Financial Topics Newsletter Archive
SBT Investment Services, Inc. through its relationship with Infinex Investments, Inc., member SIPC/FINRA, offers a range of educational resources to help customers achieve their life goals. These include the personal attention of our Advisors, registered representatives of Infinex Investments, Inc., periodic educational forums, and topical articles in our Financial Newsletter.
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December 2007
In This Issue:
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Will Low Inflation Continue?
Since the mid-1980s, inflation has been much lower and more stable than it was in the past. The high inflation rates of the 1970s detracted from the country’s standard of living, hindered capital formation and economic growth, and took the country many years to overcome the adverse effects. It is now generally believed that maintaining a low and stable inflation rate provides lasting benefits to the economy, which is why it is one of the Federal Reserve’s primary monetary policy goals. As detailed in the 1977 amendment to the Federal Reserve Act of 1913, the Federal Reserve’s goals when setting monetary policy are “to promote maximum sustainable output and employment and to promote stable prices.”
In recent years, inflation has changed in a number of ways:
- • Movements in inflation now convey less about future inflation. In the late 1970s and early 1980s, the most accurate forecast of future inflation was an average of inflation over the past few quarters. Sharp increases in inflation took a long time to reverse. Since the mid-1980s, shocks to inflation have not lasted long. Thus, the best estimate of future inflation is a very long average of past inflation.
- The correlation between inflation and unemployment has decreased. In the 1960s and 1970s, inflation tended to rise in periods when unemployment was low and vice versa. Starting in the 1980s, this correlation weakened substantially. Thus, a rapidly expanding economy will tend to generate a smaller increase in inflation. However, once inflation increases, it will be more difficult to get it under control, since the economy will have to slow more to reduce inflation.
- Changes in energy prices have less impact on inflation. In the 1970s, increases in energy prices had a significant impact on core inflation, which is the change in consumer prices excluding food and energy. Since the early 1980s, energy price changes have had little impact on core inflation.
- Economic volatility has decreased significantly in the United States. Since the mid-1980s, output growth has been 50% less volatile, and employment growth has been two-thirds less volatile than the previous three decades (Source: Business Review, Quarter 1, 2007). Inflation’s volatility has also fallen substantially.
Inflation expectations significantly influence actual inflation. Long-term inflation expectations vary over time, depending on economic developments and current and past monetary policy. U.S. monetary policy has become much more focused on low inflation, and the Federal Reserve has been strongly committed to keeping inflation under control. During the 1980s and 1990s, the Federal Reserve brought inflation down from double-digit levels to approximately 2%, a level that has been maintained for the past decade.
The Federal Reserve has done such a good job that expectations about future inflation have moderated significantly in recent years. Thus, when there is a shock to inflation, the public believes that the Federal Reserve will control the situation, so expectations about future inflation do not change much, keeping inflation under control. A recent example is the substantial increase in oil prices, which has not led to increased inflation or a recession, as it did in the 1970s.
Will low inflation persist for the foreseeable future? Like all questions about the future, this cannot be easily answered. Inflation now reacts less persistently to shocks, which is a result of better monetary policy and inflation expectations. Now that the public believes that the Federal Reserve will keep inflation under control, it acts in a manner that makes the economy more stable. Thus, it would seem that interest rate changes do not need to be as great to achieve stable inflation. But these circumstances will only last as long as monetary policy meets the public’s expectations. Long-run inflation expectations must be monitored closely, and the Federal Reserve must respond aggressively to shocks that could have long-term impacts on inflation.
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What Is Happening with Long-Term Interest Rates?
Typically, when the Federal Open Market Committee (FOMC) raises the federal funds rate, long-term interest rates react by increasing also. However, between June 2004 and July 2006, the FOMC raised rates 17 times in .25 percent increments, from 1% to 5.25%, and long-term rates barely moved.
In the past, a 1% increase in the fed funds rate produced at 0.3% increase in the 10-year Treasury yield (Source: Economic Letter, September 2006). Thus, with a 4.25% increase in the fed funds rate, you would expect the 10-year Treasury yield to increase by 1.3%, but it only increased 0.3%.
Similarly, since 1980, the difference between the yield on 3-month Treasury bills and 10-year Treasury notes has averaged 1.79% (Source: The Federal Reserve Board, June 16, 2006). As recently as the end of 2006, the difference was less than 0.5%. Currently, the difference is still only 0.8% (Source: Federal Reserve Statistical Release, November 26, 2007).
