Monday, November 21, 2011

The Problem with Wealth

The paradox of wealth

Didn’t know there was a problem, did you? But, there is. Wealth from the perspective of individuals doesn’t match wealth from a society’s perspective. That’s a problem.

The posting, “The 99%ers: Part 4, WEALTH DEFINED” provided a number of ways wealth can be defined and measured from the perspective of individuals. They all boil down to ways to value a future income stream. That’s fine for individuals.

Problem is: when a government starts handing out entitlements to income streams, they are creating wealth from individuals’ perspectives. That sounds great, but there’s a problem. They haven’t created an income stream from a society’s perspective. Economic growth, a society’s income stream, is the product of the inputs (factors of production in economics speak). Adam Smith’s WEALTH OF NATIONS used the idea to make his argument against the crony capitalism of his era. Embedded in his thinking one finds the idea of the productivity of the population (i.e., their ability to generate an income stream) is the wealth of a nation.

Here’s the paradox: some government actions that create wealth from individuals’ perspectives, actually decrease society’s wealth if not structured properly, and they seldom are structured properly. Clearly, we have entitlements that discourage work (e.g., facilitate retirement and reduce the urgency of work) and reduce capital formation (i.e., promote consumption and subsidize borrowing), and hold resources out of economic use (e.g., inhibit some uses of the environment and regulate working conditions). These all make sense, but if done without any thought to how their negative impacts can be offset or mitigated, they’ll fail.

All well and good you say. However, think for a minute: have you ever heard the people advocating the entitlements discuss how to structure them in a way that increases labor, capital, or even efficient resource utilization? To the contrary, they usually emphasize the opposite.

The economy has always had a secret weapon. Actually it’s not very secret to economists. Its significance has been measured. It appears as a residual in some classical production functions (i.e., the growth not explained by labor and capital). In alternative specifications of the production function is appears as a technology variable. Given the ambiguity associated with measuring labor and capital in ways that take into account quality changes, the uniformity in estimates is surprising. Any way one approaches it, the conclusion is the same: it is important, more important than the amount of labor or capital.

Despite volumes of debate and lots of analysis, how much various different factors contribute to the growth that labor and capital don’t explain is still an open question. Rule of law, scientific research, private ownership of the returns to effort, public health, literacy, even the rates of change in labor and capital, and a raft of other factors all contribute. So, policy makers get to rotate between different pet policies of the moment.

Ultimately, capital and labor are the only resources that one knows will have an unambiguous, direct connection to growth. Yet, policymakers find allocation entitlements much more enticing. So, much so that the policymakers will risk destroying society’s real income-producing capital for the temporary high of misleading the population into believing the policymakers have actually done something productive. The only thing stranger is the people let them do it (at least until the house of cards collapses).

However, the biggest paradox of all is politicians’ collective inability to realize Adam Smith was talking about the wealth of nations. Somehow, perhaps it’s the air in national capitals; politicians became unable to distinguish between the wealth of the nation and the wealth of the national government. They’ve proven amazingly effective at cultivating a similar line of “thinking” among academics and media elites. That, however, doesn’t eliminate the inevitability of the eventual failure of policies based on such nonsense.

Saturday, November 12, 2011

The 99%ers: Part 7

Looking for victims is as unproductive as playing the blame game.

The last posting closed with “Looking for victims is as stylish as searching for someone to blame. That’s sad. Neither is a very productive use of time.” But, at this point I’ve received so many victim pieces that a general posting seems appropriate.

We now seem to have degenerated into a society where the competition to be the most victimized is hot and heavy. It gets played out regularly in the media. A few stories illustrate. First, the coverage of “Generation Jobless: Young Men Suffer Worst as Economy Staggers” in the WALL STREET JOURNAL, November 7, 2011; or “US wealth gap between young and old is widest ever” ASSOCIATED PRESS, November 7, 2011. (The AP story covers “The Rising Age Gap in Economic Well-Being,” a Pew Research Center spin of Census data). Now, contrast that with “Retirement Crisis Closes In on Baby Boomers,” a REUTERS’ story published the same day.

The first few articles see the young as victims. They choose to ignore the wealth youth have in the form of the present value of a lifetime’s earning. It also fails to compare their absolute wellbeing to the absolute wellbeing of previous generations. The other article makes the startling discovery the baby boomers have done less to prepare for retirement than previous generations and are beginning to worry about the implications of that strategy. Haven’t we known the savings rate has been falling for generations and that each generation has been saving less than the previous generations?

So, we’ve covered the tails of the age distribution. It would be counter to America’s tradition of inclusiveness to ignore everyone else. Sticking with age, we find “Older Americans [are] faring worst in the recession” in THE WASHINGTON POST, October 19, 2001. In an article on Social Security, it says: “… 55 to 64-year-olds have fared worst in the recession than any other demographic.” You think they found their star victim, but this is THE WASHINGTON POST. They’re experts at the victim game so we have “The graying of the long-term unemployed” on November 2, 2011 which focuses on those out of work long term, many of whom are older workers. By contrast, USA TODAY on January 1, 2011 was much more direct about victimization in “Long-term unemployed face stigmas in job search.”

Lest you think the 35 to 55 year olds have been neglected by our quest for victims, keep in mind they are in prime years for career advancement. Even short periods of unemployment or minor foolishness with debt management can set them back enough to take decades to recover. A little research and one could probably find them as the featured victim of the day.

People who borrowed too much make good victims, especially if they took it to levels that result in bankruptcy or foreclosure. We could tick through ethnic groups; gender; geographic regions; urban, rural and suburban; the poor verses the middle class, those who pay for health insurance verses those who skip the coverage, those with college loans or those who never got to go to college, the handicapped, and an endless list.

