Rethinking Retirement Rules

By Reshma Kapadia

Rethinking Retirement Rules
Illustration: Karolis Strautniekas

Dorothy Collings retired in April at 53, a year and half after her 60-year-old husband. Her plan is to spend time with new grand-twins, help her aging mother, and travel to some of the national parks with her husband. Retiring wasn’t an easy decision: “We were both raised to work and save for retirement,” she says. “That’s what life was for us. Pulling from a portfolio is an emotional process.”

That emotional shift was just the first challenge, Collings found. Trying to tap a lifetime’s worth of savings—enough to enjoy retirement but not so much that you imperil your later years—has never been easy, but it’s about to get a whole lot harder. “It’s the worst time to retire since just before the dot-com bubble burst,” says David Blanchett, head of retirement research for Morningstar. It’s the downside of a decadelong bull market in stocks and a 35-year bull market in bonds: Rising market volatility, rising inflation, rising interest rates, and an uncertain economic outlook all point to much lower expected returns—all of which is far more dangerous to a portfolio that is being drawn down rather than still accumulating. Of course, retiring just ahead of the financial crisis or dot-com bust was painful, but in both cases the near-term outlook for market returns was far better than it is today.

All of this makes the current situation for recent and near-retirees especially dicey, even for those who have amassed a good nest egg. Retirement calculators often use historical average market returns—as much as 12% for stocks and 6% for bonds—but even the rosiest of optimists don’t expect anything near that over the next decade. Blanchett expects stocks to return less than 4% and bonds just 2% over the next decade. Add in his expected inflation rate of more than 2%, and the outlook for returns is pretty dismal.

The Collingses consulted a couple of financial advisors through their companies, and took a personal finance course offered at a local college; all suggested the 4% rule—an old rubric stating that you withdraw 4% of your assets in your first year of retirement, and then take that same dollar figure every year, adjusted for inflation, throughout retirement. But Collings and her husband, who live in the northern suburbs of Chicago, sought out more personalized advice and found an advisor who took a more conservative approach, leading them to decide on a 3% withdrawal rate.

The first wave of baby boomers had the wind at their backs, with a bull market, little volatility, and benign inflation that made winging it possible. The next crop of retirees, and those who recently retired, may not be so lucky. Everyone wants a simple, set-it-and-go formula, but the twists and turns of retirement—and the market—require a more complicated strategy that allows, even encourages, flexibility. Today’s new thinking relies on two primary factors: the mix of assets in your portfolio—stocks, bonds, pensions, annuities, even your homes and Social Security—and how you tap those assets.

“The rules of thumb have nothing to do with your plan or the life you want to live. They just leave retirees stressing over a decision that may have zero impact on their long-term success,” says Dana Anspach, who runs Scottsdale, Ariz.–based financial planning firm Sensible Money. “The key is a plan that gives you a range of possible outcomes and lets you know that if I spend this today, will the 80-year-old me be OK.”  
Yet one rule of thumb—the so-called 4% rule—has dominated retirement thinking. Financial planner William Bengen, the architect of the rule in 1994, proposed taking an initial 4% out of a portfolio that was half in stocks and half in bonds, and adjusting that dollar figure by inflation each year. This, he found, created a strong probability the portfolio could last 30 years, even during the worst U.S. market stretches dating back to 1929. Bengen, now retired himself, says the rule he proposed in 1994 was never intended to be a de facto formula, and he also revised it (with little fanfare) to a 4.5% initial withdrawal rate in 2006 after incorporating small-cap stocks into the portfolio.

Today, Bengen says he has retested the 4.5% rule, and it still holds—and is in the ballpark that his own financial planner uses for his portfolio. But Bengen is not wedded to the rule, allowing that it is based on past market behavior and that a period of low returns alongside a sharp and sudden rise in inflation could be problematic. “You can’t just expect it to work for 30 years without adjustments,” Bengen says. “That’s like shooting a rocket to Jupiter and never making any changes.”

Wade Pfau, director of retirement research for McLean Asset Management, whose work on the topic is closely followed, sees several problems with the rule. For starters, 30 years is too short; advisors should plan for a life expectancy of 100. Plus, the rule was based on a static portfolio that had half of its assets in stocks for the entire time, a high allocation by most standards. Using global market data, Pfau says the rule only works two-thirds of the time—but the bigger problem is today’s low interest rates and high stock market valuations. “We are in unchartered waters,” says Pfau, who says the rule, adjusted for some of these issues, would allow retirees an initial withdrawal of barely 3%.

Adjusting Your Portfolio

So what are near- and new retirees to do? For starters, forget about determining some perfect withdrawal rate: That is dependent on how your portfolio is invested and how flexible you can be in your spending. Today, advisors approach it with a range of 2% to more than 6% in mind. Those who have more of their spending needs covered by guaranteed income—Social Security, pensions, or annuities—can often take a higher initial rate, as can those who can tolerate some swings in their annual budget.

