## Student debt and qualifying for a mortgage

Student debt and qualifying for a mortgage  — post one

Excel Topics:  PMT function and Spreadsheet design

Question:  A person graduates from college and graduate school with \$100,000 in student debt.   The interest rate on a 10-year student loan is 5% per year.   The person wants to buy a house that costs \$300,000 with a 90% LTV loan. The home mortgage interest rate is 4.5% on a 30 year FRM.

Assume that in order to qualify for the house the person must meet two conditions.

Constraint One:  The ratio of mortgage interest to income must be less than 0.28.

Constraint Two: The ratio of total interest (mortgage and non-mortgage) interest must be less than 0.38.

How much income does this person need to qualify for a loan on this house?

Why might student debt have a smaller impact on the purchase of a \$700,000 home than the purchase of a \$300,000 home.

Analysis:   The analysis for the \$300,000 home is laid out in the table below.

 Mortgage Qualification Example for Borrower with Student Debt Note Student loan Amount \$100,000 \$0 Assumption Interest Rate 0.05 0.05 Assumption Number of Payments 120 120 Assumption Student Loan Payment \$1,061 \$0 From  PMT Function House Amount \$300,000 \$300,000 Assumption LTV 0.9 0.9 Assumption Loan Amount \$270,000 \$270,000 LTV * House Amount Intrerest Rate 0.045 0.045 Assumption Number of Payments 360 360 Assumption Mortgage Payment \$1,368 \$1,368 From PMT Function Total Loan Payments \$2,429 \$1,368 Sum Payments Monthly Income Constraint One \$4,886 \$4,886 Student Loan Payment divided by 0.28 Monthly Income Constraint Two \$6,391 \$3,600 Mortgate Payment Divided by 0.38 Required Monthly Income \$6,391 \$4,886 Max of income over both constraints Required Annual Income \$76,696 \$58,631 12* Max Income

Observations Pertaining to the \$300,000 home for a person with and without student loans

A person with no student debt could qualify for this mortgage with an annual income of \$58,630.

The person with the student debt needs an annual income of \$71,585.

The impact of student debt on purchases of a larger home:   The allowable mortgage is determined by two constraints one involving mortgage debt only and the other involving the sum of mortgage and consumer debt.   When the mortgage debt is very large, constraint one (the mortgage debt constraint) will be the binding constraint.

Continue reading “Student debt and qualifying for a mortgage”

## Is FANG overvalued?

Is FANG Overvalued?

Question:  The hot stock combo right now is FANG (Facebook, Amazon, Netflix and Google.)   What is the PE ratio of a portfolio equally weighted in these four stocks?

Provide an opinion about whether future earnings of prospects for FANG justify this valuation?

Calculation of the FANG PE ratio:

All FANG stocks have positive earning and positive PE ratios so it is appropriate to average PE ratios of the four stocks to obtain the PE ratio for the portfolio.  (I use a weight of 0.250 for each stock and SUMPRODUCT weight vector with PE ratio vector)

 FANG STATISTICS PE ratio Dividend EPS Price Facebook 38.29 0 3.93 150.58 Amazon 183.95 0 5.31 976.78 Netflix 195.38 0 0.77 151.03 Google 31.34 0 29.59 927.33 FANG 112.24

This gives me a PE ratio of 112.24 for FANG.

It is instructive to compare the recent growth of EPS and stock price for the FANG companies

 Comparison of growth of EPS and stock price for FANG Stocks 6/29/16 3/30/17 % Change FB EPS 0.97 1.04 7.2% Price 114.28 142.05 24.3% AMZN EPS 1.78 1.48 -16.9% Price 725.68 886.54 22.2% NFLIX EPS 0.09 0.4 344.4% Price 96.67 147.8 52.9% GOOG EPS 8.42 7.73 -8.2% Price 699.2 829.56 18.6%

Some Observations:

In three of the four companies the growth of stock prices exceeded the growth of earnings per share.

In two of the four companies, earnings fell while the stock prices rose.

In Netflix, the one company where EPS growth exceeded stock price, the initial period stock price was near zero.   The initial low level of earnings is why the PE ratio of Netflix is going down.   When earnings are near zero the PE ratio can be astronomic.