They all deserve sympathy, especially those who qualify for multiple victim status. However, no one seems to be willing to accept that like bubbles, busts are mass phenomena. If all the effort put into competitive victim debates was put into solutions, we’d be a lot better off. Problem with that is that the first step for most of us would be figuring out how we contributed to both the bubble and the bust, and most importantly, how we contributed to our own problems. That would be so much less fun.

We have fallen to a new low when people are more comfortable being victims than addressing problems. It would be disastrous if those more focused on their victim status than on solutions come to represent 99%. It’s especially sad that our political “leaders” and media elite have fallen to the same low; but then, at least they’ve figured out how to profit from it.

Friday, November 11, 2011

The 99%ers: Part 6

What do Greeks and 99%ers have in common?

It isn’t that they are bearing gifts. If one watches for specifics rather than assuming your grievance is their grievance, something interesting emerges. Rather than representing a broad based grievance that might be shared by some high proportion of the population, the 99%ers often represent a grievance of a small minority. Further, often the grievance isn’t with 1%, but actually with closer to 99% of the population.

Because the 99%ers represent this assortment of people with different grievances, it is probably impossible to list them all. A few examples will suffice before turning to what they have in common besides their resentment of a convenient scapegoat.

One grievance among the young members is the burden of student debt incurred to get a post-secondary (college) degree. Now that hardly represents even a large minority. First, the majority doesn’t get to go to college. Second, the vast majority of college grads get jobs (the unemployment rate among recent grads is only about 4% compared to 9% in general, and about 20% for recent high school grads). Third, most college grads pay back their student loans out of the higher income college grads tend to earn.

Does this minority have a grievance against the 1%? Seems to me the student loans aren’t an asset the 1% concentrates on creating. Rather, it is pension funds that create the demand for the asset-backed, fixed income bonds which is how student lenders get the money they lend. Do those 99ers expect pensioners to foot the bill for the money the students spent? That’s not the 1%. Further, most student loans wouldn’t have been made (certainly not at recent rates) without government guarantees. In a very real sense, their grievance is with the voters who made the loans available. It is the taxpayers who pick up the tab if the students don’t pay their bills.

If their college degrees had promoted some understanding, they’d realize that if they have a grievance, it’s with the college that sold them a degree that isn’t doing what they thought it would. At times it seems buyer’s remorse has become a basis for a class action lawsuit. They should be looking for lawyers willing to take their case. If that sounds too much like work to them, at least they should consider occupying their alma mater.

Having graduated into a slow economy with student loans, I appreciate that it’s no fun. I didn’t, however, think it was the fault of those who arranged for me to get the loans. Personally, I was quite thankful for the financial assistance my college facilitated.

A second group present at one “occupy” demonstration was people being foreclosed. One person had the audacity to represent themself as a 99%er based on foreclosure. Good God, foreclosures represent a much smaller group than people paying a monthly rent, probably a smaller group than renters who rent of necessity (i.e., never had the chance to try to buy). Throw in everyone who is underwater on their mortgage while keeping up with their payments (a larger group than foreclosures), and one still can’t get a majority, much less 99%. Even if one included everyone who has experienced a decline in the value of their house, one still isn’t at 99%. Too many people rent.

Foreclosures represent a problem, but the majority of people are still paying their mortgage. A substantial minority of home owners have paid off their mortgage. They represent a larger minority than people in foreclosure.

That said: it is still worth looking at their grievance. It seems hard to figure out how the 1% figure in. By wealth, the 1% tends to be entrepreneurs. By income, they’re more diverse, but well-represented by sports figures, entertainers, lawyers, etc. who have nothing to do with mortgages. Like asset-backed securities, the demand for the mortgage-backed securities that financed their defaulted mortgage didn’t originate with the wealthy or the high income.

Pensions and life insurers are the big holders while an entire raft of players dabbles. Banks, of course, hold some mortgages since the regulators place mortgage bonds high in the capital structure (i.e., count it as requiring less capital to cushion against default). Most importantly, when push comes to shove, one doesn’t have to look far for evidence of who is holding mortgages: it’s Fannie, Freddie and the FHA. It is taxpayers who are eating the largest portion of the defaults along with pensioners and life insurance policy holders. They come closer to being 99% than the 1%.

Debt does seem to be a widespread grievance among the 99%ers, although it’s hard to assess its importance compared to unemployment, bankers, investors, and a sense that someone else may be doing better than they are. Debt problems (as opposed to debt burdens) aren’t a 99% issue.

A lot of people have debt, but it’s not a problem because they assumed from the start that they’d have to pay it back (i.e., that the debt would be a burden). While aggregate data on debt service burdens shows they have fallen since the recession began, one can’t deny that Americans went on a debt-financed spending spree for decades. Yet, it’s unlikely 99% took it to a level they won’t be able to handle. Probably 99% would like to see their debt disappear, but among that 99%, there are many who would like it disappear because they paid it off. One thing is clear. To the extent 99ers don’t want to have to pay back their loans, they make common cause with Greek rioters.

There may also be a portion of 99%ers who lack a rudimentary understanding of what banks do. It’s hard to see how the tax-the-rich-they’re-to-blame argument can be squared with the banks-are-to-blame argument. Banks don’t have a lot of net wealth. Their assets and liabilities may be large, but regulators feel that the net (reserves or capital) are too low. Banks are middlemen. They process transactions.

Interestingly, among the financial elite there is a different grievance with banks. They see the intermediary roll as the problem. Their argument is that intermediaries don’t take responsibility for the transactions they facilitate, and they argue that banks should have that responsibility.

Recently, I ran across an alternative definition of a 99%er. One of the first emails about 99%ers I received was from someone who said simply: 99% of life is what you make of it and the other 1% should be ignored. I don’t know about that, but I’m pretty sure 1% of the population isn’t running my life. What binds the 99%ers and perhaps is common to 99% of the population is a feeling that they must be a victim. Looking for victims is as stylish as searching for someone to blame. That’s sad. Neither is a very productive use of time.