Guaranteed income is the one variable that boosts initial withdrawal rates the most—by more than four percentage points depending on the amount of a portfolio that is in guaranteed income, according to research by Morningstar’s Blanchett (see graphic “How Much Can You Withdraw?”).

                     Illustration: None 

Start with Social Security. It’s hard to find consensus around retirement income strategies, but one piece of advice gets near-unanimous support: Delay taking Social Security until you’re 70, even if you need to tap a taxable account to meet expenses in the meantime, says Marguerita Cheng, head of Blue Ocean Global Wealth. Social Security is guaranteed income for life, and the payouts are adjusted for inflation, which will probably rise in the near future. What’s more, every year (until you turn 70) that you delay claiming your benefits, the amount you’re entitled to grows 8%. That’s a far better return than you’ll likely get on stocks, not to mention it’s guaranteed. Think about this: If your full retirement age is 66, delaying for four years could increase your benefit by 32%. This gain often outweighs the tax you’ll owe from withdrawing from an IRA or 401(k), Cheng adds, especially given today’s historically low tax rates and the fact that many people drop into a lower bracket once they stop working. The advice is especially relevant for women, who tend to live longer, and are often married to an older partner, and therefore may be reluctant to draw down their savings too early. “Their expenses may be higher earlier in retirement, but when she is 82, her spouse may not be there,” Cheng says. “The money taken out of their account will be replenished eventually when she starts Social Security.”

Beyond Social Security, guaranteed income can be hard to come by—and here is where a series of counterintuitive strategies come into play. No pension? Consider creating your own income stream via a low-cost immediate annuity for a portion of the portfolio. Academics have long advocated for this strategy, but it is rarely used, since people are often reluctant to “tie up” a significant portion of their retirement savings in a low-returning vehicle.

Another option is a deferred-income annuity, also known as a longevity annuity, which addresses the fear of outliving your assets while tying up less money. These contracts can be bought at any time, and they typically kick in after age 85. While a 65-year-old man would need to hand over $200,000 for an immediate annuity that pays him a lifetime monthly income of $1,100, he could buy a deferred-income annuity for just $30,000 to get that $1,100 payment once he turns 85.

These annuities are sometimes available in a qualified plan like a 401(k), or can be purchased in an IRA, which offers additional tax benefits, Pfau says: Investors can put up to $130,000 into a deferred-income annuity within an IRA or 401(k) that won’t be subject to the required withdrawals that the IRS mandates when you turn 70½.

This guaranteed income serves two main purposes: It allows you to take more risk in the rest of your portfolio, and provides the flexibility—and peace of mind—to spend more early on, when you’re most likely to enjoy it. This is no small factor in planning: A recent study by Employee Benefit Research Institute, a nonpartisan think tank, looked at retirees’ spending behavior and found that many were reluctant to draw down their savings—so much so that retirees with $500,000 or more in assets spent less than 12% of their nest eggs in the first 20 years of retirement.

“We have to acknowledge that people feel safe by having money in the bank or an account they can look at, even if they can afford to spend more,” says Steve Vernon, a research scholar at the Stanford Center on Longevity.

That’s one reason advisors are increasingly eyeing the $14 trillion in home equity that Americans are sitting on as a source of income, and incorporating that into retirement planning. Like annuities, reverse mortgages—once thought to be the domain of unscrupulous salespeople taking advantage of retirees’ fears—have made a comeback. The industry has been cleaned up, and today’s reverse mortgages can offer a safer and smarter way for some retirees to tap the huge gains in their homes. Homeowners who are 62 or older and plan to stay in their homes can convert some of their equity into a lump sum payment, a monthly income stream, or a line of credit. This alternate way of borrowing against home equity is repaid when the house is sold, typically after the borrower dies. It’s not for everyone: Borrowers need to keep paying property tax and insurance, the upfront costs are high, and rules are in flux. In October, the Trump administration lowered the amount that could be borrowed to about 58% of the home value and raised upfront costs for some homeowners. Still, some advisors see it as a viable option, especially as a contingency reserve that lets retirees increase how much they can pull from the rest of their portfolio.

Another counterintuitive note about portfolio allocation: Retirees should consider increasing their stock allocation as they age. Conventional wisdom dictates that retirees begin with bigger stock allocations to provide enough growth to ensure the portfolio can sustain them throughout retirement, and gradually reallocate to bonds as they age and need to draw down more and have less appetite for risk. But Pfau, along with Pinnacle Advisory Group’s Michael Kitces, have made the case for the opposite: Retirees should start with less, like 30%, in stocks, and work up to 60%. Market volatility early on in retirement can be detrimental to a retiree’s long-term plan, and any losses early on can be very difficult to recover. Given that stocks are at pricey levels—the cyclically adjusted price/earnings ratio, or CAPE, is at 33, double the long-term median—this is especially salient advice today. Morningstar’s Blanchett sees little upside to having an aggressive portfolio at the moment.

