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The Fed's New Tax on Retirees

Last week, the Federal Reserve rolled out their inflation forecast and interest rate intentions through 2014, and it’s not good news for retirees or anyone else who relies on interest income.  The yield on money market funds, CDs, and other fixed income investments will likely remain well below the inflation rate for the foreseeable future. This financial repression will result in a trillion dollar transfer of real wealth from fixed income investors to the persons, businesses and governments borrowing at below free-market rates.

Inflation is a tax, even if the inflation rate is low. The Federal Reserve Board Members and Federal Reserve Bank Presidents are projecting long run inflation to be 2.0 percent, although this year the rise is expected to be slightly lower. Combine the Fed’s inflation target with their intention to leave short-term interest rates at rock-bottom levels through late 2014, and the result is an onerous phantom tax on the owners of CDs, money market funds, bonds, and bond funds.

People who own fixed income investments in the U.S. are disproportionally retirees and persons nearing retirement. Thus, the Fed has created a “retiree tax.”

Why the Fed wants low rates

I understand why the Fed has slapped this repressive tax on savers. They had no choice. The economy is in the early stages of recovery, and the Fed wants to give businesses, consumers, and local governments more time to borrow money cheaply and bolster recovery. The fragile housing market and the European sovereign debt crisis also played a large role in this policy decision.

I’m particularly interested in the housing aspect of the Fed maneuvering. Banks already own 440,000 homes and another 1.9 million homes are in some form of foreclosure. Low mortgage rates help strengthen the housing market by making homes more affordable and put hundreds of thousands of people back to work building homes. This is all very good for the economy.

It also gives existing homeowners the option to refinance at lower interest rates, thereby reducing their monthly interest payments and increasing the amount of money available for other purchases. Recall that a large number of loans issued in the housing bubble years were adjustable-rate mortgages (ARMs). The initial rate on an ARM is set low to qualify a buyer for a home, and then in the years ahead based on the prevailing rate at that time. There are $450 billion in ARMs remaining to be reset in 2012 and 2013 (see Figure 1). The Fed’s intent is to keep mortgage rates low through 2013, thereby ensuring these ARMs reset low enough to prevent widespread default and a million or so new foreclosures.

Figure 1: Value of Mortgage Resets by Year

Another issue near and dear to the heart of the Fed is the European debt crisis and the looming recession it has created in that part of the world. European banks are in much worse shape than the U.S. banks. They were heavy buyers of U.S. subprime loans from 2004 through 2007, and consequently, their balance sheets were crippled prior to the more recent sovereign debt crisis.

The U.S. Fed doesn’t have many options with Europe. It must accommodate the European banks in an effort to stop them from dumping their U.S. mortgage portfolios, and thereby killing the fledging housing market in this country. They are also concerned with a European recession spreading through contagion and hitting the U.S. shores before long.

Who the Lenders are

Interest rates are at record lows in this country, which means someone is buying a lot of U.S. debt. We know the Federal Reserve Bank is the largest holder, but who else holds it?

According to data from the Federal Reserve, about half of the U.S. debt is held by foreigners and the other half is held by investors in this country. The foreigners hold U.S. debt because they do business in the U.S. and because the U.S. dollar is still considered the world’s safest currency. U.S. investors hold U.S. debt for the interest income and because it’s generally more secure than owning equity or other investment assets.

The mix of investments that individuals own at different stages in life is of no surprise. IRA owners under age 45 were less likely to be invested in investments tied to interest rates while those over age 45 were more likely to be invested in interest rate sensitive investments, according to a 2011 Employee Research Benefit Institute (EBRI) report on IRA asset allocation.

Older investors are the primary direct holders of U.S. debt. According to the US Government Accountability Office (GOA), bank account balances, stocks, bonds, and mutual funds held outside of retirement plans—are important sources of income for retirees.

