Sal Khan: Bill Gates' favorite teacher - Aug. 24, 2010, edited by Wade Dokken

Bill Gates' favorite teacher

Khan turns out thousands of videos from a converted walk-in closet in his Silicon Valley home. By David A. Kaplan, contributorAugust 24, 2010: 5:53 AM ET

FORTUNE -- Sal Khan, you can count Bill Gates as your newest fan. Gates is a voracious consumer of online education. This past spring a colleague at his small think tank, bgC3, e-mailed him about the nonprofit khanacademy.org, a vast digital trove of free mini-lectures all narrated by Khan, an ebullient, articulate Harvard MBA and former hedge fund manager. Gates replied within minutes. "This guy is amazing," he wrote. "It is awesome how much he has done with very little in the way of resources." Gates and his 11-year-old son, Rory, began soaking up videos, from algebra to biology. Then, several weeks ago, at the Aspen Ideas Festival in front of 2,000 people, Gates gave the 33-year-old Khan a shout-out that any entrepreneur would kill for. Ruminating on what he called the "mind-blowing misallocation" of resources away from education, Gates touted the "unbelievable" 10- to 15-minute Khan Academy tutorials "I've been using with my kids." With admiration and surprise, the world's second-richest person noted that Khan "was a hedge fund guy making lots of money." Now, Gates said, "I'd say we've moved about 160 IQ points from the hedge fund category to the teaching-many-people-in-a-leveraged-way category. It was a good day his wife let him quit his job." Khan wasn't even there -- he learned of Gates' praise through a YouTube video. "It was really cool," Khan says.

In an undistinguished ranch house off the main freeway of Silicon Valley, in a converted walk-in closet filled with a few hundred dollars' worth of video equipment and bookshelves and his toddler's red Elmo underfoot, is the epicenter of the educational earthquake that has captivated Gates and others. It is here that Salman Khan produces online lessons on math, science, and a range of other subjects that have made him a web sensation.

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Khan Academy, with Khan as the only teacher, appears on YouTube and elsewhere and is by any measure the most popular educational site on the web. Khan's playlist of 1,630 tutorials (at last count) are now seen an average of 70,000 times a day -- nearly double the student body at Harvard and Stanford combined. Since he began his tutorials in late 2006, Khan Academy has received 18 million page views worldwide, including from the Gates progeny. Most page views come from the U.S., followed by Canada, England, Australia, and India. In any given month, Khan says, he's reached about 200,000 students. "There's no reason it shouldn't be 20 million."

His low-tech, conversational tutorials -- Khan's face never appears, and viewers see only his unadorned step-by-step doodles and diagrams on an electronic blackboard -- are more than merely another example of viral media distributed at negligible cost to the universe. Khan Academy holds the promise of a virtual school: an educational transformation that de-emphasizes classrooms, campus and administrative infrastructure, and even brand-name instructors.

Quick, free, and easy to understand

Distance learning and correspondence courses have been around since the invention of mail. And private, for-profit schools flourish; the University of Phoenix has half a million students enrolled, most of them online. Other private operations, like the Teaching Co., specialize in amalgamating "great courses" from nationally known teachers: the 12-hour Game Theory in Life, Business, and Beyond, from one academic star, costs $254.95 on DVD.

What's remarkable about Khan Academy, aside from its nonpareil word of mouth and burgeoning growth, is that it's free and prizes brevity. Remember your mumbling macroeconomics teacher whose 50-minute monologue in a large auditorium could bore the dead? That isn't Khan. He rarely cracks wise -- if you want shtick, check out Darth Vader trying to teach Euclidean geometry on YouTube ("The Pythagorean theorem is your destiny!") -- but in less than 15 minutes Khan gets to the essence of the topics he's carved out.

Online critics question whether he amounts to a dilettante who's turning learning into pedagogical McNuggets. But while you obviously don't learn calculus in one session -- the subject is divided into 191 parts, which doesn't include 32 more in precalc -- Khan's components seem to hit the sweet spot of length and substance. And he covers an astonishing array. There are the core subjects in math -- arithmetic, geometry, algebra, trigonometry, calculus, and statistics -- and the de rigueur science offerings, like biology, chemistry, and physics. But Khan also gives lessons in Economics of a Cupcake Factory, the Napoleonic Wars, and the Alien Abduction Brain Teaser.

The seeds of education

Like so many entrepreneurial epiphanies, Khan's came by accident. Born and raised in New Orleans -- the son of immigrants from India and what's now Bangladesh -- Khan was long an academic star. With his MBA from Harvard, he has three degrees from MIT: a BS in math and a BS and a master's in electrical engineering and computer science. He also was the president of his MIT class and did volunteer teaching in nearby Brookline for talented children, as well as developed software to teach children with ADHD. What he doesn't know he picks up from endless reading and cogitation: His gift, like that of many teachers, is being able to reduce the complex. "Part of the beauty of what he does is his consistency," says Gates. Of Khan's capacity to teach, Gates, who says he spends considerable time trying to help his three kids learn the basics of math and science, tells Fortune, "I kind of envy him."

In the summer of 2004, while still living in Boston, Khan learned that his seventh-grader cousin, Nadia, in New Orleans was having trouble in math class converting kilograms. He agreed to remotely tutor her. Using Yahoo Doodle software as a shared notepad, as well as a telephone, Nadia thrived -- so much so that Khan started working with her brothers, Ali and Arman. Word spread to other relatives and friends. Khan wrote JavaScript problem generators to keep up a supply of practice exercises. But between their soccer practices, his job, and multiple time zones, scheduling became impossible. "I started to record videos on YouTube for them to watch at their own pace," Khan recalls. Other users tuned in, and the blueprint for Khan Academy was created.

Khan continued to work for the small hedge fund he had joined after Harvard, Wohl Capital Management. He said he took away "under $1 million" before the Silicon Valley-based hedge fund wound down, and briefly started his own fund in mid-2008, which didn't really get off the ground because of the financial crisis. ("I called it Khan Capital," he says, "but it never got much beyond 'Khan's Capital.'") He used his nest egg to buy a house with his wife, Umamia, a rheumatology fellow at Stanford Medical School, and as a reserve when he gave up his investment career. On a typical day he tapes a few tutorials, answers posts from students, calls experts when he's stuck on how best to explicate a concept, and fields queries from curious potential backers.

He maintains he has no interest in monetizing the operation by charging subscriptions or selling ads. "I already have a beautiful wife, a hilarious son, two Hondas, and a decent house," he declares on his website. But that hasn't stopped the inquiries, the most notable from John Doerr, the Silicon Valley venture capitalist, and his wife, Ann. Not long ago a PayPal donation on Khan's site came in for $10,000 (a typical gift is $100). Khan e-mailed the donor. Her name was Ann Doerr. He knew of a John Doerr but just assumed the name was more popular than he realized. He e-mailed her to say thanks. She suggested lunch.