Thursday, November 10, 2011

The 99%ers: Part 5


It can appear like magic, vanish like a ghost, or never show up at all. Here are some examples from people who might feel entitled to rant. I was working on the data for something else I’m doing. Here I’m using it to illustrate how important one non-traded asset is. Since mark-to-market doesn’t work on income streams, the approach is mark-to-current annuity value. It’s analogous to discounting to present value without having to generate a discount rate or longevity assumption.

In each case, I estimated the approximate value of defined benefits as if the individual retired today. They're decent estimates, but nothing more than illustrations. Given that simplifying assumptions and the approximations used to value medical benefits, they should not be used for anything beyond rough estimation of value.

The present value of Medicare and Social Security can’t be directly compared to these benefits because of differences in tax treatment. Similarly the values of their homes can’t be directly compared because of tax treatment and real estate commissions that would have to be paid before they could be converted to an annuity. I don’t have information on health coverage differences between policies: so, I just treat them all as annuities with values based on minimum cost options. There is a high probability that pre65 healthcare employers’ shares are underestimated since average employer costs were about $11,000 in 2010 for family coverage and the average employee share was between $2,000 and $3,000. I assume that none of the individuals have any debt. Spouses’ benefits are ignored totally.

Example a:
a) $2,600 starting at 62 years old - immediate annuity single life value = $441,306,
Medical coverage for an employee’s share until 65 = $28,800,
TOTAL about $470,000

Example b:
b) $2,673 starting at 60 years old – immediate joint annuity value (with wife) = $576,018
Full family medical coverage indefinitely = $156,000 for family coverage until 65 plus $342,853 post 65 for employer and employee share for total medical of $498,853
TOTAL about $1,075,000

Example c:
c) $232 starting at 65 years old - immediate annuity value = $36,565,
Medical coverage for the employee share indefinitely for two = $103,856,
TOTAL about $139,000

Example d:
d) $514 starting at 60 years old - immediate annuity value = $91,565,
No medical,
TOTAL at $92,000

I used these benefits because all were tax-free events, so they are comparable.

In these examples, the last two (“c” and “d”) have IRAs, 401(k)s, and other investments; neither “a” nor “b” chose to fund an IRA or 401(k) to a significant extent. (I don't know the exact sizes other than the assumed pension amount). The last two have interests in private businesses that aren't liquid (have no quoted price to use as a benchmark). Estimating the value of private businesses is beyond my pay grade. However, for the last two, whether they hold traditional IRAs, Roth IRAs, or taxable assets is important. It determines how much “wealth” they have to have in order to equalize the benefit that often is not considered wealth (pensions and medical benefits). (Some data relevant to the tax equalization issues will be presented later.)

These examples roughly parallel some actual cases. With minor differences, they all should be living reasonable lifestyles (no cat food consumption or going hungry). Yet, my guess is one or more of the last two would fall in the top 10% by wealth, maybe top 5% as measured by most wealth data. I’d also bet one or more knows people in that 1%. The people with the pensions probably fall near the bottom in “wealth” data if the data ignores pensions or attributes their value to the employer. The four examples include retirees, unemployed, and working stiffs. At times the individuals move between employment status categories.

They aren’t hurting in either absolute terms or relative to people their age. Yet, with a little effort and a mischievous bent, I could start a small class war among them. I could get them fighting, then go out later and collect the change that falls out of their pockets as they wrestle.

The vesting process is an interesting generational aspect to the redistribution issue. For example, Social Security and Medicare really changed the statistics on poverty and income among the aged. The generational aspect of redistribution is one where I think the young have a legitimate gripe. But, before calling it a grievance rather than just a gripe, one should perform this little exercise. Compare the wealth distribution to the income distribution, and then compare them to the consumption distribution. Across age cohorts, consumption differences can be, and at times have been, the opposite of wealth distribution.

Then do another exercise, calculate the present value of future earnings streams of the young. The young are quite wealthy, but their asset is their wage earning power. One often gets the impression that some of them didn’t expect to have to work hard. They should be out creating the jobs of the future, not bemoaning the fact that the jobs of the past are history.

Now to the issue related to taxes. I’m not a big fan of defined benefits plans, but that is totally a reflection of two things: 1) a dislike of the fact that pensions involve turning one’s savings over to Wall Street to manage (something that others may consider a plus), and 2) there are inherent conflicts of interest between all parties involved. On the other hand, one can’t dispute their three big benefits: they shift risk from the individual to the group, 2) there’s generally no “opt out,” or, worded differently, the participant has to save, and 3) what’s important for this discussion, they are incredibly tax efficient.

To adjust for potential differences in taxes, the closest equivalent would be wealth in a traditional IRA and/or 401(k) if contributions to both were deductible. (Note that other than tax treatment all other aspects of differences, even who made the contributions, are being ignored). The focus is on wealth that could then be annuitized with the same tax treatment.

Interestingly, those that rage against the rich sometimes confuse wealth and income. Neither the recipient of “a” nor “b” thinks of themselves as rich, but in the year in which the benefits begin, either individual would fall in the 1% by income if one includes increases in wealth in the income calculation. (The 1% income cut off is somewhere in the $350,000 and $500,000 range depending on the year used). However, as mentioned, the value of pensions is not generally attributed to the individual in wealth data, nor is its increase in value or vesting included in income statistics.

This is important because a lot of people who say tax the rich, actually mean tax those with high incomes in a given year. The 99%ers flip back and forth. The individual with high incomes (top 1%) have a limited overlap with the 1% by wealth. Many none wealthy are high income: they spend it all (big hats; no cattle is the saying in Texas, but a lot of the high income are in very high cost of living areas like northern New Jersey, NYC, etc.). The wealthy not in the high income group tend to be small business owners, franchise owners, and farmer.

