policy towards soaring house prices has been…um…subsidised mortgage financing.  It’s a sad joke.
• US Dollar is king: as the Fed is turning the corner to raising interest rates, while Europe and the rest of the world are still cutting/QE’ing, the US Dollar index is up about 10% this year.  As mentioned before, if you’re American and thinking of international travel, or even moving offshore: go now.

HOWEVER

Main street?  All the above is great news for investors (though not necessarily savers).  But I’m not convinced this QE helps these economies get back to business.

The direct intervention in financial markets means stock and bond capital gains are much greater (and more predictable) than business investment.  If you’re an entrepreneur, funding can be tight from the banks; why would they lend, when the government bonds they hold spare are making a better return on equity?  If you’re a corporate director, why borrow at low rates to build new plants or try new projects when the return on buying back shares is so good?

In sum: QE had a great initial function, in my opinion.  It loosened credit for big businesses; it jumpstarted merger activity; it finally anchored inflation expectations to essentially zero.  In my opinion, the usefulness of QE has been exhausted for the most part: as central bankers have mentioned around the world (and I’ve written about), it’s time for serious fiscal policy to kick in.  Let’s see some new roads, bridges, broadband, etc.

Friday listening: Promises, Promises

Piggies in trouble. Source: Google Images.

I’ve been a bit discouraged by markets this week – the gyrations make for poor commentary.  I guess the general message is to be short: short stocks, short oil, short Euros, etc.  We’re back to zero S&P500 return in 2015.  Just stay long fixed income (particularly in Europe) and long the US Dollar.  That about sums it up.

Anyway, it’s Friday.  I’ve really enjoyed this BBC radio series called Promises, Promises, which traces the history of debt from an anthropological perspective.  Some really fun concepts and stories here, as narrated by the author of one of my absolute favourite books – Debt, the First 5,000 Years.  The radio series is 10 episodes of 15 minutes a piece, so very digestible for those short walks outdoors or quiet time in the house.

Let’s hope for better markets next week, eh?

Define market (in)efficiency: the Euro

Euro/USD prices: An anomalous move? Source: thinkorswim by TDAmeritrade

The Efficient Market Hypothesis is a well-known, well-respected theory.  It’s frequently cited by folks in the economic & financial space to justify very conventional, buy-and-hold investment products.  Particularly in the stronger forms of EMH, all publicly available information is immediately reflected in asset prices.

I’ve written before about the impact of ‘known unknowns’ versus ‘unknown unknowns’ in financial markets.  The recent crash in the Euro strikes me as an interesting case study:

• Why is the Euro crashing?  In a term, policy divergence.  The European Central Bank is providing quantitative easing to the Euro-area, which means (all other things equal) higher money supply and a cheaper currency.  In contrast, the Federal Reserve is gradually pulling back from their quantitative easing (i.e. letting their purchased bonds run-off), and thinking about raising interest rates this summer.  Both these actions should mean a stronger US Dollar.
• Why such a prolonged slide?  This is where I think the markets are interesting.  In an informationally-efficient world, I would have expected a big move at the onset of European QE, with not much happening thereafter (perhaps some oscillation around a new equilibrium level).  Instead, we’re being treated to a managed futures manager’s dream scenario: a fairly steady downward trend, without many pull-backs.
• Perhaps behaviour economics can answer?  An explanation could be found in the inefficiencies considered by behavioural economics.  Among the possibilities:
  • Discrete decision points: perhaps each business/investor considers the QE announcement at different intervals, and thus make moves in sequence.
  • Loss aversion/disposition effect: folks long Euros have been holding on, while losses pile up.  Over time, they accept their painful losses at different points based upon relative aversion.

In sum: efficient markets shouldn’t really show these kind of smooth trends.  But the trends exist all the same.  Hence it’s worthwhile considering momentum as a viable investment strategy.

Makin’ it blow: investing in renewable energy

Old school renewable energy. Source: Google Images.

I’ve written before about one of my main principles of portfolio management: diversification.  Very important, as I come to this investment game with much humility regarding my ability to forecast asset returns.  Choosing many different return streams should *hopefully* give the family portfolio the best chance at steady, but appreciable, gains.