When they met, Ann Doerr told him she couldn't believe hers was the largest donation. "This is, like, criminal," she said. "I love what you're doing." When he got home, he found a message from her: "There's $100,000 in the mail."

Khan is using that money to pay himself a salary. Later, he met John Doerr and has since relied on both Doerrs for entrée to others in the philanthropic establishment. After Gates mentioned Khan in Aspen, John tweeted it to his Silicon Valley legions. In July the academy received another $100,000 -- from John McCall MacBain, a Canadian entrepreneur who made a fortune in publishing. "If I had a million dollars," Khan says, he'd fund software development of more automated problem sets and extensive translations of his videos. Gates, whose foundation spends $700 million a year on U.S. education, plans to talk to Khan soon as well.

An academy or a library?

Khan has his skeptics in the education business. They don't doubt he means well and is helping students, but they question the broad impact of any tutorial that doesn't test performance or allow student-teacher discussion. "It's a solid supplemental resource, particularly for motivated students," says Jeffrey Leeds, president of Leeds Equity Partners, the largest U.S. private equity firm specializing in for-profit education. "But it's not an academy -- it's more of a library."

But Khan intends nothing less than "tens of thousands" of tutorials offering the "first free, world-class virtual school where anyone can learn anything." The advances envisioned by Leeds and others wouldn't hurt either. The education industry can use all the innovation it can find. 

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Bill Gates' very full life after Microsoft

What's missing for back-to-school? 135,000 teachers

Education stocks get an F

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Wow, I'm downloading this for my computer today........ I hope my 12 year old loves biology, physics, and chemistry. I hope I know more--for now.

Defying Democrat Orthodoxy on Social Security | Deroy Murdock | Cato Institute: Daily Commentary

Defying Democrat Orthodoxy on Social Security

by Deroy Murdock

Deroy Murdock is a policy adviser to the Cato Institute and a columnist with Scripps Howard News Service.

Added to cato.org on October 16, 2000

This article appeared on cato.org on October 16, 2000.

Few Democrats are more stalwart than Wade Dokken, CEO of American Skandia — a Connecticut-based mutual fund company with $40 billion in assets. Dokken calls himself "an FDR-Truman-Kennedy-Johnson-Humphrey-McGovern-Carter-Clinton Democrat." A photo in his office shows him beside a beaming Hillary Rodham Clinton. Since 1998, Dokken says he has given at least $15,000 to Democratic campaign committees. "When I hear Newt Gingrich's name, I boo," he explains. "And then, when the appeal for money comes, I start writing my check."

But Dokken has just broken with his party. In his new book, New Century, New Deal, Dokken slams the Democrats on Social Security. He laments that the "party of the people" prevents Americans from investing their payroll taxes in privately owned retirement accounts. Dokken calls Social Security Choice "a golden opportunity to appeal to the dreams and aspirations of the New Investor Class."

The problem Dokken sees is that Gore would rather arouse his party base with anti-business rhetoric than sing Americans a song about hope.

Deroy Murdock is a policy adviser to the Cato Institute and a columnist with Scripps Howard News Service.

"The liberal leadership and left-wing allies of my party have always preferred welfare over wealth creation and anti-Wall Street populism to New Investor Class pragmatism," Dokken writes, "and the Vice President desperately wanted to energize his more liberal base."

Dokken harshly attacks Gore's Retirement Savings Plus plan. First, Gore would require Americans to pay their full Social Security taxes to the government, leaving many modest workers with nothing to invest. For those who could afford portfolios, Gore promises matching tax credits — in some cases, three federal dollars for every dollar a worker invests. This hefty, new entitlement would ignore Social Security's long-term, financial pitfalls.

Second, Dokken considers the vice president's current policy hypocritical given his earlier pronouncements. Gore today says he wants to help some Americans invest for retirement. But last May he called the stock market — what else? — "risky" and said, "You should not have to roll the dice with your basic retirement security." Having denounced the casino, Gore now wants to buy Americans their chips. As Dokken observes: "Either the stock market is a terrible place to invest for the future, or it isn't."

George W. Bush's plan is broader and bolder. Dokken calls it "by far superior." Bush would free even the poorest Americans either to remain in Social Security or voluntarily to allocate two percent of their FICA taxes to personal retirement accounts they would invest in stocks and bonds. These funds would be their property, not Uncle Sam's. They could bequeath these assets to their heirs, something unimaginable under today's Social Security scheme. Bush's plan, Dokken believes, will "shift our focus from poverty prevention to wealth creation and turn every worker into an owner."

Dokken now joins other prominent Democrats who want Americans to have universal access to the capital markets. Sam Beard, former advisor to Robert F. Kennedy, Minnesota's ex-congressman Tim Penny and Nebraska senator J. Robert Kerrey enthusiastically advocate personal retirement accounts funded with payroll taxes. New York senator Daniel Patrick Moynihan wrote in a May 30 New York Times column that he wants personal retirement accounts to help Americans build estates — "for doormen, as well as those living in the duplexes above."

Even Senator Joseph Lieberman supported Social Security Choice, until he performed an Olympic-class back-flip and landed on Gore's ticket.

"A remarkable wave of innovative thinking is advancing the concept of privatization," he told the Copley News Service in 1998. He added that "individual control of part of the retirement/Social Security funds has to happen." Lieberman's Democratic Leadership Council discovered in a survey that year that 72 percent of "Democrats" favor investing payroll taxes in personal accounts.

Governor Bush repeatedly and passionately promoted his Social Security blueprint in the October 3 presidential debate. "I want younger workers to be able to manage some of their own money — some of their own payroll taxes," Bush said, "to get a better rate of return on your own money."

Bush must hammer that theme, on the hustings and in commercials. This issue will energize younger Americans like a double espresso. Remember, in 1998, motivated young voters transformed Jesse Ventura from a colorful lark into Minnesota's governor.

G.W. Bush should invite Al Gore to join Bush, Wade Dokken, Bob Kerrey and Pat Moynihan in a bipartisan appeal for Social Security Choice. If Gore refuses, Bush should ask the leader of the "party of the little guys" why he insists on keeping the little guys little.

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Multiple Compression--edited comments by Wade Dokken

In my view, the future of the stock market is not very bright as we may face a decade of multiple compression.

Whenever the market pulled back sharply, and often at the peak of panic, we would hear the chant of pessimism from the media: the fair value of S&P 500 was around 800, and we faced a downside potential of another 20% from here. This happened in February, when the Dubai crisis triggered a sharp pull back in global stock markets. It also happened recently, during the panic of Euro crisis. The supporters of such pessimism often quoted a chart from Robert Shiller’s famous book of Irrational Exuberance.