The problem is if one wants to rage against the rich, it’s easy to change assumptions and come up with different numbers. For example in a resent liberal rant they used these figures: Membership in the 1 percent can be measured by wealth or by income. By household wealth, the cutoff point would be a projected $9 million in 2010, according to an analysis of the Federal Reserve Board’s Survey of Consumer Finances by Edward Wolff, an economist at New York University. The cutoff for annual household income would be about $700,000, Mr. Wolff said. (Using Internal Revenue Service figures, which count earnings differently, the Congressional Budget Office puts the earnings cutoff at $350,000 for the 1 percent in 2007. Conservative rants come up with figures that are lower than these projections for either wealth or income.

Interestingly, figures used to assist organizations plan marketing campaigns fall in between. The most interesting figures often focus on “liquid wealth.” Not surprisingly, since they exclude real estate and “private businesses, they are lower than either.

These are just numbers. To provide a way to give them more meaning, consider this: If an individual contributed the maximum allowed under IRA restrictions every year from when the IRA began in 1975 through 2010, the return would have to be greater than a compound annual rate of 8% in order to have $400,000 to annuitize. So, replicating “a”, “c”, or “d” is possible under ideal conditions for using an IRA. Not be eligible to contribute to an IRA one year, skip a year’s contribution, or start later than 1975, and “d” or “c” could still be replicated with a reasonable return assumption.

To replicate “b,” one would have to have been lucky enough to work for employers who offered a 401(k) for the entire period since the program began in1982, and been qualified and able to make the maximum contribution every year. (Note that the maximum contribution assumption is based on IRS guidelines on deductibility which can be more generous than individual plans). The return would have to have been slightly better than 8%. Miss a year, start late, work for a business that doesn’t offer a 401(k), change jobs, have a year where one couldn’t make the maximum deductible contribution, and the result will be less. Employer contribution would help. (Technically during the early year of the program there was a way to structure a 401(k) so that larger contributions were possible, but it was so rarely used as to be irrelevant).

The 401(k) program started in 1982 with very few employers; program restrictions preclude the maximum contribution by most employees; most small employers can’t afford the administrative cost of a 401(k); job changes are common and even if the new employer offers a 401(k), new employees usually have to wait to participate; and most importantly, the program is voluntary. So, it isn’t surprising that IRA and 401(k) data indicate balances well short of these theoretical maximums.

But, that only illustrates the point. If wealth data ignores pensions, attributes the wealth to the employer, or measures the pension by assets rather than benefits, the wealth data is very questionable. When viewed from individuals’ perspectives, even under ideal assumptions, the benefits often exceed the wealth most participants accumulate in programs that are somewhat comparable in terms of tax treatment (IRAs or 401(k)s).

The calculations above are based on the laws as they existed historically. Why start from the beginning of the IRA and 401(k) programs? Why not build the calculations from current more liberal rules? Two reason justify looking backward.

First, there is no reason to believe the current rules won’t be changed to restrict the programs again. After all, the reason the rules were restrictive in the past was because the rich might use the programs (take advantage of the loophole was the expression used). It isn’t at all clear that the same logic won’t be applied retrospectively, especially since the programs have been successful at letting working people accumulate wealth. Once some politicians realize people who take advantage of IRAs and 401(k)s have become “rich,” they may well decide that they don’t deserve the programs. Closing loopholes is so fashionable, there’s no guarantee these programs won’t be targeted.

Second, a substantial portion of the changes to IRA and 401(k) rules reflect adjustments to inflation and income levels. Projecting that they won’t be changed in the future implies an assumption about future economic performance (e.g., it won’t change enough to necessitate program changes). Since we’re talking about a 35 year time span, it seems better to just assume that in the future the programs will be changed in response to the economy similarly to how they were adjusted in the past. So, the past seems as good a guide as any alternative.

Given that many people in 401(k)s or contributing to IRAs can’t legally contribute the maximum amount each year, some tax adjustment consideration should be useful. What happens if one assumes one or more of the people in this example is one of the many Americans who never had access to a 401(k)? To simplify the discussion, assume they also couldn’t have an IRA (a situation that was common when the program was first enacted, but is now fairly rare).

The first thing to note is that once taxes are introduced, things get more complicated because one is forced to use the government’s arbitrary tax cycle. Nevertheless, one thing is clear. All the benefits vest over time and become wealth when they kick in. The vesting over time is analogous to capital gains. So, using the current capital gains rules, the wealth required as capital gains would have to be 15% larger. Then the wealth could be “realized” and converted into an equivalent income steam (i.e., annuitized). Here’s the complication, annuitizing creates a tax benefit (return of principal isn’t taxed). The benefits also have different tax characteristics depending on whether it’s a pension or medical coverage. Nevertheless, it provides an interesting comparison for those who get animated by differences in “wealth.”

If one ignores the vesting process for benefits and the accumulation process for capital gains, the benefits appear as a one year increase in wealth equivalent to fairly substantial income relative to the tax rate structure. Here are the 2011 tax tables. The table makes it easy to see which marginal tax bracket would apply to equivalent annual flows:

Tax Bracket/ Head of Household
10% Bracket = $0 – $12,150
15% Bracket = $12,150 – $46,250
25% Bracket = $46,250 – $119,400
28% Bracket = $119,400 – $193,350
33% Bracket = $193,350 – $379,150
35% Bracket = $379,150+

Since the tax issues only provide perspective, I haven’t bothered to show average tax rates. Average rates would be lower than marginal rate. This should, however, make clear why I referenced tax efficiency as a benefit of defined benefits programs.

Even ignoring tax efficiency, measuring wealth as an income stream has major implications for one’s perception of the wealth distribution. One’s assumptions about ownership of benefit streams, such as pensions, Medicare, and Social Security, have to be explicit. Unfortunately, they often aren’t. Worse yet, they often are intentionally ignored in order to score political points. The figures involved should also make one thing clear: How benefits are treated isn’t a trivial matter for data about either income or wealth distributions.