Concluding thoughts:  Basically FANG stock price is rising because of expectations of future growth not concrete earnings growth.   The one exception Netflix is because of really low earnings in a base period.    Netflix has done a great job but it is in a competitive industry and unlike the other three companies has no monopoly power.

These four companies will face challenges going forward.   The PE of Amazon seems especially high because there is going to be a lot of competition in the cloud sector a lot of costs integrating Whole foods and low margins in the on-line grocery business.

Investors who own FANG should consider taking some profits.

Featured Policy Blog Post:

I have created a list of 11 pragmatic progressive education policies.   These posts will be part of a book on economically feasible policies that might improve the world.   Here is a link to this important work.

http://policymemos.blogspot.com/p/education-policy-list.html

## Are Tech Stocks Overvalued?

Are Tech Stocks Overvalued?

Issue:   Professor Jeremy Siegel maintains that the stock market and tech stocks are still fairly value.

http://www.cnbc.com/2017/05/26/were-not-in-the-danger-zone-for-overheating-says-longtime-stock-bull-jeremy-siegel.html

He supports this argument with the observation that the PE ratio of Tech stocks in the S&P 500 is still under 20.

What are the limitations of using the PE ratio for a basket of stocks to measure the valuation of the portfolio when some stocks in the portfolio have negative earnings?

Does an analysis of the PE ratios of the stocks in the Vanguard Information Technology ETF support or contradict Professor Siegel’s view on the valuation of Tech stocks?

Is Professor Siegel correct in his assertion that tech stocks are valued correctly?

Discussion of ETF PE Ratios:

Professor Siegel pointing to a PE ratio for a basket of tech stocks in the S&P 500 has argued that the sector is valued fairly.   My problem with this argument is that published statistics on ETF PE ratios often fail to accurately include information on firms with negative earnings.

Firms with negative earnings have negative PE ratios.  These firms often have a lot in common with high PE firms.   Often startups have negative or low earnings.   If earnings are negative the PE is negative.  If earnings are slightly positive the PE is large.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.   Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because firms with negative PE ratios have high valuation compared to earnings.

PE ratios have no clear economic interpretation when earnings are negative.  When earnings are slightly below zero (a small loss) the PE ratio is a very large negative number.   When a company has a larger loss the PE ratio is a smaller negative number.

 Why PE ratios make no sense for firms  with negative earnings Earnings per share Price per share PE ratio (0.10) 3.00 (30.00) (5.50) 3.00 (0.55)

In short, PE ratios incorrectly rank firm valuation when earnings are negative.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.

Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because the firm with a negative PE ratio has a high valuation compared to earnings.

I am not the first to write about the problem of measuring ETF PE ratios.  Here are some additional resources.

Why ETF Price/Earning Ratios Lie.

http://www.etf.com/sections/blog/23121-why-etf-priceearnings-ratios-lie.html?nopaging=1

Understanding Negative PE Ratios for ETFs

http://www.etf.com/sections/blog/21801-understanding-negative-pe-ratios-for-etfs.html/page/0/1?fullart=1&start=2

Data used in this study:

I obtained a list of stocks in the VGT mutual funds from Zachs guide at the link below.

https://www.zacks.com/funds/etf/VGT/holding

Vanguard Technology Fund VGT has a total of 356 firms.  This study examined the PE ratios of all firms where the equity investment was greater than or equal to 0.1 percent of the value of the VGT portfolio.     There were 109 such firms.

Results:   The frequency distribution of dollar share values invested and number of firms for five PE categories – less than zero, 0 to 15, 15 to 30, 30 to 40 and over 40 – are presented below.

 Shares of Firms in VGT by PE category PE Category Dollar Share Invested by PE Category Percent of Companies <0 6.31 17.43 0-15 5.74 6.42 15-30 36.19 34.86 30-40 31.16 12.84 40< 13.12 28.44 Total 92.52 100

Sample consists firms in VGT where the equity position was greater than or equal to 0.1 percent of the total value of the VGT portfolio.   There were 109 firms meeting this criterion.   These 109 firms represent 92.5 percent of the value of the VGT Portfolio.