The following chart is from Robert Shiller’s website of Irrational Exuberance.

click to enlarge

The chart tells us that the current normalized P/E of 19 is still far above its historical mean. According to the chart, it happens pretty often that after a major market crash in history, the normalized P/E dipped to levels much lower than the historical mean, often years after the crash. Some see from the chart that we are in a secular bear market since 2000, when normalized P/E overshot to extremely high levels, and believe this secular trend of declining multiples won’t be over until the normalized P/E falls below its historical mean. Optimists brush this aside, citing strong rebounding of global economy and stock markets. Some argue for the wider stock ownership in the US compared to the historical level and the risk taking characteristics of American people. Many strongly believe in the results of empirical studies that stocks on average outperform bonds over long term.

I have no intention to put myself into the debate, but if we do assume that multiple compression IS running its course as suggested by the Schiller Chart, we probably can make educated guess as to HOW the course may look like.

Based on information available so far, I can see two possible scenarios for the multiples to go down.

1) Slow growth with more frequent recessions

With the high unemployment rate and the anemic recovery, domestic demand just isn’t enough to drive an annual GDP growth of 2-3%. Banks balance sheet improved significantly, but their loan portfolios are still shrinking, because there isn’t enough demand for loans. Consumer debt level remains high. At bad times like this, it is not likely for consumers to take on debt. Deflation will become a long-term issue, because there is less money to buy the same amount of goods, so the price has to go down. Paul Krugman argued many times that US stimulus wasn’t enough to propel a strong recovery. He also pointed out recently here that the Fed isn’t doing enough to fight deflation. Japanese type “liquidity trap” is already in the shape.

In this scenario, equities may underperform bonds for a prolonged period.

Recessions may become more frequent due to weaker economic growth. During the bull market period, growth may not be strong enough to spur multiple expansion to the high level of the last cycle, and when recession is back, multiples may drop further to be lower than the low point of last recession. Over multiple business cycles, secular bear market drives down multiples lower and lower. People aren’t going to lose interest in stocks overnight, but if investments in stocks fail to pay off repeatedly, more capital will flow out of stock markets and into bonds. The baby boomers may still have childhood memory of an era after the Great Depression that stocks were considered evil. Look at what happened to Japan in the past 20 years, how many Japanese still invest in the stock markets?

Compared to Japan, there are several factors that may help alleviate the problem so that the US may end up with a better story than Japan. First, the demographics of the US is much better than that of Japan. A growing population is one of the most important factors that contribute to long-term economic growth. Second, the US consumer spending habit may help. Japanese and Asians tend to save more than US consumers. Third, the economic structure of the US is quite different from that of Japan. Japanese economy relies heavily on export and the US economy doesn’t.

2) Higher growth pumped up by massive stimulus

If the Fed and the US government decide to fight the deflation and shower the American people with printed dollars to spur growth and job creation (of course it is a big if), what are the measures they may take?

The Fed interest rate is already zero, so they can’t further lower the interest rate. They can resume the mortgage buyback program, but with historically low mortgage rates, the extra benefit by this measure may not be very meaningful.

Even if money printing prevented the country from a long-term deflation, such a dramatic measure portends a high inflationary risk. Stocks won’t do well with high inflation either, particularly if the Fed has to fight off inflation by raising interest rates. The Shiller Chart shows the normalized P/E of the US equity consistently declined throughout the 70s, and dropped to as low as 7 during the early 80s recession when the inflation was eventually fought down.

It appears to me that the Fed and the government have a higher chance to under-stimulate instead of over-stimulate the economy, because they are under pressure to contain the deficit and fear of hyper inflation. So I believe the slow growth scenario is more likely to happen.

If we are truly in an era of multiple compression, how shall we invest in equities during such period?

I believe that investors can profit by paying attention to the following three principles.

1) Invest in emerging markets

Bill Gross pointed out in his investment outlook this February that the deleveraging process of major developed countries after this past financial crisis may last multiple years and result in significant drag on GDP growth. Comparatively, Asia and emerging market countries have much lower debt levels, are still growing rapidly, despite various problems of their own. There are fundamental economics supporting continued growth of these regions, most important of which includes: demographics, growing labor force, improved education level, trend of industrialization and urbanization, etc. However, investing in emerging markets entails higher volatility. For those who are deterred by the volatility of emerging market stocks, another strategy is to invest in multi-nationals with a significant presence in emerging markets; examples are: Coke (KO), Yum (YUM) and Citi (C).

2) Focus on value

At a time of multiple compression, high flyers are crushed. Buy companies at a price much lower than its true worth to ensure a significant margin of safety. Value investors like Warren Buffett had historically invested in the period of 70s and generated great returns. It is important to note that valuation methods based on historical multiples may be misleading, if multiple compression over a long period is expected. I prefer to value a company based on its net asset and the profit it can generate in the long term, without the assumption of a favorable economic environment; and only buy when the price of the stock is significantly lower than the true value of the stock implied by its net asset value and long-term profitability.

3) Focus on quality

In bad economic environment, high quality companies have much greater capability to survive and grow their business. Many multi-national large caps well positioned in their respective industry currently trade at very reasonable multiples, examples are Microsoft (MSFT), Pfizer (PFE), BP (BP), Johnson & Johnson (JNJ), IBM (IBM) and Wal-Mart (WMT). With their strong competitive positions, these companies are able to generate strong cash flow for many years to come, in both good and bad times. They pay rich dividends. They also have a significant global presence, allowing them to participate in global opportunities and profit from the growth of emerging markets.

Disclosure: Long in C. No positions in all others.

via seekingalpha.com

Today financial advisors continue to sell variable annuities 3-4x times current index annuity sales. A continued weakness--beyond the last--decade--will further erode investor confidence in stocks as a perpetual money machine. The proactive financial advisor will want to further incorporate index annuities--what many believe to be a separate asset class-further into their portfolio. Safe money alternatives, with guaranteed lifetime income and principal guarantee provisions will continue to be more attractive.

Consumer Confidence

By Rom Badilla

The U.S. Conference Board released its monthly sentiment index, which rebounded after plummeting in the previous two months. The Consumer Confidence Sentiment Index, which is based on a representative sample of 5000 households, increased to by two and half points to 53.5 in August, surpassing market forecasts as economists were expecting an index reading of 50.7. The August increase reverses the freefall of the last two months as Consumer Confidence reached a 2010 high of 62.7 in May. While encouraging, confidence among consumers remains low relative to the period prior to the onset of the recession as the index averaged 103.4 in 2007.

As reported on the Conference Board website, Director, Lynn Franco stated that, “Consumer confidence posted a modest gain in August, the result of an improvement in consumers’ short-term outlook. Consumers’ assessment of current conditions, however, was less favorable as employment concerns continue to weigh heavily on consumers’ attitudes. Expectations about future business and labor market conditions have brightened somewhat, but overall, consumers remain apprehensive about the future. All in all, consumers are about as confident today as they were a year ago.”