Your Withdrawal Rate

So how much can retirees actually withdraw? It depends in large part on their spending flexibility. Patricia Miller is a gynecologist in Huntsville, Ala., who started a blog,, in part because she found that so many of her fellow doctors were struggling with these issues. Miller, 60, had planned to retire at 61. She is beginning to close down her practice, but now says she may work part-time at a local hospital. Miller is well-prepared, and has three years’ worth of living expenses in cash she can draw on if the market falls. Plus, she’s willing to be flexible in her spending: “If we encounter a bad bear market, foreign travel becomes domestic,” Miller says.

One of the myths about retirees is that they’re unable to tolerate variability in their annual spending, but that doesn’t hold up under scrutiny, says Anna Rappaport, a veteran retirement consultant and fellow at the Society of Actuaries. In fact, a recent SOA survey of those 85 and older showed that increased expenses for dental or medical expenses or home repairs didn’t have a major impact on their finances.

The EBRI study also showed that retirees have been living largely off the income and gains thrown off from their portfolio, rather than tapping principal.

Sudipto Banerjee, the author of the EBRI study, who is now at T. Rowe Price, said uncertainty about the future—longevity, the need for long-term care, medical catastrophes—may have contributed to retirees’ desire to just live off returns or income from a portfolio rather than dipping into the principal. Not to mention the difficulty of switching from decades of trying to get account balances to grow, to becoming comfortable watching them decline. The trouble is that as inflation and market volatility rises, living off gains could become more precarious.

The task then is deriving an initial amount to draw from a portfolio. For retirees doing it themselves, Vernon proposes using the required minimum distribution formula that the Internal Revenue Service lays out for people once they turn 70½. It’s not perfect, but it accounts for market volatility, by calculating the year’s spending amount off the portfolio balance, and longevity, via mortality tables. The initial rate for a 65-year-old, for example, would start at 3.5% and rise to 5.35% at 80. One drawback is that spending starts slow, and can swing along with markets. For context, drawing from a balanced portfolio during the financial crisis would have triggered a 25% spending cut, Vernon says, adding that big swings are easier to swallow if you have a source of guaranteed income covering your biggest expenses.

There are several dynamic withdrawal strategies that adjust spending, typically based on market gains, creating a floor or ceiling. Financial planners Jonathan Guyton and William Klinger suggest a “guardrails” approach that lets retirees start with a higher withdrawal rate. In its simplest form, it allows spending to increase faster than inflation if markets are doing well, in return for sacrificing the inflation boost if the portfolio is in the red. The details are more complex, with four broad rules, including using a cash reserve to fund spending needs if the portfolio is declining. There are also parameters around spending cuts and increases, such as taking the inflation-related boost only if the new withdrawal rate as a percentage of the current portfolio balance exceeds the initial rate. For a retiree invested in a 75% stock and 25% bond portfolio, the initial withdrawal rate can be as high as 5.9%—or 4.6% for a more moderate portfolio.

Some advisors—and Pfau—favor a strategy borrowed from pension plans that matches assets with liabilities, rather than focusing on a withdrawal rate. Advisors use a bucket approach: The first bucket covers five to 10 years of spending, and is funded with guaranteed income, bond ladders, and, as rates rise, stable value funds or two-year CDs if the money is in a tax-advantaged account or the retiree is in a low tax bracket. By setting aside this money, it keeps retirees from having to pull from a portfolio that is in decline to pay for near-term costs.

The bucket is replenished from gains in the other buckets, and in a downturn advisors can wait a year or two, until the portfolio is in positive territory, to refill the bucket. The second bucket is intended to fund more variable expenses—like travel or entertainment—and is typically invested in a mix of bonds and stocks, increasingly dividend-oriented to fend off inflation. The third bucket funds bequests and can be invested more aggressively in stocks.

For those without an emergency fund, advisors can carve out gains from these portfolios to cover unexpected expenses, such as $18,000 dental implants or $20,000 to help a child with substance abuse. That’s a relatively easy task during a bull market. But Joe Heider, founder of Cleveland-based Cirrus Wealth Management, worries about complacency. “The dilemma is if those ‘unforeseen’ expenses become somewhat of a regular occurrence. If the markets fall 20% and the kids have become accustomed to that money, it’s going to be problematic.”

These complexities are exactly why retirees latch on to anything that looks like a formula to use, but those can push retirees off course. The best strategy, says Anspach, is a plan that is updated over time and uses the same common sense most have used throughout their financial lives: If someone lost their job or the twins went off to college, dinners at home became the norm, while a promotion or strong run in the market made it a good time to renovate the kitchen: “It’s about bringing that same flexibility to retirement.”