Observations:

Around 6.3 percent of dollars invested in the 109 positions of VGT are in firms with negative earnings.  Around 17.4 percent of the 109 firms had negative earnings.

Over 13 percent of dollars invested in the 109 VGT positions had PE ratios over 40.   Over 128 percent of the firms in this group had a PE ratio over 40.

Analysis:

What can we conclude about the question of whether tech stocks are overvalued after examining the distribution of stocks in VGT?

The large number of tech stocks with high PE ratios or worse yet negative earnings is consistent with a bubble.   Perhaps the bubble is in the early stages and some people can buy, sell, and make money before the crash.   However, there are a lot of overtly optimistic analysts and a lot of inaccurate or misleading information out there.

This is not going to end well.

## Comparing 15-year and 30-year Mortgages

Question One: A person is considering taking out a \$180,000 mortgage and must choose between a 15-year FRM and a 30-year FRM.   The interest rate on the 15-year mortgage is 2.90 while the interest rate on the 30-year mortgage is 3.40.

What are the monthly payments on the two loans?

What are the total interest payments on the two loans over the life of the loan?

What is the after-tax cost of the interest payments on the two loans?

What is the tax savings from the tax deductibility of mortgage interest?

What is remaining loan balance after 15 years for the two loans?

Answer: The monthly mortgage payment calculation is directly calculated from the PMT function in Excel.  The variables inputted into the PMT function are the interest rate, the term and the loan balance.

The lifetime interest cost is calculated two ways.   The first way involves noting that the difference between total payments and the repaid loan balance is equal to interest payments. (180* \$1234-\$180,000) =\$42,193.

The second way involves calculating cumulative interest payments directly from the CUMIPMT function in Excel. Put Rate=0.029/12, NPER=180, PV=\$180,000 STARTPERIOD=1, ENDPERIOD=180, and Type=0 into CUMIPMT and get \$42,193.)

The after tax cost of interest payments is (1-MTR) x INTEREST.

The tax savings from interest payments is MTR x INTEREST

The mortgage balance after 15 years is obtained directly from the FV function in Excel. Note FV (RATE=0.029/12,NPER=180, PMT=-1234,PV-180000) is equal to \$0. This is a good way to check your work since the balance on a 15-year mortgage held for 15 years must be \$0.

The complete answers are laid out in the table below.

 A Comparison of 15-year and 30-year FRM 15-year FRM 30-year FRM Notes Rate 0.029 0.034 Assumption Period 180 360 Assumption Loan \$180,000 \$180,000 Assumption Payment -\$1,234 -\$798 Calculation From Payment Function Interest Cost Calculation One \$42,193 \$107,376 Calculation: Total Payments – Loan Balance Interest Cost Calculation Two \$42,193 \$107,376 Calculation From CUMIPT Function Marginal Tax Rate 0.3 0.3 Assumption After Tax Interest Cost \$29,535 \$75,163 Calculation: (1-mtr)*Interest Cost Tax Savings from Mortgage Deductibility \$12,658.05 \$32,212.75 Tax Savings from Mortgage Deduction Mortgage Balance After Fifteen Years \$0 -\$112,435 Calculation: From FV Function Total Mortgage Payments Over 15 Years -\$222,193 -\$143,688 Calculation 180*MONTHLY MORTGAGE PAYMENT

Discussion of Comparison of 15-year and 30-Year FRM:

• Over a 15-year period the homeowner with the 30-year FRM has accumulated \$112,435 less house equity than the homeowner with the 15-year FRM.
• Over the 15-year period, the homeowner with the 15-year mortgage has paid over \$78,000 more in mortgage payments than the homeowner with the 30-year mortgage. However, the owner with the 30-year mortgage is not done yet.
• The additional tax savings from the use of the 30-year FRM is around \$20,000.

Authors Note:   People interested in what will happen to the Affordable Care Act under Trump should go to my health care blog on the topic.

Here is a post on Senator Paul’s health care plan.

http://healthcarememos.blogspot.com/2017/01/senator-rand-pauls-health-care-plan.html

My own outline of potential modifications to the ACA will be presented shortly.