Why haven’t long-term interest rates increased as expected? Returns on bonds have two components — the real component, which compensates investors for the risk of loaning money, and the inflation component, which compensates investors for expected inflation over the bond’s term. In recent years, both components have been trending downward:
- Real component — The real component is also called the term premium, since historically investors have received a premium for increasing the term the bond is held. Since the mid-1980s, economic growth has been less volatile, making investors more confident about future economic stability, so they require less return to hold longer-term bonds. It is also believed that demand for long-term bonds has increased, while supply has not kept pace, bringing down returns.
- Inflation component — Compared to a 5% inflation rate from 1980 to 1999, inflation in industrialized countries averaged 2% from 2000 to 2004 (Source: The Federal Reserve Board, June 16, 2006). Not only has inflation decreased, expectations for long-term inflation are in the 2% range. This has put significant downward pressure on long-term interest rates.
The behavior of long-term interest rates is not unique to the United States — other countries around the world have experienced similar declining patterns. The trend is so widespread that globalization of trade is suspected to be a major factor. Since goods, services, money, and ideas can cross borders so easily now, economies in different countries are tied together more closely. Excess demand in one part of the world can be filled by excess supply in another part of the world, evening out economic activity in individual countries.
This has major implications for monetary policy. Central bankers have control over short-term rates, which is the primary means of implementing monetary policy. Typically, when short-term rates are increased, long-term rates follow. Higher long-term rates reduce consumption and investment, which helps contain inflation. Reducing short-term rates typically reduces long-term rates, which increases economic activity. If those relationships no longer hold, monetary policy will be significantly impacted.
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Working toward Your Financial Goals
To help pursue your financial goals, you need a plan to help you get there. These five basic tips can help:
- Set exciting goals. Putting money aside for a distant goal, rather than spending that money now, is a difficult thing for most people to do. To make it easier, set exciting goals that will motivate you to pursue them. For instance, rather than “saving for retirement,” make your goal “to retire at age 60 with $1,000,000 in investments so I can travel and golf.” Then quantify your ultimate goal and interim goals, so you’ll have a way to track your progress.
- Consult with a financial advisor. The number of decisions that must be made to help ensure you meet your financial goals can seem overwhelming. Even if you have a basic grasp of some financial areas, you may be unfamiliar with other areas. A financial advisor can help coordinate your entire plan, making sure all financial areas are adequately considered. A financial advisor can also monitor your progress. Sometimes you feel more committed to goals when you know someone else is also watching your progress.
- Determine the financial issues that are causing you problems. Almost everyone has difficulty coming to grips with some aspect of their financial life. Perhaps your credit card debt is becoming burdensome, making it difficult to find money to save. Maybe you don’t understand investing basics and have left your money in a low interest-bearing savings account. Or you may have totally ignored estate planning, leaving your spouse and children at financial risk if you die. Whatever area is causing problems, resolve to make strides in overcoming it this year.
- Spend less than you earn. The amount of money left over for saving is a direct result of your lifestyle. Your lifestyle decisions will impact you now and in the future, since you will typically want a similar lifestyle after retirement. To get a grip on your spending, take time to analyze your expenses and to set a budget. Try reducing nonessential expenditures, such as entertaining, dining out, and vacations. Another strategy is to find ways to spend less for the same things. For instance, obtain car insurance quotes from several companies, placing any premium reductions in savings.
- Save it before you see it. If you have to find money to save every month, you’ll likely find there isn’t much left after all the bills are paid. Typically, a better strategy is to set up an automatic savings program where money is automatically deducted from your bank account every month and deposited directly in an investment account. Another good alternative is to sign up for your company’s 401(k) plan, having funds withdrawn every paycheck. Try to save at least 10% of your gross income. (Remember that an automatic investing plan, such as dollar cost averaging, does not assure a profit or protect against loss in declining markets. Since such a strategy involves periodic investment, consider your financial ability and willingness to continue purchases through periods of low price levels.)