Retirement Income Funds Fall Short

The confusion—even panic—over how to determine how much you can spend in retirement should be a rallying call for the fund industry. But so far, the attempts at solving this problem have been slow to roll out and most have missed the mark.

The efforts fall into one of two categories—target-date retirement income funds, which are similar to what’s often found in 401(k) plans, and managed payout funds, which try to create a regular income stream from your portfolio. The two categories are quite different, and there are important distinctions within each of the categories.

Target-date retirement funds are aimed at saving; they’re funds of funds that reallocate toward a more conservative mix of stocks and bonds as the calendar moves toward the year indicated in the fund’s name. (A 2050 fund, aimed at someone retiring 32 or so years from now, will have a more aggressive allocation than a 2020 fund.) Target-date retirement income funds are, in some cases, simply where your money ends up when you’ve hit your target date. Their allocations can vary meaningfully, just as they do in other target-date funds. For example, the $4 billion JPMorgan SmartRetirement Income (ticker: JSRAX) has 21% in U.S. stocks, 14% in foreign stocks, and 8% in cash; the $304 million Fidelity Freedom Index Income fund (FIKFX), which is aimed more for people who have been retired for 15 years, holds less than 25% in stocks and has 30% in cash.

The differences among managed payout funds are even more stark. Conceptually, these funds sound like a good fix for retirees struggling with the withdrawal puzzle, but there’s a reason the entire category has a scant $5 billion in assets. These funds suffered from the problem many recent retirees and those approaching retirees are worried about: A market downturn early on is far worse than one a decade or so into retirement. Fidelity, Vanguard, and Charles Schwab, the earliest entrants, launched their managed payout funds just ahead of the financial crisis. It did not go well. Some were forced to return principal to investors; others had to tweak their approach.

That approach is important: Some managed payout funds operate like an endowment, aiming to preserve capital and generate the payouts from the income the portfolio produces. Others offer larger payouts by strategically drawing down the principal; some even plan to liquidate entirely by a certain date. Understanding how these funds are constructed is crucial, says Jeff Holt, an analyst at Morningstar.

Fed’s dilemma grows more acute after EM and Europe turmoil

Bank of India governor pleads for US central bank to relax tightening plans

Joe Rennison and Robin Wigglesworth

© AP

The US Federal Reserve is often buffeted by fierce cross-currents but investors caution that balancing the strong domestic economy and rising turbulence in emerging markets — and now Europe — will require a particularly adept hand at the tiller this year.

Although Argentina and Turkey have been the focus for their own idiosyncratic reasons, Urjit Patel, India’s central bank governor, argued that emerging markets are suffering a broader bout of “upheaval” caused by the “double whammy” of the Fed’s balance sheet shrinkage and the US Treasury’s borrowing binge.

“Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet,” Mr Patel wrote in the FT on Monday. “If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

At the same time, Italy’s political crisis may have abated with the formation of a new government but the anti-establishment, populist and Eurosceptic parties that will now control Italy are hardly beloved of investors. Longer term concerns over the durability of the common currency remain, something that sent US Treasury yields tumbling early last week.

On the other hand, analysts note that the US economy continues to expand at a robust clip, exemplified by unemployment numbers and manufacturing data released on Friday. That double dose of strong data prompted traders to lift Treasury yields back up higher again to end the week — and it improved the odds of the Fed staying on its path of monetary tightening this year.

“I think it steadies the Fed’s hand. I do think that three increases this year are there, and the chance of four is back on the table,” said Jim Paulsen, chief investment strategist at the Leuthold Group. “The market message is that the Fed should continue to tighten. I would think the Fed sees that message, too.”

The tug of the cross-currents is well-illustrated by the oscillations in the Fed funds market. The odds on three more interest rate increases this year, on top of the first rise announced in March — as implied by Fed funds futures — had risen to a high of nearly 40 per cent by May 22, plummeted to a low of 13 per cent on May 29 and rose back to 30 per cent on Monday.

The implied probability of the Fed only raising interest rates once more this year, after the March increase, jumped from 13 per cent on May 22 to nearly 40 per cent at the peak of the Italian turmoil but has since slid back to under 20 per cent.The Treasury market has also see-sawed with the 10-year Treasury yield bouncing back from a low of 2.76 per cent on May 29 to 2.92 per cent on Monday.

The Fed itself has indicated that it plans to raise interest rates twice more this year. And many investors and analysts reckon that the US central bank will not be pushed off course by stresses in Europe and the developing world — something that Lael Brainard, one of the Federal Reserve’s governors, hinted in a speech last week.

“An environment with a strengthening dollar, rising energy prices and the possibility of rising rates raises the risks of capital flow reversals in some emerging markets that have seen increased borrowing from abroad. Although stresses have been contained to a few vulnerable countries so far, the risk of a broader pullback bears watching,” she noted.