## Increases in Undergraduate Debt 2003/2004 to 2011/2012

The statistics presented in this post document the dramatic increase in student debt between 2004 and 2012.

Increases in Undergraduate Debt 2003/2004 to 2011/2012

My holiday visit with in-laws included less discussion of politics this year for obvious reasons but I did have a brief discussion on student debt with one relative.   His view of the issue is that since his generation paid for their college no additional cost subsidies are needed. My concern is that the recent increases in costs are having substantial adverse impacts on the current cohort of students.

I am planning several more posts on college costs and their economic and impacts.   This post looks at the trend growth of student debt between the 2003/2004 and the 2011/2012 academic years.

The Data: The source of data for this study is the NSPAS database. I was able to access the data from the NCES Power Statistics Portal.

https://nces.ed.gov/datalab/index.aspx

My variable of interest in this post is cumulative amount borrowed in the undergraduate years by people receiving a bachelor’s degree at four-year institutions.   I have presented separate tables for private and public four-year institutions.
Three statistics are presented – Average debt for borrowers, the percent of students who borrowed, and the percent of students who borrowed more than \$25,000.

The data does not include information on borrowing by parents through the PLUS program.

Statistical Results:

The statistics describing change in cumulative student debt are presented in the table below.

 Cumulative Under Graduate Student Debt at Four-Year Institutions 2004 to 2012 Bachelors Degree Four-Year Public 2003/2004 2011/2012 Diff. % Diff. Average Debt for Borrowers \$11,958 \$18,845 \$6,887 57.6% % of Students who Borrowed 56.6 63.5 6.9 12.1% % of Students with debt greater than \$25,000 5.3 16.9 11.6 218.7% Bachelors Degree Four-Year Private 2003/2004 2011/2012 Difference % Diff Average Debt for Borrowers 14,536 22,962 \$8,426 58.0% % of Students who Borrowed 66.9 69.1 2.2 3.3% % of Students with debt greater than \$25,000 9.6 22.9 13.3 138.0% Both Public and Private Four-Year Programs Average Debt for Borrowers 12,876 20,163 \$7,287 56.6% % of Students who Borrowed 60.8 65.2 4.4 7.2% % of Students with debt greater than \$25,000 6.8 18.7 11.9 176.4%

Summary of Statistical Results:

The growth of cumulative student debt among people receiving a bachelor’s degree from a four-year institution was tremendous during this brief eight-year period.

Total debt incurred by student borrowers receiving a bachelor’s degree rose by around 57% over this eight year period.

The proportion of undergraduate bachelor degree students incurring debt rose by 6.9 percentage points at public institutions and 2.2 percentage points at private institutions.

The proportion of undergraduate bachelor degree students incurring more than \$25,000 in debt went from 5.3% to 16.9 percent for students at public schools and from 9.6 percent to 22.9 percent for students at private institutions.

Other Student Debt Trends

These issues will be addressed in future posts.

The expansion of PLUS loans to parents:

Increases in the use of private debt:

Changes in debt incurred by graduate students:

Changes in the number of students with excessive levels of student debt:

Economic Financial and Social Implications:

Economic issues related to the increase in student debt include – (1) A decision by many young people to live with parents and delays in starting a family, (2) a decision to delay home purchases, (3) the choice between a 30-year and 15-year mortgage, and (4) a decision to delay placing funds in a 401(k) plan.

Many older financial experts do not agree with the decision by many in the current generation to delay home purchases and delay saving for retirement.

My view is that the older generation is not in fully touch with the economic realities facing many in the millennial generation from the explosion in student debt occurring over a mere eight years.

I am planning a lot more empirical work on this issue.

PREVIOUS WORK:

Some of my previous work examines proposal to provide financial relief to some debtors who get over their head in debt. Here are some examples:

Seven Ways to Provide Debt Relief:

http://betterworldpolicies.blogspot.com/2016/09/seven-ways-to-provide-student-debt.html

Is IBR the best way to provide student loan debt relief:

http://betterworldpolicies.blogspot.com/2016/09/is-ibr-best-way-to-provide-student-loan_8.html

In addition, I have a short book on Kindle on managing debt and the impact of debt on lifetime savings.