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Your Retirement Planning Assumptions
To enjoy your retirement without financial worries, make sure you have enough money saved when you retire. However, that calculation can be a daunting task, since a variety of factors affect your answer and inaccurate estimates for any factor can leave you with way too little in savings. Some of the more significant factors include:
What percentage of your preretirement income will you need? You can find various rules of thumb indicating you need anywhere from 70% to over 100% of your preretirement income. On the surface, it seems like you should need less than 100% of your income. After all, you won’t have any work-related expenses, such as clothing, lunch, or commuting costs. But look carefully at your current expenses and how you plan to spend your retirement before deciding how much you’ll need. If you pay off your mortgage, stay in good health, live in a city with a low cost of living, and engage in inexpensive hobbies, then you might need less than 100% of your income. However, if you travel extensively, pay for health insurance, and maintain significant debt levels, even 100% of your income may not be enough. You need to take a close look at your expenses and planned retirement activities to come up with a reasonable estimate.
When will you retire? Your retirement date determines how long you have to save and how long investment returns can compound. You want to make sure your retirement savings and other income sources, such as Social Security and pension benefits, will support you for what could be a very lengthy retirement. Even extending your retirement age by a couple of years can significantly affect the ultimate amount you need.
How long will you live? Today, the average life expectancy of a 65-year-old man is 81 and of a 65-year-old woman is 84. For a 65-year-old couple, there is a 25% chance that one of them will live to 95. Most people look at average life expectancies when estimating this, but average life expectancy means you have a 50% chance of living beyond that age and a 50% chance of dying before that age. Since you can’t be sure which will apply to you, it’s typically better to assume you’ll live at least a few years past that age. When deciding how many years to add, consider your health as well as how long other family members have lived.
What long-term rate of return do you expect to earn on investments? A few years ago, many retirement plans were calculated using fairly high rates of return. Those high returns don’t look so assured now. At a minimum, make sure your expectations are based on average returns over a very long period. You might even want to be more conservative, assuming a rate of return lower than long-term averages suggest. Even a small difference in your estimated and actual rate of return can make a big difference in your ultimate savings.
Have you considered inflation? Even modest levels of inflation can significantly impact the purchasing power of your money over long time periods. For instance, after 30 years of just 2% inflation, your portfolio’s purchasing power will decline by 45%. When estimating an inflation figure, don’t just look at the historically low inflation rates of the recent past. Also consider long-term inflation rates, since your retirement could last for decades.
What tax rate do you expect to pay during retirement? Especially if you save significant amounts in tax-deferred investments that will be taxable when withdrawn, your tax rate can significantly affect the amount you’ll have available for spending. You may find your tax rate is the same or higher after retirement.
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Retaining Financial Information
Feel like you’re buried under an avalanche of paper? The steady accumulation of paper over the years can make even the most organized system seem uncontrollable. Some general guidelines on which papers to retain and which to toss include:
- Never throw away copies of your federal and state tax returns, records of gifts you made or received, deeds, birth certificates, or marriage certificates.
- Retain for at least six years any records that support tax deductions or taxable income. Those records include canceled checks, expense records, employment and other contracts, and tax-related forms such as W-2s and 1099s. Keep in mind that the Internal Revenue Service (IRS) has three years to audit your return, but can go back six years if substantial underreporting of income is suspected. There is no time limit if fraud is suspected.
- Keep the cost records until the asset is sold plus six years, such as brokerage statements reflecting the purchase and sale of securities, other records detailing the cost basis of investments, contributions to nondeductible and Roth individual retirement accounts, and purchase and sale documents for significant assets, such as homes, land, and cars.
- Monthly or quarterly statements can be thrown away once you receive an annual detailed listing of transactions at year end. Old annual reports, proxy statements, prospectuses, and promotional information can be tossed when you receive current information.
Keeping your records organized will make it easier to find that paperwork when you need it. Organized files will also help your heirs readily locate all important financial information should something happen to you. This will help them identify all your assets and liabilities and let them know which professionals to contact, such as lawyers, accountants, and financial advisers.
To assist your heirs, be sure to gather and record details about safe deposit boxes; life insurance policies; hospital, medical, and disability insurance; homeowners insurance; employee savings and stock plans; individual retirement accounts; credit cards; income tax records; real estate records; outstanding debts; children’s accounts and trusts; savings accounts; investments; and advisers. Many of these records should not be kept at home, but you should indicate where the original documents are located. Make sure to note where birth, marriage, and military records are kept, since these documents are usually needed to collect benefits. Update this record annually, and make sure your family knows where it is kept.
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Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2007-0827-0057
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