Count benefits as income in the year they begin (or capital gains in the year they’re realized, for that matter) and one gets one income distribution as well as wealth distribution. Count them as they vest (or appreciate) and the income distribution is different as is the wealth distribution. Ignore them as income or wealth and, not surprisingly, one gets a third set of distributions.

Keep in mind that I used pensions simply for convenience. It would be equally possible to do the same analysis with the same conclusion using Social Security or Medicare. It just would have been a lot more complicated.

As explained earlier in this posting, tax treatment, COLA indexing, and all the complexities associated with any government program make clean calculations of annuity values impossible. That presents problems since in aggregate Social Security provides more than half the income of people over 65 years old. In other words, half of the wealth of people over 65 is ignored in wealth distribution data. However, given almost universal coverage of Social Security and Medicare, wealth that isn’t counted as wealth is important to most Americans.

The 99%ers and many liberals who focus on redistributing income think they are responding to an important social development. In fact, to a large extent, they are just reacting to a tax code that recognizes some forms of income and wealth, but not others. To support their rant they’re ignoring Social Security, Medicare, Medicaid, etc. and misallocating the wealth of pensions.

In America, nothing is more indicative of this phenomenon than the intergenerational shift in poverty. Poverty used to be a concentrated among the aged. Now children living in poverty should be a greater concern. Does that sound political? It’s not. Given that children in poverty can’t vote, chasing erroneous impressions generated by the tax code has far greater political appeal. So, don’t expect the real issues to even make the political radar.

Wednesday, November 9, 2011

The 99%ers: Part 4


Pick your poison. What wealth is seems obvious. However, when one tries to rigorously define it so that it can be measured, things get complicated. Different definitions yield different wealth distributions.

For those who believe the market is always right, mark-to-market seems like a reasonable approach. That presents some problems for those who don’t believe in the efficient market theory. Since markets are very volatile, it also leads to a volatile definition of wealth and who the wealthy are.

For those who only focus on what one could consume over a short time horizon, mark-to-cash seems like a reasonable approach. That presents problems for those who recognize a difference between liquidity and wealth (i.e., net worth). It also presents an element of uncertainty. There are multiple ways to measure liquidity, and they’re all designed to address the fact that at any given moment, liquidity isn’t knowable. It’s only knowable after the fact (i.e., after the transaction is complete).

One might argue that having the right to an income stream is wealth. On the other hand, one might argue an income stream isn’t wealth; it’s an income stream. Then, however, one is left with the awkward question of what is wealth if it is not the ability to consume over time. Being able to consume over time is exactly what an income stream is. It’s also what wealth is. So, from an individual’s perspective, having an income stream seems like a worthy candidate for wealth.

To some people, the only thing that counts is being able to convert it to consumption immediately. To others, it’s the ability to convert it to consumption within in a year or a given tax year. To those who are very security oriented, it’s the ability to ensure that they have the ability to consume over the rest of their life, or theirs and their spouses’ lives. To others, it’s a multi-generational time frame that matters. The most interesting form is the endowment of a charitable fund where the endowment is intended to finance the charity’s consumption of resources indefinitely. Personally, I put a high premium on optionality (i.e., the flexibility to manage the consumption stream), but I fully recognize that the selection of an accounting period is arbitrary.

So, it seems more legitimate to define wealth as control of an income stream than to base the definition on a specific form of the income stream. In the next posting, the issue of comparing income streams with different time patterns is addressed by reducing them to annuity values.

People who want the option to consume it all immediately may object that it overvalues the income stream. Given their time preference for immediate gratification, that’s true for them (although, conceptually, they could swap their benefits for an immediate settlement). Similarly, people who know how difficult it is to build a reliable income stream may also object for the opposite reason (although they could purchase an annuity). Again, however, that just reflects their preference for a particular form of income stream.

Tuesday, November 8, 2011

The 99%ers: Part 3


Is the data grass greener within the 99%? The problems that arise with mark-to-market assumptions don’t end with just the evil 1%. What happens when one tries to look at the data in terms that relate to real world people, rather than as potential political posturing points? One should still be very careful about deciding what it shows. But, at least within the realm of imaginable wealth ranges, we are equipped to make reasonable intuitive adjustments for data deficiencies.

Think about this from the perspective of the retiring baby boomers. Within age cohorts, the data are more meaningful than in aggregate. A millionaire at 25 isn’t the same as a millionaire at 65. We can all make a reasonable adjustment for our age, but often don’t. Data on a single cohort forces the adjustment.

We can also intuitively understand why differences between age cohorts (65 year olds verses 25 year olds) influence the aggregate distribution more than changes in distributions within individual cohorts (25 year olds verses other 25 year olds). After all, most of us start life naked and broke. With time, we dress differently and accumulate different amounts of wealth. Wealth distributions overall (i.e., without reference to age) doesn’t say much.

What also becomes apparent is that wealth held in different forms isn’t directly comparable. We know a house isn’t money in the bank and a CD isn’t equivalent to a stock. Mark-to-market only hides that fact. What market-to-market has going for it is that it seems to allow comparisons that we intuitively know don’t apply.

Even ignoring mark-to-market measurement problems, there are instances where mark-to-market just can’t be applied. Not every asset trades. Using an example of assets that can’t be traded illustrates the shortcoming. The 1% is indicative of nothing without reference to pensions, Medicare, and Social Security. Pensions, Medicare and Social Security are big assets left out of the 99%ers thinking and the data.