Looking beyond the headlines, the Expectations component of the survey, which represents people’s outlook, increased 7.4 percent to an index value of 72.5 in August. However, the Present Situation component fell 5.7 percent to 24.9. Furthermore, employment prospects remain relatively low. The Labor Differential Index, which is by defined by subtracting the Jobs Hard to Get component from the Jobs Plentiful component and is correlated to the official unemployment rate, mires in negative territory suggesting difficult employment conditions. The Labor Differential Index fell from -40.7 in July to -41.9 in August. As a source of comparison, the index reached a low of -46.1 in November 2009 and peaked in March 2007 at 11.4. (Click to enlarge)

Labor Differential Index (White) & Unemployment Rate (Red)

In addition to today’s consumer confidence release, Standard & Poor/Case-Shiller released its Home Price indices. The 20-city composite, which measures home values in the largest metropolitan markets in the U.S., increased slightly by 4.23 percent on a year over year basis in June. The increase came in above consensus surveys as economists expected an increase of just 3.5 percent. The better than expected number follows a May reading of 4.64 percent which was revised upward from initial readings by 0.3 percent. In addition, home prices on a national level increased. For the second quarter, the S&P/Case-Shiller U.S. Home Price Index increased by 3.6 percent from last year. Furthermore, the first quarter home prices were revised upward from an initial increase of 2.0 percent to a final 2.3 percent.

Disclosure: None

via seekingalpha.com

This is great counter-balance to the last two months of sentiment--which is often self-perpetuating.

Lead Generation by Wade Dokken

Taxes are an incredible controversial issue in moral, philosophical and economic terms. However, no tax is as controversial or as passionately argued as the estate tax. The estate tax, also know as the inheritance tax or the death tax is elaborated on by the I.R.A. The IRA writes,

“The Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death (Refer to Form 706 (PDF)). The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets.” Historically the tax rate has been 55% on all inheritance over 1 million dollars. The debate about estate taxes was a major political talking point in the early 2000’s. Former President Bush passed a bill that created a one-year experimental repeal of the estate tax. That year happened to be 2010.  Since January 1^st Congress has not made any political move to repeal the act, which is surprising in a House and Senate with a Democrat majority. In 2011 the estate tax will be reenacted and will probably remain at its prior level of taxation of 55%.

The moral debates concerning the inheritance tax are a philosophical battle between freedom and equity. Ultimately estate taxes are arguably better for both the individual and society in objective economic terms, whereas the morality of the tax is up for dispute.

 

Moral Arguments

The estate tax is a fundamental values debate. Those who are in favor of it usually stress the equity it brings to the system. Mike Lapham a multi-millionaire and a proponent of the Estate Tax elaborates in CommonDreams.

“ I am organizing wealthy members of Responsible Wealth to oppose the repeal of the estate tax. As multi-millionaires, we have benefited handsomely from all that our country provides: public education, roads, clean water, legal protection, research funding and public safety, just for starters.” Lapham’s argument is essentially that people should give back to the system that gave them so much.

However many people’s principal concern is that the estate tax undermines the right for people to give what they want to their children. It is understandable that this tax can be seen as an erosion of fundamental liberty. 

Tracy C. Tarum a candidate for House from Tenessee’s 5^th congressional district writes,   

“I believe we need a Constitutional Amendment that when an individual dies, the power of the Federal or State government to tax that person dies with them.  Or better yet, an enactment of the Fair Tax and repeal of the 16th Amendment (the Income Tax).  Obviously any back taxes due any government body would be extracted from the estate, the same as any other personal debt.  However, the government would not be entitled to any further taking of monies from the estate.”

His point of view is by no means out of the ordinary and many people who identify themselves as member of the tea party or own small business agree. At the same time a majority of Americans are against repealing the Estate tax. The Foundation Center finds that, “ A majority (57 percent) of respondents in the national poll said they prefer reforming or keeping the tax as is, while only 23 percent said they favor full repeal.”

 

 

Economic Arguments:

There are a couple of economic arguments that are against the state tax but I will emphasize why the benefits of the estate tax outweigh the costs. One of the largest arguments against the estate tax is that it encourages wealthy individuals to spend or invest all their money rather than save or invest.  Jim Saxton Chairman of the Joint Economic Committee Study writes in 1998,

            “McCaffery argues that estate taxation penalizes work and saving and encourages large-scale consumption by the very rich. If individuals know that they will be unable to pass on their wealth, then they may choose to simply produce less wealth or to consume their wealth. The accumulation of savings does not occur merely by accident or as a by-product of work. Rather, savings represent the conscious decisions of individuals to forgo immediate consumption.¹⁰ The prospect of tax rates up to 60 percent, however, diminishes the value of their deferred consumption.”

Saxton could very well be right but even if a wealth individual chooses to spend most of their money to avoid taxes that should still be viewed as an economic success. The bulk work of the American economy is based on consumerism and any investment is good for American society as a whole. Not to mention that taxes are still be collected through sales, real estate etc. by buying places and things.

The economic arguments for keeping the estate tax are two fold. The first concern is an economic concern for society at large. The belief being that repealing the estate tax would cost a massive amount of expenditures in to enforce.  The Center on Budget and Policy Priorities elaborates on enforcement,

“ Making permanent the repeal of the estate tax after 2010 — repeatedly proposed by President Bush— would add almost $1.3 trillion to the deficit between fiscal years 2012 and 2021, the first ten years in which the full costs of extending repeal would be reflected in the budget.  This cost includes $1 trillion of lost revenues and $277 billion of higher interest payments on the national debt.”

The nation is already in the midst of a national deficit crisis. Right now our country does not have the monetary or political will to undergo such a massive expense. This reason alone is good enough to allow the estate tax to go back into place after 2011.

The second reason not to repeal the estate tax is because of individual economics. Many people think that they will save money if their inheritance is not taxed. But in reality they will just experience a larger capital gains tax. The estate tax provides a “ step up” bonus wherein an inheritance recipient is spared from most capital gains taxes.

Liz Pulliam Weston of MSN Money elaborates on the “ step up“ bonus, “Say your parents paid $20,000 for stocks that were worth $200,000 on the day they died and bequeathed them to you. Without the step up, you'd have to pay capital gains taxes on that $180,000 increase in value if you sold the investments. Thanks to the step-up, however, the stocks get a new basis of $200,000. If you sold them for $200,000, you wouldn't owe any capital gains tax.”

            In conclusion many of the arguments behind an estate tax are values issues. However, the economic reasons to maintain the estate tax are very compelling. Repealing the inheritance tax would add more than one trillion dollars to the United States deficit. In addition, the level of money the individual is saving is relatively marginal because instead of paying an inheritance tax they would simply be paying a larger capital gains tax. While there may be some truth in the fact that families will give less to their children to be exempt from the taxes, more money into the consumer market is hardly a bad thing. This is all the more true in our current economic condition where frugality is killing businesses. 

Fair Tax--or Not Fair

Underlying all conversations about annuities is the issue of tax deferral and the marginal tax bracket for most investors.   This calculation of the value of tax deferral,  plus the acknowledgement of the exclusionary ratio (the percentage of annuitized withdrawals credited as principal or interest) represent the two key tax advantages annuities provide American savers.