However, “continued gradual increases” in interest rates remained “appropriate”, Ms Brainard said, given the economic stimulus that the $1.5tn of tax cuts and a $300bn increase in federal spending would entail.

Indeed, given the robust US economic outlook, some analysts even caution that it runs the risk of overheating. The 10-year “breakeven” rate, a market measure of investors’ inflation expectations, remains above the Fed’s target 2 per cent at 2.07 per cent, despite recent declines, and inflation is expected to continue to accelerate into the summer.

“The Federal Reserve has to focus on stable growth in their own economy,” said David Kelly at JPMorgan Asset Management. “They cannot be overly worried about what is going on in other markets.”

Even investors that remain sceptical of inflation accelerating forcefully doubt that US policymakers will be pushed off course. “The Fed monitors these situations but the US has a pretty good growth story,” said Dan Ivascyn, global chief investment officer at Pimco.

Nonetheless, political stress was easier for markets to ignore when central banks were accommodative, and cracks could emerge or widen as the Fed continues to ratchet back its monetary stimulus, according to Aaron Kohli, a strategist at BMO Capital Markets. “The Fed is exerting stress — not just in the US but globally — as it tightens conditions,” he said.

This is what worries Mr Patel of the Reserve Bank of India. He argued that the current pace of Fed balance sheet shrinkage could be slowed to avoid the otherwise “inevitable” fallout from boomeranging back on the US economy.

“Such a move would help smooth the impact on emerging markets and limit effects on global growth through the supply chains that span both developed and emerging economies.

Otherwise, the possibility will increase of a ‘sudden stop’ for the global economic recovery,” he wrote. “That might hurt the US economy as well. Circumstances have changed. So should Fed policy.”

The Fed’s Statement Was Short, but It Wasn’t Sweet

The FOMC takes a more-hawkish tone, indicates it won’t hesitate to raise rates if it sees signs of an overheating economy

By Justin Lahart
Federal Reserve Chairman Jerome Powell speaks at a news conference Wednesday after the central bank raised a benchmark interest rate by a quarter percentage point.
Federal Reserve Chairman Jerome Powell speaks at a news conference Wednesday after the central bank raised a benchmark interest rate by a quarter percentage point. Photo: Andrew Harrer/Bloomberg News

Brevity might be the soul of wit, but investors might wish the Federal Reserve was a little more long-winded.

Fed policy makers on Wednesday raised their target range on the central bank’s benchmark short-term interest rate by a quarter percentage point while also boosting their projections for how much they will raise rates this year and next. Given what has been happening with the economy, these moves shouldn’t have counted as a big surprise. Fed policy makers now have a median projection that inflation will reach their 2% target by year-end. Their year-end forecast for the unemployment rate has shifted to 3.6% from 3.8%.

Federal Reserve median projections for theyear-end federal-funds rate

Source: Federal Reserve

But what the Fed didn’t say seemed to have the biggest impact, initially helping to send stocks lower and short-term yields higher. It lopped off 80 words of longstanding language from its postmeeting statement which discussed how rates were “likely to remain, for some time, below levels that are expected to prevail in the longer run.” This amounted to policy makers saying they don’t expect to keep leaning with the economy, and that maybe they will need to start leaning against it.

Indeed, the Fed took one additional step toward that possibility Wednesday. Fed Chairman Jerome Powell announced that, starting next year, the central bank will hold a press conference following each of its policy meetings rather than after every other meeting as it now does. This will make it easier for the Fed to raise rates at any meeting, rather than just the four each year that are accompanied by news conferences.

What the Fed actually does will, of course, depend on the economy. What has changed, however, is that the Fed is no longer treating the economy as a fragile thing. If it thinks there is a risk of things running too hot, it isn’t going to hesitate much about raising rates to cool them down.

What Are ETFs?

By Daren Fonda

         Photo: Fabio Ballasina 

Exchange-traded funds are similar to mutual funds: Both hold baskets of individual stocks, bonds, or other investments. ETFs are called “exchange-traded” because investors can buy or sell them on a stock exchange, just like shares of a publicly traded company.

ETF prices fluctuate with the value of their holdings. Investors can trade ETFs as frequently as they like. And ETFs are hugely popular among hedge funds, institutional traders, and individual investors. These funds now account for almost 22% of the volume on the New York Stock Exchange, with 1.2 billion shares changing hands on an average day. 
Mutual funds, in contrast, aren’t geared for trading. Funds are only available at their net asset value (excluding any commissions or fees), calculated after the market closes at 4 p.m. every day. Many mutual funds also impose minimum holding periods of 30 days to prevent investors from dipping in and out over a short period.

What do ETFs invest in?

In most cases, ETFs are index-based stock funds: their goal is to mirror the performance of a market benchmark such as the Standard & Poor’s 500 index. That was the objective of the first ETF, the SPDR S&P 500 (ticker: SPY), which hit the market in 1993. Holding more than $270 billion in assets, SPY remains the largest ETF. But it’s now one of more than 1,850 ETFs, holding a combined $3.6 trillion in assets.