Sunday, November 6, 2011

The 99%ers: Part 2


To quote Mark Twain: “Liars, damned liars, and statistics.” I used to study the Survey of Consumer Finance every three years (which is how often reliable data on the “wealth” distribution in the US are available). In between, I'd create estimates based on National Income Accounts data on personal income, supplementing it with Summary of Income data from income tax filings. It was great sport. The intent was to see if differences in savings rates in an age cohort explained differences in wealth distribution as the cohort aged. Unfortunately the data were too aggregated to find anything conclusive.

What I learned was to just ignore media reports on the distribution of income and especially wealth. One can't even rely on the media to know the difference between income and wealth. Heaven help them if one asked them the difference between income and cash flow. Plus, they’ll go to any source for a story regardless of whether the data is at all reliable or even well defined.

Any analysis of the issue, even by the best academics, should be taken with a big grain of salt. If one plays my game of analyzing the data, two things should stand out. The data is highly questionable, and it doesn’t support any broad conclusions. Minor differences in analytical technique, those pesky assumptions, really change the impression one gets.

If one researches “distribution of wealth in America,” the result will be lots of opinion pieces with different data and definitions. There are few actual data sources where the sources, measurement errors, or even the data are well defined. For example, an asset may be owned by one person, managed by another, while yet a third is the beneficiary of the assets value. Some often unspoken assumption has to be made in order to attribute the wealth to someone.

There are related issues arising from unfunded or underfunded assets represented by promises/entitlements. Viewed from the recipients’ perspectives, the assets have one value. Viewed from the perspective of economy (as capital stock), the assets have a different value. Which is right?

Often assumptions about issues like these are never spelled out. One has to suspect many of the “analyses” are designed with political objectives in mind, not in order to investigate the phenomena.

It is particularly interesting that in order to make data meaningful, analysts usually drop outliers from a sample. However, the 99%er crowd is largely focused on quirks created by a few outliers in a highly questionable data set. Even the Survey of Consumer Finances, which intentionally includes an over-sampling of the upper tail of the distribution, doesn’t try to pretend to know what the 99%ers purport to know.

One of my favorite mental games is to pick a few dozen stocks where ownership is concentrated in the hands of the members of the Forbes 400 wealthiest people. One then tries to guess how much the wealth distribution at the 1% level would change if some of their stocks underperformed or over performed relative to GDP. The 99%ers are reacting to supposed changes in society caused by such ephemeral issues as how a very limited set of stocks are preforming.

Now, you might ask: Why play that silly game? Well, taken at market value, Buffet, Gates, etc. look rich. When one focuses on the 1%, if they tried to sell their stock, mark-to-market would hardly be what they would get. They still are rich under mark-to-cash assumptions, but the gap between them and someone more liquid would shrink appreciably (i.e., the wealth distribution would narrow). That’s one illustration of the types of assumptions hidden in wealth distribution data.

Another more dramatic example is illustrated by one of the recent bankruptcies by a real estate tycoon. (The major owner of Simon properties, I think). Under mark-to-market he was in that 1%. Alas, when Simon had to liquidate a big portion of its real estate, conversion to cash bankrupted the company. Oops!

That’s why, although often described as a permanent plutocracy, the Forbes 400, the richest of the rich, is actually quite unstable. One study found that only 27% of America's top 400 have made the list more than once since 1994. Some of today's wealthy (very rich) become tomorrow's fallen kings. It’s very similar among the 1%. A small slice of a distribution is seldom made up of a stable population.

It may be nice to think that once the evil 1% is vanquished all will be right with the world. An evil villain is so convenient. But, like the poor, the rich will always be with us; they just won’t be the same people.

Friday, November 4, 2011

The 99%ers: Part 1


To quote Pogo: “We have met the enemy and he is us.” Recently, I receive this email and link. It’s good material for some serious thought. It will be the point of departure for the next few postings. Unfortunately, it’s also fodder for political, posturing often done without any thought. The postings will stick to measurement issues and try to avoid the politics.

“I understand the targeting of the 1% of the population that holds 40% of the wealth. By that standard, I would argue that the number of Americans is well over 1%. When all of Africa and Asia are added into the base, we are very well off. I would think that an annual income of $500.00 would put someone into the top 1% of the world. However, I have no data to even begin to figure out the US wealth ranking per capita. So I share this rant for your fun, and wonder what your thoughts are......
An interesting rant....”

Agree. Americans who rant about the wealthy should rant into a mirror. They are the wealthy.

Even so, globally, the leveling of the wealth and the income distributions are the big events of the 21stcentury. While you point to Africa and Asia, one used to say everything outside Western Europe, Australia, and English speaking North America. However, the increases in average incomes in China, India, Southeast Asia, Eastern Europe, Latin America, etc. have narrowed the income gap. It takes a lot more than $500 today, but still much less than the US “poverty” level. My guess is someone who gets unemployment insurance for a year would be upper income in most of the world, and if they lived like a local, would end up wealthy.

Globally, inequality is decreasing. Still, all Americans except a very few are richer than most of the world’s population by order of magnitude. THE ECONOMIST MAGAZINE had an interesting supplement on this recently. The title was something catchy like: Surprise, inequality is decreasing. It pointed out that inequality is increasing in many countries, but deceasing globally because of narrowing differences between countries. It focused on income rather than wealth. So, the data aren’t directly relevant, but the discussion of issues related to international comparison is interesting and relevant.

Funny thing is, no matter how big, fast, tough, or sexy one is, there is always someone bigger, faster, tougher, or sexier. The same is true of wealth. If others’ wealth makes one envious, covetous, or resentful, welcome to a miserable life. It’s sad when Americans (and Europeans for that matter) who are the wealthy of the world, make fools of themselves this way.

It seems that envy and resentment tend to cloud people’s judgment. Also, some people think a good rant gets it off their chest and they’ll feel better: I haven’t seen that very often. Rather, it seems to make them unhappier as often as not.