This is true for fixed annuities.  In the case of variable annuities, and to a lesser extent fixed annuities, a potential annuity consumer needs to analyze the current preferences for either dividends or capital gains.  Low marginal tax brackets and high tax preferences for capital gains results in variable annuities becoming more competitive from purely tax perspective.  Elimination of these preferences for dividends and raising of the marginal tax brackets makes fixed annuities and variable annuities more competitive.

There is a nationwide debate emerging over the extension of the tax cuts initiated under President George W. Bush early last decade.   Marginal income tax rates as well as the preferences for capital gains and dividends were lowered.   Today there is a public policy debate over spending, taxation and the long-term deficit.   

A side portion of this debate focuses on the core structural design of our tax system.  A recent proposal for tax reform that has gained an incredible amount of support is the fair tax. The fair tax is a major consumption tax that seeks to replace the major existing tax structures—namely, income, property, estate, and capital gains.  Historically, policies like the “Fair Tax” and the “Flat Tax” have emanated from the political right.  I don’t know whether there is a real groundswell for this change, but the last decade of public policy decisions; our two wars, the Medicare prescription drug benefit, the Bush era tax cuts, and now the twin problems of the recession—lower receipts and stimulus spending—are creating greater discussion.

 

Robert Longley of About.Com elaborates,

“In place of all current federal taxes, the Fair Tax would place a 23 percent tax on the final sale of all goods and services. Exports and business inputs (i.e. intermediate sales) would not be taxed. Individuals would file no tax return at all. Businesses would only need to deal with sales tax returns. The IRS and all 20,000 pages of IRS regulations would be abolished. Under the Fair Tax, no federal taxes would be withheld from employees' paychecks. Social Security and Medicare would be funded by sales tax revenue.”

       There are three advertised major benefits of such a tax. First, a fair tax would make the system infinitely less complicated and nuanced. Second, it is hoped that a fair tax generates more revenue than the existing federal taxes because it eliminates the underground economy. Finally, proponents predict that a fair tax would make the United States an attractive place to do business.

 

      However, the existing political capital in this country is probably not enough to pass such a bill, never mind overturn the 16^th Amendment.  

 

 

 

        The federal tax system has not been refined with age. Throughout the years additional rules and regulations have been implemented.

The graph above shows how much the total number of pages of the federal tax rules has expanded. As of 2003 the IRS had 54,846 pages of tax laws and regulations. In order to make the system run, we have had to create a massive coalition of lawyers and accountants. Chris Edwards of the CATO Institute writes,
             “Income taxes are so complex that there are up to 1.2 million paid tax preparers in the country -- six times more than the number of troops in Iraq. The tax army includes legions of accountants, lawyers, and computer experts -- some of the best minds in the country. Unfortunately, their brainpower is adding little to the nation's standard of living.”

Regardless of your political affinity and biases; individuals, companies and nations must ruthlessly fight against inefficiency and waste.  My personal enlightenment during the health care debate was the level of waste in the system.  The underwriting process—each insurer attempting to improve their pool of the insured—represents a significant waste of our nation’s resources.   The same is true of the tax preparation, however, it is not only the tax preparers, it is also the millions of hours we all dedicate to the tax preparation process.

I haven’t prepared my own taxes for years.  Long ago I lost the ability to translate 1040 in any reasonable manner.   I do remember my midnight drives to the post office on April 15^th of previous years.  So, like most Americans I sympathize with the frustration of tax filing and the complication.  A recent report purports that Americans’ spend $140 billion on filing costs and $7.6 billion hours per year to file their taxes.  This undoubtedly does not count the hours or dollars invested to avoid taxes.

 

This large, inefficient bureaucracy has not helped to enforce compliance with tax codes. Arduin, Laffer, and Moore of Econometrics predict the following results of a fair tax:

“Government revenues, after accounting for Social Security expenditures, also benefit from the growing economy. In the first year following implementation of the FairTax, total government revenues are estimated to be 0.5 percent above baseline revenues. Revenue growth under the FairTax exceeds the baseline scenario during the first six years following implementation. However, beginning in year seven revenue growth under the baseline scenario begins to grow faster due to the more progressive nature of our current tax system, which increases tax revenues at a faster rate than economic growth. This leads to total revenues under the FairTax to be only 6.2 percent above the baseline scenario by year ten, compared to 6.9 percent above the baseline scenario in year six.”

Art Laffer

Stephen Moore are both friends of mine—and they have been passionate about these issues for their entire careers.  Stephen Moore was a very influential friend of mine during my work on Social Security reform.

The principal reason for this is that the United States has a massive underground economy. What is an underground economy? The Wall Street Journal Class Room Edition differentiates between a legitimate economy and an underground economy:

“First, there's the legitimate economy, in which craftsmen are licensed and employers and employees pay taxes. Then there's the fast-growing underground economy, where millions of nannies, construction workers, landscapers and others are paid off the books, their incomes largely untaxed. The best guess as to the size of the output of this shadow economy is about $970 billion, or nearly 9% that of the real economy. It could soon pass $1 trillion.”

            Consumption taxes take away individual tax filings and make the IRS a null and void institution, except for the management and supervision of the collection of consumption taxes. Illegal immigrants and people involved in traditional underground professions could no longer undermine the income tax system.  They would need to invent means to short the consumption tax system, however, the predominance of electronic funds transfer, credit cards, debit cards, PayPal and electronic banking make circumvention of consumption taxes far more difficult.

            The last major benefit of the fair tax is that America’s image as a great place to do business is once again restored. Embedded taxes, like capital gains and corporate taxes, steer businesses away to tax free havens. In the case of the United States several businesses have opened up shop in places like Bermuda to offset these costs. This is particularly true of my industry, insurance.   Although corporate taxes are often the plaything of demagogues, they are ultimately merely a “pass-thru” tax. Much evidence exists of their growth-reducing effect.   Most importantly, they can be an inducement for corporations to locate factories and jobs elsewhere, and this creates a negative drag on productivity, and income growth.

Leo Linnbeck of the Wall Street Journal writes,

“Eliminating embedded taxes will also do something else -- it will remove significant price disadvantages suffered by American producers competing with tax-free imports. Eliminating corporate income taxes and capital gains taxes, which the Fair Tax would do, would likely make the American economy the most desirable place in the world to do business.”