Social Security is the largest source of retirement income for households with someone aged 55 or older, earned income is next, and pension income is third. Income from investments accounts for 13 percent, with annuity payments and pensions making up most of the remaining income (see Figure 2).

Figure 2: Income of the Population 55 or Older, 2008

Source: U.S. Social Security Administration, Office of Retirement and Disability Policy

The findings from the EBRI database show the most detailed average asset allocation of IRAs currently available, by providing more asset types from various IRA administrators/record-keepers. The asset allocation found in IRAs is very similar to that in 401(k) plans.

The asset allocation of an IRA investment portfolio for all investors showed 38.5 percent in equities, 22.3 percent in cash investments (market market funds, savings accounts and CDs), 13.6 percent in bonds, 12.1 percent in balanced funds, and 13.6 percent in other assets (stable value funds, annuities). When combining the allocation of balanced funds attributable to assets that are interest rate sensitive (bonds, cash investments, stable value and some annuities), the average allocation to interest rate sensitive investments is about 50 percent.

The allocation to interest rate sensitive investments increases to about 60 percent in the 60 year and older age categories. This shift in risk preference is consistent with the idea that as people prepare to enter retirement they become more conservative. There are some extremes in the data. About 40 percent of people over the age of 60 have less than 10 percent of their assets in equity and about 30 percent held no equity. These extremes tended to be investors with lesser amounts in their retirement portfolios.

Retirees who are spending the interest they are earning in money market funds, CDs, bonds and other fixed income investments are earning less than they would be if the Fed were not keeping interest rates artificially low. On average, this amount is about 2.0 percent less based on calculations I made in an earlier two-part article titled The Fear of Soaring Rates are Overblown.

What investors can do about low rates

What options do those over the age of 55 have to stem the transfer of wealth from lenders to borrowers?

Unconventional times require unconventional ideas. Too often we fall into traps created by a rule-of-thumb that hurt our chances for investment survival. This is a time to step back and question those rules-of-thumb.

For example, the rule-of-thumb in the 1990s was to follow the Fed Model for stock valuation. According to the model, the right price-to-earnings ratio (PE) for the market, simply divide 100 by the 10-year Treasury bond yield. That may work fine when rates are at 6.0 percent, but now that rates are 2.0 percent, the Fed Model says that the stock market is about 200 percent undervalued. Maybe stocks are 200 percent undervalued, but I doubt you’ll find many people using this model today.

Another rule-of-thumb says to find an appropriate asset allocation for your age, invest your age in bonds (or CDs, fixed annuities, money funds, etc). According to the model, a 40-year old should have 40 percent in fixed income investments and a 70-year old should have 70 percent. In my opinion, this rule-of-thumb needs to be put on ice for a while because it isn’t the right model for today.

Burton Malkiel recently wrote an opinion article for the Wall Street Journal titled The Bond Buyers Dilemma where he offered some alternatives. Dr. Malkiel is Chemical Bank Chairman’s professor of economics at Princeton University and a former member of the Council of Economic Advisers.  At the end of the article, he made a general comment that I do believe sums up the situation, “The traditional diversification advice of a simple stock-bond mix needs to be fine-tuned.”

I’ll borrow Dr. Malkiel’s line by saying that the rule-of-thumb for a simple stock-bond mix needs to be fine-tuned. Your age-in-bonds may work OK in free-market interest rate environment; but it doesn’t fit well into a period of artificially low interest rates created by unusually accommodating Fed policy.

I’m not a big fan of Dr. Malkiel’s investment solutions for the bond buyer’s dilemma because they infuse too much specific risk into a portfolio. One rule-of-thumb that does seem appropriate for today is “Don’t fight the Fed.” The Federal Reserve is pumping money into the economy by every means possible. There is no other period in history to which you can compare their actions.

Although we are in this unprecedented period, I'm very cautious to recommend any asset allocation changes based on economic or market conditions, which is why I have a policy not to do it. In the long run, staying the course is the best option. Accordingly, my recommendation is to stay on course.