The Nine Essays on Debt and Your Retirement:

http://amzn.to/2iYe1iV

## Retire Mortgage Debt or Accumulate in Your 401(k) Plan?

Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan. A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.

http://www.forbes.com/sites/nancyanderson/2014/01/03/7-reasons-not-to-pay-off-your-mortgage-before-you-retire/

http://www.kiplinger.com/article/real-estate/T040-C000-S002-should-you-pay-off-your-mortgage-before-you-retire.html

http://www.washingtonpost.com/news/get-there/wp/2015/03/26/the-case-for-not-paying-off-your-mortgage-by-retirement/

http://www.schwab.com/public/schwab/nn/articles/Should-You-Pay-Off-Your-Mortgage-Early-Before-You-Retire

http://www.principal.com/planningcenter/retirementplanning/nearingretirement/retirementnews/mortgagequestion.htm

My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions.   I have two reasons for this view.   First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement.   Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage.   The Wall Street analysts always say don’t sell on a panic the market will come back.   Well retirees with a large mortgage often have no choice but to sell.

Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans. During working years mortgage interest and 401(k) contributions reduce income tax burdens.   During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.

All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate.   A person with no mortgage disburses enough to cover discretionary expenses and taxes   A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.

The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed. MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.

Part of Social Security is taxed for people with income over a certain threshold. A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status — \$25,000 for filing status single and \$32,000 for filing status married.

http://www.irs.gov/uac/Newsroom/Are-Your-Social-Security-Benefits-Taxable

Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax.   Of course any 401(k) disbursement used to pay the income tax is also taxed.

So let’s take a household with all financial assets in their 401(k) plan with a \$30,000 annual mortgage.   This monthly mortgage is \$2,500, not huge.   Let’s assume that the person has to pay around \$1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage. A first order approximation of the amount of additional tax needed because of the additional \$31,000 disbursement is \$31,000 x the marginal tax rate for the taxpayer.   For most filers the marginal tax rate would be around 25 percent in 2014.

So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse \$39,000 more per year from their 401(k) plan.

This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement.   The answer is much more if you have not paid off your mortgage.

Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises.

Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize. Downsizing may make sense but most people don’t want to downsize until they are fairly old.

Some people who end up selling their home may choose to rent rather than buy a new home.   The main risk of choosing to rent throughout retirement is that home prices and rents may rise.   This exacerbates longevity risk.

Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests

Concluding thoughts on mortgage debt in retirement: An increasing number of households are retiring prior to their mortgage being entirely paid off. Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.   Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.

These financial planners are not being upfront with their clients.   Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation.   The advice that put people in this position is in my view a form of malpractice.

Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement

The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers.   The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.

Question:   A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage.   The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.

The person makes \$80,000 per year. The initial mortgage balance is \$400,000.   The person’s 401(k) balance at age 50 is \$200,000. The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.

Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.

Analysis:

Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four.

Observations and Thoughts on Mortgage Choice Issues:

• The monthly payment on the 30-year FRM is nearly \$900 less than the monthly payment on the 15-year FRM. The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.
• After 15 years the 15-year FRM is completely paid off.   The remaining loan balance on the 15-year FRM is around \$257,000.
• Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations.   The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.
 Analysis of 15-Year Versus 30-Year FRM 30-Year 15-Year Mortgage 0.039 0.031 Term 360 180 Loan Balance 400000 400000 Payment -\$1,886 -\$2,781 Future Value \$256,799 \$0.00

Observations and Thoughts on Two 401(k) Contribution Strategies:

As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market.   Outcomes are presented for two market scenarios.   The first involves 7% returns for the entire 15-year period.   The second involves 7% returns for 10 years followed by -4% returns for 5 years.

• The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around \$211,000.
• The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around \$131,000
 Analysis of Different 401(K) Contribution Strategies 5% Contribution Rate 15% Contribution Rate Difference 7.0% Return for 15 Years \$675,442 \$886,752 \$211,309 7.0% Return for 10 years followed by -4.0% return for 5 years \$394,339 \$525,090 \$130,751

The initial balance in the 401(k) plan for both scenarios is \$200,000.