While some exchange-traded funds track traditional indexes, most mirror custom-made ones, focused on, say, large-cap growth stocks, small-cap value equities, or high-yield bonds. These indexes may target a sector, such as industrials, or a sliver of a sector, such as consumer-related internet stocks. Other ETFs cover everything from foreign stock markets to real-estate investment trusts, energy master limited partnerships, and preferred shares.

A new class of ETFs called “smart beta” has emerged lately. These aim to beat traditional market-cap weighted indexes by emphasizing stocks with certain attributes, such as low price/earnings ratios, momentum in their share prices, or strong company fundamentals (such as high returns on equity).  

Beyond stock and bond ETFs lies a realm of alternative funds. Leveraged ETFs, for instance, borrow money to boost their exposure to an investment by up to three times a standard amount (on a daily basis). Inverse ETFs, which may also use leverage, wager against the market, sectors or asset classes such as currencies. These can be complicated and risky, especially for inexperienced investors.  
Exchange-traded notes also exist. These are issued by banks and other financial firms, ETNs are debt securities that aim to mimic the returns of an index (less fees). Most ETNs focus on alternative assets, such as commodities, currencies, and master limited partnerships. The largest ETN, the iPath Bloomberg Commodity Index Total Return (DJP), offers exposure to a broad basket of commodities. ETNs aren’t taxed the same as ETFs, however, and, as debt securities, they pose a risk that the issuer may default, potentially wiping out shareholders.

How are ETFs made?

When investors buy shares in a mutual fund, they essentially hand over cash to a fund sponsor, which issues shares as money flows in and redeems them when investors cash out. That’s why most mutual funds are “open-ended.”

ETFs don’t have a fixed number of shares. Instead, their shares are created and redeemed by middlemen—big institutional investors called “authorized participants.” AP will buy a block of the ETF’s underlying holdings—say shares of every stock in the S&P 500—in the same proportion as the ETF holds them. The AP exchanges the securities for a “creation unit”—typically a block of 100,000 ETF shares—and then sells them on the open market. To remove ETF shares from the market, the process works in reverse: The AP buys enough shares to form a creation unit, delivers it to the fund’s sponsor and receives a basket of underlying securities in return.

This creation-redemption process keeps the share price of an ETF in line with its net asset value. If demand for an ETF pushes the share price above the NAV, the AP will issue more creation units, increasing supply and pushing the price closer to the NAV. Conversely, the AP can remove ETF shares from the market through the redemption process if the price drops much below NAV, thereby pulling the price back up.

That arbitrage mechanism doesn’t work perfectly—it can short-circuit during periods of extreme volatility and for funds holding thinly traded assets. Bond ETFs are particularly susceptible to trading at discounts or premiums because most bonds don’t trade on an exchange and some might not trade for weeks at a time, making it harder to ascertain a bond portfolio’s “intrinsic value,” says Dave Nadig, managing director of Nonetheless, for major ETFs, the arbitrage process generally ensures that wide discrepancies between the share price and NAV are rapidly traded away.

viernes, junio 15, 2018



Doug Casey on the Crisis in Argentina

Justin’s note: Argentina is teetering on the edge of a full-blown crisis.

Its currency, the peso, is in free fall. Inflation is skyrocketing. And foreign investors are fleeing the country.

In short, it’s starting to feel like 2001 again. So, it’s no surprise that the Mauricio Macri government is doing everything it can to prevent a repeat of that disaster.

It’s already raised the key interest rate to 40%. It’s unloading the foreign reserves. And Argentina is in talks with the International Monetary Fund (IMF) to secure a massive bailout.

No one knows if these emergency measures will work or backfire. But if there’s anyone who might have an answer, it’s Doug Casey.

Doug isn’t just a student of money. He’s also lived in Argentina for years. So, I recently phoned him to see what he thinks about all of this…

Justin: Doug, what do you make of what’s happening in Argentina? Is the government taking the right steps to prevent a crisis?

Doug: Let me start by saying that no government should be in the money business. Money is something that society should determine for itself. In today's world, it would probably be gold, some type of cryptocurrency, or some combination of the two. Remember that, before about 1933 in most cases, all the world’s currencies—the pound, the mark, the franc, the dollar, all of them—were just national names for a specific amount of gold. Then governments withdrew gold coins from circulation, and would no longer redeem their currencies with anything. But people continued to use them—even though they then started dropping radically in value.

This is especially true about Argentina, which has about the worst track record of any government. They’ve completely destroyed numerous currencies since they went off the gold standard in the 1930s. They’re neck and neck with Brazil for creating tens of trillions of percent of inflation over the last 80 years. Repeatedly wiping out their lower and middle classes in the process.