The latest iteration of this approach finds me looking at renewable energy; in particular, corporate bonds secured on renewable energy infrastructure such as solar panels, biomass power plants or wind turbines.  Here are a few websites I came across while researching the space:

• Aegis Power
• Abundance Generation
• Investor Square

Some thoughts:

• Returns seem decent-high: most projects offer 6-10% p.a. interest, with tenors of 5-10 years.  Way better than the ~2%ish on government debt, or ~3.5% on corporate debt.
• Bond security seems decent: in the docs I’ve seen, the asset (e.g. a windmill) is pledged as security for the bonds.  So more security than you get with the debt mentioned above.
• Key risk is government risk: the economics of renewable energy are still tightly bound to government subsidies of various sorts.  In the UK (the focus of my research) the overarching EU scheme forces countries to generate ~30% of power through renewables by 2020.  The UK, for one, is nowhere near this.  So the government has rolled out several programmes to ensure those building renewable infrastructure get a guaranteed revenue stream.  BUT – as my dad always says, the only risk you can’t hedge is government risk.  In this case, suppose way more windmills get built than can possibly be used – would the government still provide the subsidies, particularly when some/all of these subsidies are paid through consumers’ energy bills?
• Other risks seem mostly insured/hedged: these include construction insurance, operating insurance, power purchase agreements, etc.
• In sum: the juicy return is in return for government risk.  If subsidies get slashed, with no grandfathering, you (as bondholder) end up with a windmill which generates uneconomic power.

Will I invest?  Given the timeline for most of these subsidies/schemes/agreements/quotas measure decades, it might be worth a punt for 5-10 years.  By then, we’ll likely either have far too much renewable energy than we know what to do with (not, in itself, a bad thing) or maintain status quo of needing more (with associated subsidies).

Is it better to spend time budgeting or choosing asset managers?

So I read an interesting blog post on Noahpinion today, regarding whether ’tis better to ditch active fund management (e.g. follow Jack Bogle’s advice and stick with index-tracker ETFs, which charge very little fees), or to save more, in terms of retirement savings.  The article gets a bit economist-like, involving some basic utility functions and the like, to come up with a tentative ‘better to ditch active management’ conclusion.  The short blog post + comments are worth a read.

Anyway, this got me thinking.  And when I get thinking, I get modelling.  So here’s a spreadsheet which models the analysis I think of, when considering this problem.  Method:

• Hypothesis: I think the time spent figuring out asset managers (whether passive or active) is probably about the same as creating a basic budget.  The latter allows for increased savings.  So let’s find out whether time is better spent ditching active management for passive, or creating a budget, in terms of accumulated retirement saving.
• Data: for simplicity, I use the total returns of the S&P 500, data which comes from Aswath Damodoran.
• Assumptions:
  • Starting salary of $50,000.
  • A savings rate, without budget, of 5% p.a.
  • Salary growth of 2% p.a., which is reflected in increased savings (i.e. we save 5% of the new, higher salary).
  • Performance drag of active management over passive of 2% p.a. So I assume active managers under perform a passive S&P 500 fund by 2% each year.
  • Budgeting increases savings by 3% p.a.  So a person who currently saves 5% p.a. can up that to 8% p.a. by making a budget.
• Results: 

• 

  Budget or bin the manager? Source: Damodoran Data.

• • A Monte-Carlo simulation of 100 lifetimes (44 years of accumulated saving), randomly choosing years of S&P500 returns with replacement, brings the above picture.
  • Each run charts the net benefit, in terms of wealth at retirement age, of choosing to budget rather than switch the active manager for passive.  See the worst line there?  That’s happened because the luck of the draw meant lots of good years for the S&P 500 portfolio: in that case having the fee drag is a really bad thing versus just saving a bit more (however you’d be very rich in either case).
  • It turns out the ‘break even’ is around 4% for budget savings to exceed fee savings.  So if the savings ratio can be bumped from 5% to 9%, in this example, better to budget.
  • In brief: just choose the method that saves more.  Unless your budget increases your saving by a fair bit more than active fees (2% in this example), focus on active fees first.
  • In Noahpinion’s favour, one of his problems with this type of conclusion is that, because we can’t know how much more $1 today means to someone than $1 at retirement, we can’t use phrases like ‘better off’ to characterise the result.  All we can say is the wealth is higher at retirement.
  • Go ahead and play with the assumptions and see the accumulated benefit on the line chart, if you like!