A lot of Americans are thinking about the issue in terms of an exclusively American perspective. My overall thought is that the entire issue of wealth distribution in America is a smoke screen to cover-up policy failures.

Regarding the targeting of the “1%,” I’ve never been able to get into the envy and resentment thing. I don’t begrudge anyone their success. It isn’t a zero sum world. Their wealth just makes me better off.

The 99%ers as used below refers to a political posture, and 1% is used to refer to those the 99%ers think they are targeting. Here’s an interesting aspect of the international dimension of the 99%ers. The 99%ers probably think they’re making common cause with the Greek rioters. Whether they’re in the 1% is questionable, but clearly Greece is looking mainly to other Europeans to bail them out. Seems ironic that people protesting capitalism in the USA think they’re making common cause with Greeks protesting their socialist government.

So, you say: How does that relate to Americans as a gaggle of people in the 1% globally? Although one doesn’t hear much about it, the IMF is on the hook for part of the bailout, somewhere around 23% at one point. Who is the largest contributor to the IMF? You guessed it, the USA. Thus, some of the 99%ers will be bailing out other 99%ers, but look at it globally and a substantial portion of 99%ers on both sides of the Atlantic are actually the 1%.

It looks like IMF could be asked to do more. This organization, designed to help poor countries, may have to ask for contributions from low income countries in order to finance assistance to a relatively developed country. The 99%ers should look in the mirror, and shouldn’t be very proud of what’s staring back.

Thursday, November 3, 2011

Cash Flow And Balance Sheet Management: Part 2

Managing both never ends.

If you think the difference is just an issue for financial analysts, you are wrong. You’re wrong big time. Financial analysts may need a more detailed understanding than you do, but at least a passing understanding is probably more important to individuals.

“How can it possibly be more important for me than for a financial analyst?” you ask. Simple. Remember the statement from “Whose Future Is It?”: “The borrower is betting his or her future.” When the issue is an individual’s cash flow and balance sheet, it’s the entire enchilada that you are betting. One needs to understand the difference and have a passing understanding of how they interact. Any decision one makes with regard to money has both cash flow and balance sheet implications immediately, and those immediate implications will shape the future.

If you want an example of how easily errors are made when only the balance sheet is considered, it’s easy. Just envision the miser who dies from his or her self-denial despite the cash-generating potential of the accumulated wealth. That doesn’t seem to be the US’s problem.

Errors resulting from only focusing on cash flow are probably more prevalent. For some very current examples, see the discussion of the numerous errors people make when discussing the federal government budget. They are described in “Balanced Budget And Balance Budget Amendment: Dangerous Fiction.” This quote summarizes the problem: “The Federal government does its accounting on a cash flow basis…. That approach substantially increases the likelihood of errors – errors in each step and cumulative errors. To illustrate the risk on each step, both the initial Boehner and the Reid proposals to end the deadlock on the debt ceiling came up short when scored by CBO. For cumulative error, how have the forecasts of Medicare and Social Security faired?”

For discussions of balance sheet management that is more oriented toward the individual, see “Truth In Lending” and “Borrowing For Investment.” The first, “Truth,” addresses myths associated with borrowing for consumption. The second, “Borrowing,” introduced some balance sheet issues more directly. However, it ignored the fact that “debt carrying capacity also involves cash flow,” a point made in the discussion of a balanced budget. Consequently, it only introduced the issue. It is when cash flow and balanced sheet are viewed together that a financial plan becomes possible.

Back in “Investing Part 3: Setting the Volume,” the ability to anticipate cash requirements was introduced. It goes by many names from forecasting expenses to the often-dreaded budgeting. No matter the name used, without it a financial plan is close to impossible and balance sheet management a bit constrained.

The constraint seems to lead in self-contradictory directions. As mention before on this blog, some people only view assets as a way to transfer consumption between time periods. They ignore assets as an income-producing resource. It isn’t unusual for that approach to assets to be associated with an inability or unwillingness to try to project cash flow requirements. It’s what, for lack of a better term, might be called the “how long can I hold out on what I have” approach to balance sheet management. The result is an excessive focus on current market values (an obsession with mark-to-market accounting).

The contradiction is that if it’s just a transfer of consumption into some future period, why the heck does current market value matter? What matters is the value at the time when it will be translated back into consumption. The only explanation that seems to fit is a conclusion that if they can’t forecast their own behavior, they conclude that trying to forecast cash flow or future market values is hopeless or just too darn hard. Somehow no forecast is better than one that is uncertain. Perhaps their ego cannot accept the fact that their forecast will be wrong (unless they incorporate a margin of error). So, they find refuge in the “certainty” of current market value.

The unfortunate result is people ready to retire one year and planning to “have” to work forever the next year. Just as sad are people who have to accumulate great stores of low return assets before they can accept the risk of a long life, or, even worse, people who run out of money during old age, often late in old age.

At the other extreme are people who can forecast cash requirements, but can’t relate them to a balance sheet. If we’re giving these tendencies a name, let’s call it the “they’ll take care of it for me” approach. The approach totally ignores what is referred to as the “agency issue.” That’s a fancy term for the fact that the interests of the person abdicating responsibility and the interests of the person accepting the responsibility (the agent), aren’t the same. In fact, they conflict. The agent wants / needs the cost of fulfilling the responsibility to be high. The person who turned over responsibility wants / needs them to be low so that they don’t eat up all the returns.

Here’s the contradiction. The person who abdicated responsibility actually retained an even more daunting responsibility. They have to manage the financial manager. It really gets weird when the person who abdicated responsibility faults the manager with statements like “even I would have seen that (fill in the blank) was a bad investment,” or even weirder “any idiot should have known.” The strangest explanation is when they turn the responsibility over to a pension fund manager, an annuity manager, or a mutual fund management company because “Wall Street is a bunch of crooks.” Seems to me those people are Wall Street.