            Unfortunately these perceived benefits are meaningless because the United States may never have the political capital to enact a full fair tax and perhaps we should not.  There are tremendous issues of equity and the veracity of the tax that are yet to become clear. We also have the small issue of the constitutional amendment authorizing the federal income tax.  The reason is that the 16^th Amendment would first have to be repealed, entirely eradicate the federal income tax. Some suggestions have been made: namely, to get rid of the income tax for people making less than $100,000 and replace it with a national sales tax of somewhere between 10 and 14%. This is essentially the same thing as enacting the fair tax and it’s more politically viable. Fareed Zakaria, a major Newsweek and CNN contributor as well as a bestselling author, is one of the largest proponents of enacting such a tax. In his strategy to alleviate the national debt Zakaria states,  

“First, adopt a value-added tax. More than 100 countries have some kind of a national sales tax. If America were to enact one tomorrow, at something like the average for industrial countries (18 percent), and drop income-tax rates to compensate somewhat, we could bring in hundreds of billions of dollars every year. To get a sense of the revenue potential, imagine if the United States were to adopt a VAT at the high end of the range—25 percent, similar to that of many Scandinavian countries whose economies have still grown as fast as America's over the last three decades. Such a tax, Leonard Burman calculates in the University of Virginia Tax Review, would bring in enough money to balance the federal budget, pay for health-care expansion, eliminate the income tax for all those earning less than $100,000 (90 percent of households), and cut the top tax rate to 25 percent. The tax would also restrain Americans from over--consuming and reward them for saving, the single most important long-term shift we need to encourage.”

            The opponents make two strong cases against the fair tax.  One is basically math—the tax does not raise what proponents’ claim.  Competing math, some of it from non-partisan agencies, suggest that the appropriate fair tax level (the new sales tax) would actually need to be around 34%, rather than the much more palatable 23% suggested by fair tax supporters.  The second issue relates to the regressive nature of a Fair Tax.

 

 

“With the prebate program in effect, those earning less than $15,000 per year would see their share of the federal tax burden drop from -0.7 percent to -6.3 percent. Of course, if the poorest Americans are paying less under the FairTax plan, then someone else pays more. As it turns out, according to the Treasury Department, “someone else” is everybody earning between $15,000 and $200,000 per year. The chart below compares the share of the federal tax burden for different income groups under the current system and under the FairTax. Those in the highest and the lowest brackets will see their share decrease, while everyone else will see their share of taxes increase.”

Annenberg Political Fact Check

 

“Americans for Fair Taxation rejects the Treasury Department analysis, objecting that Treasury considers only the income tax. By leaving out payroll taxes (which are actually regressive) Treasury’s chart makes the FairTax look worse by comparison. We found that including all the taxes that the FairTax would replace (income, payroll, corporate and estate taxes), those earning less than $24,156 per year would benefit. AFT’s Burton agreed that those earning more than $200,000 would see their share of the overall tax burden decrease, admitting that “probably those earning between $40[thousand] and $100,000” would see their percentage of the tax burden rise.”

Annenberg Political Fact Check

 

 

Most Americans are frustrated with the level of complexity that has evolved into our current 1040 tax filing.   The complexity results in wasted human energy—both in the attempted avoidance planning and the actually submitting.

 

We have differing opinions on equity and justice—the level of progressivity embedded in the tax code and the inherent level of the social safety net provided by our tax receipts.   In many cases the debate around the Fair Tax has these ancillary debates waiting in the wings, however, it doesn’t need to be this way.

 

A debate around a new, simpler tax system, can focus upon tax preferences, impacts to our consumer economy, overall societal acceptance (thus reducing the illegal economy), and elimination of wasted effort on avoidance and processing.    As the debate relates to annuities, and other savings vehicles, my assumption is that  as the cost of benefit programs—Medicare and Social Security—continue to rise as a percent of America’s GDP, then we will move to more incentives for saving and cost-sharing.  However, as they say—that’s another story.

New century, new deal: how to turn ... - Google Books

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Ideas still have not been addressed

Wade Dokken | Wade Dokken, Tom Hamlin, Lincoln Collins, etc on Fixed Index Annuities Investments of the annuity

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Wade Dokken Part 1 of 2 Las Vegas presentation at the Pallazo Hotel for The Gold Standard Event

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Capitalism Magazine - Interview of Wade Dokken: The Social Security Crisis and What to Do About It

"By creating private accounts, you'd create private assets and private assets could be passed onto another generation as capital. And I think that would change the lives of millions of people," says Wade Dokken. And Wade would know. A former advisor to Hillary Clinton, he is the President and Chief Executive Officer American Skandia, Inc. a financial services companies in the country, with more than $30 billion in client assets under management.

James Glassman: Wade Dokken, you have written a book about Social Security, what 's the title?

Wade Dokken: "New Century, New Deal, How to Turn Your Wages into Wealth through Social Security Choice."

James Glassman: You know, so many people who write about this subject are policy wonks like me. How did you get involved in it?

Wade Dokken: Well, that's a great question. I have always loved public policy but this was more motivated by a series of things, I would say three or four things. One is my love of public policy, my access to information about how out of line our Social Security system is and what we can do about it, and the fact that I, like a lot of people, am a parent and I have three boys for whom I know the Social Security system is not going to deliver.

James Glassman: Now, what would you like to see as far as reform for Social Security is concerned, just briefly.

Wade Dokken: Well, the most important thing we need to do is we need to have a funded versus an un-funded system. We need to be honest about putting aside money now for the retirement of people at a future date. Today we're not doing that.

Once we've established a funded system, I believe we need to invest it in what I call a modern way, so that those assets that are set aside are being invested as any modern portfolio manager would invest assets, whether that's like the state of California or the state of New Jersey or anybody's 401K.

James Glassman: When you say a "funded system," I think this is worth spending some time on. How does the current Social Security system work and how is it similar or not similar to a conventional pension plan?

Wade Dokken: Well it's not similar to any other pension plan because the law of the land of the United States is that you can't have pension plans like Social Security. Social Security does not have any assets set aside for anybody's retirement. It's a pay-as-you-go system. You and I as under 62 or under 65-year-old taxpayers pay money in, and people who are now receiving Social Security receive that money within 30 days. It's a conduit system. What we pay in, somebody else receives. Therefore it is dependent upon, when I retire, another generation of people to be doing the same thing.

The problem is -- and it is the crisis question -- the demographics of this nation have changed profoundly in two ways. One, longevity has increased tremendously so we have an ever-increasing percentage of our population that is over age 62, 65. And all those subgroups are the largest growing groups of our population.

The second part is our birth rates are way down. So not only are we living longer but the replacement population is smaller. When Social Security was created we had 43 people supporting every retired person. Today we have 3.1 and in a very short matter of years we'll have two people supporting every retired person. It won't work.

James Glassman: And so your solution is to allow individuals to invest part of what they now pay in payroll taxes in private accounts in stocks and bonds, is that correct?

Wade Dokken: That's correct. That's the third part. I said number one: a funded system. Number two: invest in a modern way. And the third conclusion, I believe, is to allow people to at least have the option of having their money invested in private accounts.

James Glassman: And exactly how would that work? Would people be free to put their money just about anywhere, the way they do now with 401Ks? The 401K plan, of course, is limited by the offerings of the employer. But there are hundreds, probably thousands of choices, is that the way this would work?