• The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy.   All mortgage interest is tax deductible and the 401(k) contribution is not taxed.
• The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy.   The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements.   Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates.   By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.
• Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity.

## Review of Retirement Heist

Review of Retirement Heist:  How Companies Plunder and Profit from the Nest Eggs of American Workers

Ellen Schulz describes the different ways companies have reduced worker’s pension benefits in order to increase profits, manipulate earnings, cut costs, or fund pension benefits for top managers instead of workers.

http://www.amazon.com/Retirement-Heist-Companies-Plunder-American/dp/B00AK3WCZ8

Some highlights:

Chapter two describes how companies cut or froze benefits in the traditional defined benefit plan without antagonizing workers or creating bad publicity for the firm.   The replacement of a generous defined benefit plan with a new less generous plan is generally introduced in a way where changes are not transparent to workers.   Phillip Strella a lawyer with Mercer consulting advised the industry to “Pick your words carefully.  The law doesn’t require you say, “We’re significantly lowering your benefit,” “

Chapter three discusses how pension reductions allow companies to report greater earnings to shareholders. Management has a strong incentive to report good and stable earnings because their compensation is often tied to the stock price of the firm.  Pensions are often cut to increase earnings when the company suffers losses from its core business activities.  One of the main problems is that actuaries have great latitude in the assumptions used to price health and retirement benefits hence; official accounting standards allow management to reduce or increase the value of pension and health benefits in order to report whatever income figure it needs to report.

The drop in pension and health benefits and the increase in health premiums have significant impacts on workers, retirees and their families.  The most difficult situations revolve around the loss of health benefits because Medicare does not begin coverage until age 65.  According to a Department of Labor Review cited by Schulz by the late 1990s around two-thirds of retired workers with employer sponsored health coverage were dropping coverage when costs of the health plan rose.  The departure of individuals from employer sponsored health plans resulted in adverse selection or a “death spiral” because sicker workers and families tended to maintain coverage while healthier workers tended to exit.  One of the more important aspects of the still not fully implemented and tested Affordable Care Act was to fix this problem by mandating that all people be covered and by establishing age-rated premiums that will be unaffected by health status.

Schulz’s book includes a lot of personal stories.  Some of the anecdotes involved overpayments to workers that companies tried to reclaim.  Often companies that acquire other firms and their pension obligations look for past overpayments to retirees in order to claw the overpayments back.  This can create large problems for households who created a budget based on their anticipated and previously receive pension.

Chapter 11 discusses denial of benefits with a focus on disability claims in two industries -– energy and football.  The discussion of how the NFL aggressively denies claims to injured players was especially revealing.  It demonstrates that even in a small high-profile industry with a strong union the system is rigged against workers.

The pension system based on company-run defined benefit plans is experiencing a slow death.  The 401(k) has become the dominant pension vehicle for current workers.  There are a lot of problems with 401(k) plans including inadequate contributions by workers and a high degree of investment risk.  Schulz’s disturbing book vividly reminds us that there are also problems with traditional defined-benefit pension.

## Understanding the four percent rule

Question:   Is the 4.0% rule an appropriate guideline for determining the amount of savings a retiree should spend each year?

Background on the 4.0% rule:  Under the four percent rule (as I understand it ) the retiree’s expenditure in her first year of retirement is four percent of wealth in certain accounts.  It is more difficult to apply the 4.0% rule to total household wealth because house equity, a major component of wealth is not liquid.  (The application of the 4.0% rule to total wealth including house equity would at some point require the sale of the home.)

Whether strict adherence to the 4.0% rule leads to a smooth, stable, and sustainable consumption pattern for the household depends on asset returns, inflation, and the timing of inflation and asset returns.  A sharp decrease in returns at  the beginning of retirement could lead to a relatively quick depletion of assets.  A sharp increase in returns at the beginning of retirement could allow retirees to spend more than allowed or provide a bequest to heirs.