The unfortunate result is the proverbial angry old man, disappointed when he or she discovers that their manager didn’t quite fulfill their unrealistic expectations. They often resent the success of the person they entrusted with the responsibility. Let see, they entrusted the responsibility to the person on the assumption the person knew how to plan for the future. Why are they resentful when that the person planned for their own future? That very ability to plan was the selection criteria.

The people who manage financial institutions aren’t crooks. Generally, they are honest, hardworking, and reasonably bright people. Uncertainty is there whether you face it or pay someone else to face it for you. Turning over responsibility to someone else because it’s hard to address that responsibility doesn’t suddenly make it easier. If anything, it increases the likelihood of an error.

Why does it make it harder? Because you now have to know the incentives you’ve created for the manager and forecast how he or she will react to those incentives. Further, there is a high probability that you as the investor have created conflicting incentives. The best illustration of the conflicting incentives is when someone sets up a retirement account designed to generate cash flow at some future date, then evaluates account performance based on short-run changes in the accounts’ current market value.

By forcing the manager to focus on mark-to-market value, the person who set up the account has forced the manager into a situation where he or she has to ignore future cash flow implications in favor of current balance sheet impacts. The grantor of responsibility is creating a situation analogous to that of someone who doesn’t understand their cash flow objective. If the manager is forced or encouraged to ignore the objective, it isn’t surprising that they frequently fail to achieve it.

However, there is a conflict of interest that is so strong that the government has set up regulations to mitigate it and provide insurance as a backup when the regulations fail (of course governments exempt themselves from the regulations and insurance requirement). Specifically, it relates to defined benefits pensions (i.e., pensions that promise a specific payment – usually a percent of some reference salary or a dollar amount -- for life). Person covered, organization offering the pension, pension manager, regulator and especially those who appoint the regulator, employees’ representative (if not the individual) all have conflicting objectives. Now, lest this be misinterpreted, a fully-funded, well-managed defined benefits pension is a great hedge against some risks that are otherwise very difficult to manage. The problem is nobody involved has an incentive to fully fund a pension.

The easiest way around funding a pension applies equally well to any retirement plan. Just assume a high enough return on the investment. It instantly solves the problem. But, even if one recognizes that risk to retirement planning, there is a greater risk. Ignoring the volatility in asset returns is by far the greatest risk. However, volatility in asset return can be broken down into volatility in price (the balance sheet impact), and volatility in cash generated (cash flow impact).

Mistaken estimates of return volatility don’t just mess-up peoples’ retirement plans; they undermine their ability to simultaneously manage their cash flow and balance sheet. Mistaken volatility estimates obviously lead to mispriced assets. Clearly that leads to false conclusions about the balance sheet.

The other issue here is the pattern of the cash flow. Even if you knew the average return you would earn on your savings throughout retirement, you still can't know exactly how much lifetime income you will get. When you're drawing money from a portfolio, the pattern of returns, not the average, determines how long your savings will last. These uncertainties exist. You can’t make them go away; financial manager can’t, pension fund managers can’t, and the government can’t. The uncertainty is still there.

The key to addressing this uncertainty is understanding volatility in returns. No amount of knowledge, even prescience, regarding price volatility eliminates the uncertainty (unless all returns are generated through trading). Interestingly, for many assets, price volatility is harder to forecast than return volatility. The volatility of the non-price component of return is often much easier to forecast. Yet many people base their plans to provide for their cash flow requirements on price forecasts.

Wednesday, November 2, 2011

Cash Flow And Balance Sheet Management: Part 1

It may not be an elephant in the room, but it’s bigger than a bread basket.

Income and expenses are flows. Assets and liabilities are stocks. They relate, but aren’t the same. Income and expenses relate to consumption. Wealth only relates to potential consumption when it is translated into income (or expense in the case of liabilities that exceed assets). People who confuse income with wealth are ignoring the difference and not recognizing the cost associated with getting from one to the other.

There are many ways to try to equate one to the other. Market-to-market is one. Just assume perfect markets for assets and, voila, wealth equals market value. It shouldn’t be surprising that The Hedged Economist sees some problems with that approach. Numerous postings on this blog have highlighted the foolishness of the instantaneous liquidity assumption implicit in the perfect market assumption. It has been addressed directly, in terms of the consequences of changes in liquidity, and in discussions of approaches to managing one’s own liquidity needs. However, it’s only one approach, and it is a useful tool.

Another approach, often used as a retirement planning tool, is simulations, Monte Carlo being the most common. It, too, has limitations. Constructed simulations, with explicit assumptions and coefficients, share some of those limitations, but have their own set of problems. They too are useful tools.

An intriguing alternative is market-to-cash or liquidation value. It does try to envision the income the wealth would represent if converted to cash. The obvious problem is that the conversion period is arbitrary (e.g., this week, this year, the length of a bankruptcy proceeding?). The value under mark-to-cash is dependent on the time frame. The reason is mark-to-cash forces an estimate of the liquidity available. The estimate of liquidity is just that, an estimate or guess. Yet, it’s another tool.

One can use the price of an asset with a benchmark income stream. Treasury bills and treasury bonds are used extensively in financial economics as a benchmark return. They present some problems since their prices are volatile and subject to numerous risks. Theoretically, if the comparisons are instantaneous, they would yield what appear to be reliable relative comparisons. But, in fact the relative comparisons are totally dependent on how risk is being priced. An alternative benchmark income stream is to annuitize the wealth. This is another approach.

Each of these approaches yields its own estimate of the relationship between the stock (wealth) and the flow (income). Given the uncertainty associated with measuring the relationship, it is advisable to manage that relationship carefully. It makes sense to take steps to ensure that the management of each is as robust as possible. Also, it is dangerous to make too much dependent on getting the estimate of the relationship exactly right. As in everything, provide for mistakes. They’re guaranteed.