Wade Dokken: I doubt it. It's not what I would recommend. Social Security is the foundation retirement plan for all Americans. And as such, if that money is squandered in any way, you would have a social crisis. So I think what would happen is there would be some significant limitations.

I believe a recommendation would be to let people invest in bank CDs which are guaranteed and are very safe and have a rate of return that is far in excess of Social Security's rate of return today.

It is also possible that you allow people to stay invested in a Social Security system and that all the money is held in a pooled account and managed like any other state pension system.

A third option is to allow people to have a limited number of choices and those choices would probably be automatic portfolios that have a combination of stocks, bonds, and cash so the risk would be very low.

James Glassman: Now when you said your second option, which is pooled accounts, are you saying that you think that it would be a good idea if, let's say, government employees or a government-run board were to make investment decisions for Americans? That is what, I guess, Alan Greenspan has been alarmed about, the notion of the government itself becoming a large shareholder in American corporations.

Wade Dokken: I think it's a possible outcome, but it's not one that I support. The reason I don't support it is I believe the politicization of it would be too great. For example, if the government owned the stocks, who would vote the shares of those stocks? I think that's a problem. I think quickly it would be politicized another way, in which the government would set up laws that we can't invest in certain types of stocks.

So it's not a proposal that I personally support, but I think it is a proposal that is supported by almost half the people in Congress.

James Glassman: But you don't think, in general, that people should have a wide range of choices. Another model might be the thrift savings plan, which is kind of the federal equivalent of a 401K plan.

Wade Dokken: I think that's a very good model. It has five choices. It's a great model because there are limited choices, they're indexed funds, and there are very low fees.

Currently there is a way to save for college education which is known by a lot of people, it's called a 529 plan, and what occurs in 529 plans is, you get those five choices. But there are combinations of stocks and bonds already established. So, for instance, as you're younger, you'll have a higher percent in stocks. And as you get older and you have less time to take risk, [the plan] would automatically [move savings] to a lower [risk of investment]. And I think some kind of structure like that would ultimately be the best thing to do.

James Glassman: Now let me get this straight. Is a reform of this nature intended to save Social Security in a financial sense? Or is it to provide Americans with a way to own their own retirement plan and have more money when they retire?

Wade Dokken: Well, I would argue that it's both. Social Security is a bankrupt system. At one point, we can model that it will be $27 trillion in deficit in about 30 years. So there's no financial scenario except for a growth rate for the U.S. economy sustained over decades that we've never achieved that will bail it out.

Having said that, one of the things that is important to realize is that the kind of implicit rate of return for Social Security today, for people under 50, is approximately zero. And it gets negative as you get younger. Compare that to the worst 50-year period for the stock market, which is plus 4 percent.

So we can save Social Security and at the same time create an income stream for people retiring which is greater than Social Security.

James Glassman: Now some people say this is not a good time to bring up the idea of reform that involves any kind of stock market investing. Isn't it risky for Americans to have their retirement dollars tied up in the stock market?

Wade Dokken: Well the risky scheme would be to do nothing. I can guarantee you that people will lose money on Social Security if we do nothing. So if guaranteed loss of your investment principle is safety, then we have the safest system we can create.

Having said that, there's no level of analysis that does not tell you that owning a basket of stocks and bonds over a long period of time is going to produce superior returns. And the risk is focusing on the very short period of time, or the risk is having an insufficiently diversified portfolio, both of which would be solved by using indexed funds and having long-term, pooled accounts.

James Glassman: So the point is that over a long period of time, if you have a diversified account, the riskiness of stocks is….

Wade Dokken: Negligible.

James Glassman: Certainly no greater than bonds, as many economists have found.

Wade Dokken: Well bonds are riskier than stocks. Risk is two things. Risk is short-term volatility [and] bonds can have short-term volatility just like stocks can. But risk is also opportunity foregone. And when you look at the average rate of return for a basket of stocks over a 50-year period, it is nearly seven percent after inflation. It's almost nine, ten percent before inflation. And Social Security is, today, for the entire population, at 1.7 percent. And for the younger population it's a negative number. It's difficult for me to see the risk in diversified equity portfolios.

James Glassman: Now your own firm, American Skandia, is in the annuity business. I think people would be wondering whether your book might be self-interested. Are there ways that you can gain as a result of this reform?

Wade Dokken: Well it depends on what the reform is. My reform has been careful on that. I'm thrilled if the outcome is 100 percent of the assets go into the thrift savings plan, in which companies like American Skandia do not participate.

I do believe that the economy -- and therefore all of our boats -- will rise if Americans are actually converting Social Security to a savings program. The pool of investment capital available will almost, undoubtedly, mean that we'll have sustained, longer, and higher growth rates.

James Glassman: Just as a last question since we focus on technology on our website, Tech Central Station. What would be the effect on technology companies as a result of a reform like this?

Wade Dokken: I'm not a futurist, but I would give you one small example. There's no predicted reform that will not focus on the administrative costs of the accounts. And the only way to solve the administrative costs will be to have everybody able to avoid talking to people on the telephone but build their access to accounts and model things right on the Internet.

But this is a powerful application, because if you now have 280 million people, all with the same need to access data on the Internet that involves their money, I think what will flow from that will be a much greater sophistication in Internet banking, Internet investing, and Internet shopping.

James Glassman: As well as providing capital for Internet companies.

Wade Dokken: As well as providing capital for them, yes.

James Glassman: Wade, some people might be surprised to find out your party affiliation and that you've been fairly active politically. Tell us just about your politics?

Wade Dokken: Well, I'm standing in my office looking at a picture of myself and a picture of Senator Hillary Clinton, so you can get some ideas on it. I'm a Democrat and I'm a liberal. I'm a socially tolerant liberal and a fiscal conservative, and I see nothing that I've said which is in conflict with that.

If you create pools of capital where the guy today -- who might be a laborer or anybody today who might be of the underclass -- could have a pool of capital of $250,000 or $500,000 of their own wealth, I think that's the greatest social program you could create.

James Glassman: I mean in a sense, of course, wealthier Americans already have pension plans that are oriented around stocks and bonds, and less well-off people don't have those things and really don't own their own retirement accounts, is that correct?

Wade Dokken: That is correct. And in fact, what people forget is the class of people most damaged by Social Security today: single, black men. And the reason is that they often are poor, and poverty creates lower mortality rates, and lower mortality rates mean that which they paid in they don't ultimately receive. By creating private accounts, you'd create private assets and private assets could be passed onto another generation as capital. And I think that would change the lives of millions of people.

James Glassman: Well, thank you, Wade Dokken, this was a good note to end on.

Wade Dokken: It was my pleasure, thank you.

-- Made available through http://www.techcentralstation.com.

 

via capitalismmagazine.com

Capitalism Magazine - The Fed's Biggest Bubble

While Wall Street and Washington are petrified of the deflation boogieman, the real menace lurking in the shadows is the Fed's bond bubble.