But back to your question. Argentina’s central bank has just raised its key rate to 40%. And people are saying, "Oh, this is horrible, this is terrible. It's going to destroy the economy.

Nobody's going to be able to borrow anything. It'll bankrupt businesses that need to borrow.”

But it’s actually very intelligent—within the context of what a mess the Argentine government has made of everything. They created a high inflation environment by printing up vast amounts of pesos to pay the government’s bills. Government spending is mostly individual and corporate welfare, subsidies, and employees. Similar to the US, but much worse.

That puts them in a bind. The State needs to print money—inflate—to support itself. But it also needs people to save. Saving is how you accumulate capital. It’s how you become wealthy. You produce more than you consume, and save the difference. In a high inflation environment, people will still produce, but they won't save because they know the money's going be inflated away from them. So they spend it as soon as they get it. And the economy goes nowhere.

Raising interest rates to 40%, when inflation is probably 25% is very intelligent in that it will encourage people to save. That will help them build capital—you don’t need to do anything.
Raising interest rates will also strengthen the currency because people will get a positive yield.

Foreigners even might buy the Argentine peso, if they can get 40%—a real return of 15%.

But there’s no free lunch. The problem is that if the government is offering 40%, how are the banks going to make loans? Who’s going to borrow at, say, 50% when inflation is 25%? This is one of the many reasons governments should have absolutely nothing to do with the money system. Everything they do to solve one problem just creates another problem.

Justin: What about the other things that Argentina’s government has done? Should Argentina’s central bank be unloading its foreign reserves?

Doug: A mistake. They're selling dollars in an effort to control the exchange rate between the peso and the dollar, propping up the value of the peso.

This is very stupid because it makes the peso artificially expensive. And Argentina is already quite expensive—it used to be about the cheapest country in the world. An overpriced peso discourages people from investing down here. It discourages tourists from coming down here. It encourages Argentines to buy foreign currencies and other foreign assets, taking advantage of the artificially strong peso.

Macri impresses me as an OK guy—probably the most decent head of any major state in the world today. But he’s clearly getting bad advice. All the people around him are educated in Keynesian economics, as are the IMF apparatchiks inundating the country. The government should go to a gold peso, and completely withdraw from the economy. Interest rates and prices will find their own levels.

But that’s not going to happen anywhere, until there’s a complete collapse, and there’s no alternative.

To have a strong currency they have to stop printing money. That's why the Swiss Franc is relatively strong. That's why the Deutsche Mark used to be strong.

But the Argentine government has done the exact opposite. They’re burning through their reserves to artificially support their worthless currency. It’s very stupid.

So, Macri is doing one relatively smart thing and one quite stupid thing. But that’s much better than the last Argentine government. They would only do stupid things. One out of two ain’t bad when it comes to Latin America.

Justin: Let’s not forget that Argentina also went to the IMF to ask for money. I know a lot of people here aren’t happy about that. What do you think about that?

Doug: Yes, they’re planning on borrowing money from the IMF. They’re doing this to prop up their currency. But they’re just frittering that money away. It’s like borrowing even more money to avoid bankruptcy, when you’re already hopelessly in debt.

The only good thing about this is that it sets up Argentina to again default on the national debt in the future. That would punish the IMF, which has no right to exist. It should be abolished.

Justin: Do you think the IMF will impose austerity measures on Argentina? And if so, should Argentina be cutting spending right now?

Doug: Argentina should fire many, many more government employees. Macri has already gotten rid of about 80,000 of them. But that's a drop in the bucket.

They should, for instance, sell the national airline. It’s the only major airline in the world, that I know of, that loses money. Every other airline is coining money right now. Aerolineas loses about a billion dollars per year. That’s mainly because of the unions.

Unions basically run Argentina. They’re everywhere. And they treat their members like gods at the expense of the public.

They've got to destroy the union movement down here. It’s totally corrupt. They would put the Teamsters in the United States to shame on their worst day. Unions everywhere are basically run by thugs. But, as in the US and Europe, the average guy has been programmed to believe unions are good, and protect the downtrodden worker from employers, who are evil.

Unions don’t have to be abolished. They simply shouldn’t be protected by the State. If unions were voluntary, no problem. But they’re not. Membership is almost always compulsory, everywhere. They put a straightjacket on the working man, and damage society as a whole.

Unions are just part of the problem. They also need to get rid of their price controls, their subsidies, their duties, their taxes, and their regulations. Argentina, however, is probably no worse than France, Italy, or other EU countries. They’re all a nightmare for the entrepreneur.

Justin: So, Macri hasn’t done enough yet?

Doug: Macri has done some good things. But he's not moving nearly fast enough.

I've got to say that the best thing that's happened to any country in South America in the last 50 years was Augusto Pinochet in Chile. However he's a good news/bad news situation. The fact that Pinochet was a military dictator. That’s bad news.