The 4.0% rule may result in retirees too quickly depleting their resources in the current financial environment where the risk free return is lower than inflation.

http://financememos.com/2013/02/15/chasing-yield-by-investing-in-long-term-bonds/

Illustrating the 4.0% rule:  We consider four scenarios — (1) 2.00% returns and 3.0% inflation all years, (2) 4.0% returns and 3.0% inflation rate for all years, (3) a -20% return the first year followed by 2.0% returns and 3.0% inflation, and (4) -20% return the first year followed by 4.0% return and 3.0% inflation.

We calculate the number of years it would take for the retiree to deplete all assets under the four scenarios.  Results presented in Table Four indicate that years until depletion range from 19 years for scenario three to 30 years for scenario two.

 Adequacy of resource for 4% rule under four scenarios Shock Return Inflation Rate Year Balance goes to \$0 None 2.00% 3.00% 23 None 4.00% 3.00% 30 -20% first year 2.00% 3.00% 19 -20% first year 4.00% 3.00% 23

I suspect that these calculations understate the financial risk associated with adherence to the 4.0% rule.   Some analysts suggest that investors who use the 4.0% rule should maintain a larger portion of their portfolio in equites.  I disagree.  The worse case scenario for the 4.0% rule involving poor stock returns in a period of inflation actually occurred during the 1970s.

 Initial Balance \$100,000 Disb. Rate 4.00% Rate of return Inflation rate Real Value of initial balance Beginning of year balance Disbursement End of year balance 1 2.00% 3.00% \$100,000 \$100,000 \$4,000 \$98,000 2 2.00% 3.00% \$103,000 \$98,000 \$4,120 \$95,840 3 2.00% 3.00% \$106,090 \$95,840 \$4,244 \$93,513 4 2.00% 3.00% \$109,273 \$93,513 \$4,371 \$91,013 5 2.00% 3.00% \$112,551 \$91,013 \$4,502 \$88,331 6 2.00% 3.00% \$115,927 \$88,331 \$4,637 \$85,460 7 2.00% 3.00% \$119,405 \$85,460 \$4,776 \$82,393 8 2.00% 3.00% \$122,987 \$82,393 \$4,919 \$79,122 9 2.00% 3.00% \$126,677 \$79,122 \$5,067 \$75,637 10 2.00% 3.00% \$130,477 \$75,637 \$5,219 \$71,931 11 2.00% 3.00% \$134,392 \$71,931 \$5,376 \$67,994 12 2.00% 3.00% \$138,423 \$67,994 \$5,537 \$63,817 13 2.00% 3.00% \$142,576 \$63,817 \$5,703 \$59,390 14 2.00% 3.00% \$146,853 \$59,390 \$5,874 \$54,703 15 2.00% 3.00% \$151,259 \$54,703 \$6,050 \$49,747 16 2.00% 3.00% \$155,797 \$49,747 \$6,232 \$44,510 17 2.00% 3.00% \$160,471 \$44,510 \$6,419 \$38,982 18 2.00% 3.00% \$165,285 \$38,982 \$6,611 \$33,150 19 2.00% 3.00% \$170,243 \$33,150 \$6,810 \$27,003 20 2.00% 3.00% \$175,351 \$27,003 \$7,014 \$20,529 21 2.00% 3.00% \$180,611 \$20,529 \$7,224 \$13,715 22 2.00% 3.00% \$186,029 \$13,715 \$7,441 \$6,548 23 2.00% 3.00% \$191,610 \$6,548 \$7,664 -\$985 24 2.00% 3.00% \$197,359 -\$985 \$7,894 -\$8,899 25 2.00% 3.00% \$203,279 -\$8,899 \$8,131 -\$17,208 26 2.00% 3.00% \$209,378 -\$17,208 \$8,375 -\$25,927 27 2.00% 3.00% \$215,659 -\$25,927 \$8,626 -\$35,072 28 2.00% 3.00% \$222,129 -\$35,072 \$8,885 -\$44,659 29 2.00% 3.00% \$228,793 -\$44,659 \$9,152 -\$54,704 30 2.00% 3.00% \$235,657 -\$54,704 \$9,426 -\$65,224