Image by kugelfish via Flickr

I've made a living out of exposing economic fallacies, but there's one whale that I can't seem to harpoon. Even top-flight Wall Street analysts seem to believe that the Fed's doubling of the monetary base after the credit crunch has not had an inflationary impact on our economy. Their logic can be summed up like so: "The money the Fed created and dropped from helicopters has all been caught in the trees." In other words, the Fed is creating money, but it is just being held as excess reserves by the banking system instead of being loaned to the public. Therefore, the money supply hasn't truly increased, there is no money multiplier effect, and aggregate price levels are behaving themselves.

But this is only a half-truth. Yes, most of the money created by the Fed has been kept by commercial banks as excess reserves. However, the Fed doesn't conjure reserves by magic. It first creates an electronic credit by fiat, then purchases an asset held by a financial institution. Those primary dealers then deposit that Federal Reserve check into their reserves. The act of creating money from nothing and buying an asset -- be it a Treasury bond or Mortgage Backed Security (MBS) -- drives up the price of that asset in the open market. Those price distortions send erroneous signals to private buyers and sellers, eventually creating gross economic imbalances.

Therefore, the inflation created by the Fed first gets concentrated in whatever asset it has chosen to purchase - before spreading throughout the economy. 

In the latest example of the Fed's monetary manipulations, Bernanke & Co. purchased $1.25 trillion in MBS. The prices of MBS were therefore driven up (and yields down). Before that, the Fed forced the entire yield curve lower by purchasing not only Treasury bills but also $300 billion in notes and bonds. The Fed has also recently indicated that it will be swapping maturing MBS for longer-dated Treasury securities in an effort to keep its balance sheet from shrinking.

While it is true that -- for now at least -- we have been spared from the imminent curse of skyrocketing consumer prices, thanks to the falling money multiplier, it is blatantly untrue that the trillion-plus dollars the Fed created have been rendered inconsequential.

Not only has the huge buildup in the monetary base put pressure on the US dollar and caused gold to soar, but it has also broadcast an egregious and distortive price signal for US debt securities. The 10-year note is now trading just above 2.5%. That yield is near its all time record low, nearly 5 percentage points below its 40-year average, and 13 percentage points below its record high of September 1981. 

Image via WikipediaUS sovereign debt should only enjoy such historically low yields due to an overabundance of savings, low inflation, and low debt. None of those preferable conditions currently exist. Hence, US Treasuries are the most over-supplied, over-owned, and over-priced asset in the history of the planet! Once the debt dam breaks, it will send the dollar and bond prices cascading lower, and consumer prices and bond yields through the roof. 
While Wall Street and Washington are petrified of the deflation boogieman, the real menace lurking in the shadows is the Fed's bond bubble - and it's going to eat small investors alive.

Related articles 

• Warning: Why Cheaper Money Won't Mean More Jobs (tpmcafe.talkingpointsmemo.com)
• "Monetary Shock and Awe": The Fed Prepared to Launch Most Radical Intervention in History Bernanke's "Nuclear Option"... (projectworldawareness.com)
• Fed buys $360 million in TIPS buyback (marketwatch.com)
• Jackson Hole Bubble Clash Shows Challenge for Central Bankers (businessweek.com)
• Where the Robber Meets the Road (lewrockwell.com)
• TREASURIES-Bonds fall after Fed fails to expand purchases (reuters.com)

Trinity study - Wikipedia, the free encyclopedia

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In finance, investment advising, and retirement planning, the Trinity study is an informal name used to refer to an influential 1998 paper by three professors of finance at Trinity University.^[1] It is one of a category of studies that attempt to determine "safe withdrawal rates" from retirement portfolios that contain stocks and thus grow (or shrink) irregularly over time.

Its conclusions are often encapsulated in a "4% safe withdrawal rate rule-of-thumb." It refers to one of the scenarios examined by the authors. The context is one of annual withdrawals from a retirement portfolio containing a mix of stocks and bonds. The 4% refers to the portion of the portfolio withdrawn during the first year; it's assumed that the portion withdrawn in subsequent years will increase with the CPI index to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It's assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period.

The authors backtested a number of stock/bond mixes and withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995. They examined payout periods from 15 to 30 years, and withdrawals that stayed level or increased with inflation. For level payouts, they stated that "If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured." For payouts increasing to keep pace with inflation, they stated that "withdrawal rates of 3% to 4% continue to produce high portfolio success rates for stock-dominated portfolios."

The authors make this qualification:

“

The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.

”

Other authors have made similar studies using backtested and simulated market data, and other withdrawal systems and strategies.

The Trinity study and others of its kind have been sharply criticized, e.g. by Scott et al. (2008)^[2], not on their data or conclusions, but on what they see as an irrational and economically inefficient withdrawal strategy: "This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform."

Laurence Kotlikoff, advocate of the consumption smoothing theory of retirement planning, is even less kind to the 4% rule, saying that it "has no connection to economics.... economic theory says you need to adjust your spending based on the portfolio of assets you're holding. If you invest aggressively, you need to spend defensively. Notice that the 4 percent rule has no connection to the other rule—to target 85 percent of your preretirement income. The whole thing is made up out of the blue."^[3]

Ironically, the 4% rule of thumb would, in many instances, mandate a more frugal level of retirement expenditures than a portfolio that was fully invested in government inflation-indexed bonds, such as U.S. Treasury Inflation Protected Securities (TIPS). As of mid-October 2008, Treasury Inflation Protected Securities (TIPS) boasted real yields of approximately 3%. A laddered, 100%-TIPS portfolio yielding 3% real would sustain a 5% safe withdrawal rate over a 30-year period. A 100%-TIPS portfolio yielding 3% real would not only be less volatile than a diversified, part-stock portfolio, but also safely sustain a much more generous level—25% more generous, in fact—of retirement expenditures than a diversified portfolio to which the "4% rule" was applied. While a 3% real TIPS yield is well above historical averages for TIPS yield, even a TIPS portfolio that yielded only 1.3% real would sustain a 4%, inflation-adjusted, safe withdrawal rate over a 30-year period.^[4]

[edit] References

1. ^ Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable." AAII Journal 10, 3: 16–21
2. ^ Scott, Jason S., William F. Sharpe, and John G. Watson: "The 4% Rule: At What Price?"
3. ^ Fonda, Daren (2008), "The Savings Sweet Spot," SmartMoney, April, 2008, pp. 62-3 (interview with Ben Stein and Laurence Kotlikoff)
4. ^ Prospercuity LLC, "The 4% 'Safe Withdrawal Rate' Rule Of Thumb"

Retrieved from "http://en.wikipedia.org/wiki/Trinity_study"

Categories: Retirement

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I just stumbled upon this a second time and felt it should be shared. This data should give you key observations as you decide upon guaranteed withdrawal rates for your portfolio.

Retirement Crisis
http://www.wealthvest.com/blog/category/wade-dokken/
Wade Dokken