But—strange for a general—he had good economic instincts. That’s the good news. Before him, Chile was just a poor, isolated mining province. He took Chile from a backwater with some copper mines to the most successful country in Latin America. Now, everything works there.

The average Chilean is, believe it or not, wealthier than the average American. One reason for that is their national Social Security funds are individually owned accounts, invested in their stock market. Argentina needs something like Pinochet.

Everybody says, "Oh, Pinochet, he killed a couple thousand people." Yeah, he did. And that's too bad, even though they were mostly communists. But you’ve got to remember that the Argentine generals killed 30,000 or 40,000 people. The Brazilian generals probably killed another 20,000 or 30,000 people. Even the Uruguayan generals killed a couple thousand people.

And that's Uruguay, which used to be called the Switzerland of South America.

Pinochet was mild by South American standards. The only reason that he was pilloried, brought to trial, and hated so much, is because he put economic reforms into effect. It wasn't because he killed a couple thousand people. It’s because he was pro-capitalist. That’s why he was persecuted.

That's the direction Argentina should go. The country is still following the model Mussolini set for Italy in the ’20s. Hopefully, they can accomplish this without killing anybody.

Justin: So, are you still optimistic about Argentina? I ask because you recently told me that Argentina was one of the only countries in the world headed in the right direction. Do you still think that, given what’s happened recently?

Doug: Yes. They’re absolutely moving in the right direction. But, like I said, they’re doing one smart thing followed by one stupid thing. Two steps forward, one step back. But that’s better than doing one stupid thing after another. The previous government, under Cristina Kirchner, did something unbelievably stupid every single week—nothing intelligent, ever. If she’d been re-elected, Argentina would have moved in the direction of Venezuela, or at least Bolivia.

But let me say this. The average voter, anywhere in the world, has no philosophical bearing whatsoever. Look at New Zealand. By the mid-1980s, the country had become the shallow end of the gene pool. Anybody with any sense and enough money to buy a ticket to Sydney, London, or LA was getting out.

Then, Roger Douglas, a reformed socialist, started deregulating the economy, cutting taxes, and privatizing. The place boomed. It became an extremely prosperous country in the ’90s, ’00s, and early teens. Everybody started doing well. The currency got strong, it doubled against the US dollar. Real estate prices tripled and quadrupled.

But what did the stupid Kiwi voters do after 30 years of good times? They elect a 37-year-old female, who's a hardcore communist. Now New Zealand's going downhill rapidly.

And as corrupted as the average Argentine voter has become over the last 70 years, I don’t know if they can handle four years of a good thing. That may be too much to bear. So, they might elect someone even worse than Cristina after Macri. It's unpredictable.

But we really shouldn’t be worried about what happens with Argentina. Instead, we should be worried about what comes after Trump. Because the chances are excellent that we'll be deep in stage two of The Greater Depression by then. Perhaps we’ll also be in something resembling World War III. The next president of the United States is likely to be extremely dangerous.

Justin: So, I don’t take it that you’re buying Argentina’s 100-year bonds.

Doug: Of course. They’re a monument to human stupidity. $2.3 billion of them, 8% coupon, in US dollars. The idea that anyone would lend any government money for 100 years, let alone Argentinian government, is crazy. It’s completely insane. You won’t have to wait 100 years for them to be worth zero. They’re now trading at about 8x.

These bonds were sold as a speculative vehicle. They were a bet on lower interest rates, an improving Argentine economy, and the ability to repay the bonds getting better over the short run.

The fools that bought them will probably consider playing Russian roulette with an automatic pistol in the near future as well.

The fact that these things even exist shows you how loose credit has become. It’s telling us how much funny money has been created. Next thing you know, Zimbabwe will be able to float a 100-year bond...

Justin: You can’t rule it out. Anything is possible these days.

So, what should the average Argentine be doing right now to protect themselves?

Doug: They should be buying precious metals. This used to be very easy to do in Argentina. But the Kirchners shut down the local gold exchange. This made it harder and more expensive to buy gold coins. I don’t know if Macri has plans to allow it to start up again. It would be a good idea.

Argentinians should also buy property, specifically farmland. Commodity prices are still very low. Farmers aren’t making any money—but commodity prices have been perking up. Buying farmland is an excellent bet right now.

You could also speculate in cryptocurrencies. I know a lot of Argentines that have done this.

They were early adopters. They got involved in the space because you can't save pesos, and it was inconvenient to save dollars. So they saved Bitcoins. And they made a lot of money.

Of course, Bitcoin’s up an enormous amount over the last few years. But there are waves of new cryptocurrencies coming out. So, there’s still a lot of profit opportunity.

Those would be my three recommendations for an Argentine.

Justin: Yeah, those are all better ideas than shifting wealth from pesos to currencies like the US dollar and British pound. After all, you and I both know that every paper currency on the planet is losing value. So, you just end up playing a game of hot potato.

Doug: Absolutely. All of them.