In sum: suppose you’re holding some actively managed mutual funds, and are considering dumping them all for passive ETFs to save on fees, or even whether to dump one manager/ETF for another.  Before spending time with the withdrawal forms and whatnot, consider creating a simple budget to increase your savings.  The latter may pay off more in future.

Obamacare: the tyranny of choice

My mom and I had a good catchup yesterday, and among the topics was health care.  As a newly-minted UK citizen, I’ve lived in the country long enough to have my concern/interest in health care take a back back back seat.  Alas, for my family continuing to live in the US, it’s just not an option.

Many questions, many choices, much confusion. Source: enrollmissouri.org

Speaking of options: I just perused the Missouri ‘health care marketplace‘, to see how far insurance has come since the very contentious legislation. Some thoughts:

• For anyone interested in how much health care costs for Americans, consider this spreadsheet from the website.  Some explanation is required, so use the earlier link to hear the differences in tiers.
• First impression: OH MY GOD THE AMOUNT OF CHOICE IS RIDICULOUS.
  • I’m reminded of buying peanut butter when I first came to the UK: at first I was near-horrified there were only about 5 choices of peanut butter at the grocery store; how do people live without so much choice?  Now?  I’m plenty happy to have that many choices…peanut butter just kinda works.
  • Following from the above: my naive impression is that the ultimate criterion for useful health insurance is just like peanut butter.  Does it work?  If it does, great.  I couldn’t care less which insurance provider it is, for example.
  • Given this is a health exchange, all the plans are meant to fit very specific criteria about what can be offered.  Somehow this still involves different pricing among many variables, including the country one resides within the state.  Really?
• Second impression: how can any reasonable person be expected to make an optimal choice?  Mom found the site confusing, and she’s a smarty pants.  It’s like the site was designed to encourage normal folks to hire ‘navigators’.  Sound familiar?  I’ll give you a hint: the US tax system encourages exactly the same thing.  
• Third impression: it’s a shame Obamacare was watered down so much.  
  • The huge amount of ‘choice’ looks to me like a ruse for price discrimination writ large.  +1 for the lobbyists.  Optically separating the risk pools for insurance will probably also keep premiums high, maintaining profits for private insurers.
  • My understanding of insurance is that the larger the risk pool, the cheaper the cost of insurance provision.  That’s the reason for the much-hated ‘mandate’ Obamacare places on supposedly healthy (but taxpayer-unfriendly) young folks choosing to only use the emergency room for health care.  By having all these different providers, risk pools stay small.  Costs can’t come down.
• Final impression: it’s still a step in the right direction.

In sum: I had very high hopes for Obamacare as initially proposed.  Its move towards a single-payer model (which seems to work in every other developed country) is the right call to lower costs.  But no: as with many things, the final legislation seems to have kept all the unpalatable bits (e.g. the ‘mandate’) without the clearly beneficial bits (e.g. single-payer, very small number of options to ease choice and maximise risk pools).  My big hope for the future is to see Obamacare continue to succeed; consolidation among providers; and eventual phasing out of the private market for primary insurance.

Proof I’m a personal finance geek: the recent French Aviva story

I have been told by many over the years that I have an abnormally calm demeanour – very few things make me go nuts, or even make the outward manifestation of an exclamation point.

HOWEVER: this story, narrated by Matt Levine at Bloomberg, really made me excited and giddy; with big laughs, scoffs, etc.  The fact it’s about financial innovation gone horribly wrong probably helps prove the point (if any more proof were needed) that I am, indeed, a personal finance geek.

Let this be a lesson to us all: read the fine print.  Sometimes the institution messed up in your favour.

Finance 101: From the Simple Dollar, retirement on $1,000,000

Just a quick shout out to one of my favourite blogs, The Simple Dollar.  Yesterday’s entry on how to retire on $1 million (or if it can be done) well-illustrates the type of basic analysis underpinning retirement planning calculators everywhere.

My only caveat with the analysis, like most of these simple ones, is the sensitivity to assumptions.  This article tries several types of assumptions, which makes the thing stand out (in my opinion).  But particularly when long time periods are involved, small changes in assumptions can drastically change results.  Given we have basically no idea what the correct figures will be, caveat emptor for those placing too much reliance on one run of the ‘simulation’!

Sadly there isn’t a good fix for unknown parameters in the analysis, but rest assured I’ll let you know when I have a reliable crystal ball.