Friday, October 17, 2008

Elect Democrats, get less freedom, more taxes

This article talks about Democrat leaders in the US House of Representative who are planning to eliminate the tax shelter for 401k accounts and force all workers to contribute to a Federally guaranteed retirement savings plan.

House Education and Labor Committee Chairman George Miller, D-Calif., and Rep. Jim McDermott, D-Wash., chairman of the House Ways and Means Committee's Subcommittee on Income Security and Family Support are considering a proposed plan which would end privately owned 401k accounts and instead force all workers into a government-run plan which would pay interest rather than allow for investment in equities.

This is standard Democrat theory. You don't know how to plan and invest for your own retirement, so the government is going to do it for you. Instead of allowing you to invest in stocks, which historically return around 10% over the long term, your money will be invested in the equivalent of Inflation Adjusted Treasury Bills. TIPS are not bad investments for certain purposes, but for long-term investment such as retirement planning, where the time-horizon is forty or fifty years, they are not at all appropriate. But if you look below the surface you can see why this is attractive to Democratic politicians. When I invest in the stock market, I am buying equity in privately-owned companies. I own a small share of thousands of different companies. When they profit, I profit, and when they lose money, so do I. TIPS are government debt instruments. When I invest in a TBill, I am not buying equity in anything. I am loaning money to the government. That is money which Congress can now spend. Politicians would love to get their hands on all that money. But for the long-term good of the nation, investing in corporations which produce a product, employ people, and create wealth is much better than lending the money to the government, who will just spend it.

But the real test comes in comparing the results. Let's take a middle-class wage earner who makes $40,000 per year. Under the current plan, he contributes 5% of his income to his own 401k which is invested in stocks, which we will assume return a real rate of 6%, which is pretty much in line with historical performance. His employer matches half of his contribution. Each year his out-of-pocket cost is $2,086 after tax, and his total contribution is $3,600, including the company match. This is the system that many people have in place today. For comparison, the new system would provide $600 government subsidy in place of the company match, and the 5% mandatory contribution would be $2,000. But don't forget that his contributions are now taxable, so his real out-of-pocket cost after taxes is $2,300, $214 more than under the old plan. By the time they reach full social security retirement age of 67, the 401k balance is $815,429 and the new and improved government-run plan has $250,903. Under the current system he retires with 3 times as much in savings. Well, 3.25 times if you want to be nitpicky. That is the difference between a financially secure retirement and a paycheck to paycheck existence. Pay more, get less. That is the government plan. Trust them. They know what is better for you better than you know yourself.

Another way to look at the difference in outcomes is to compare the standard of living that the savings could support. If you take a 5% withdrawal rate, the 401k nest egg of $815429 would allow you to live on $40,771 per year. The government plan nest egg of $250,903 could only sustain an income of $12,545. The 401k would allow you to maintain your career standard of living, providing the same income you got from your job. The government plan would slash your yearly income from $40,000 to $12,545. Your life style suddenly goes from middle-class to far below the poverty line. You're going to have trouble making mortgage payments, let alone having food to eat. Forget about any extras like entertainment or travel.

The Democrat's argument will be that the stock market is too risky for people to invest their retirement savings in it, and therefore the government is doing people a favor by protecting us from ourselves. Left to our own devices, we would surely gamble away our life savings on the wild risks of capitalism. They will use the current market crash as an example of why the stock market is unsuitable for retirement savings. The truth is that the stock market is the most sensible place to invest money for long-term goals such as retirement. When I started investing for retirement at age 23, I expect all of that money to be invested for forty years. Some of it might be invested for much longer than that. Historical data shows that the longer your time horizon, the more sure thing the stock market is. Over one year or three year periods, it is quite possible that stocks will underperform bonds or TBills. It happens about one in three cases. It is less likely, but still possible, that stocks underperform for five years. Over ten year periods, stocks almost always do better. There is no twenty year period in recorded history where stocks didn't blow away TBills. So when we are talking about forty to sixty years, stocks are a no-brainer slam dunk.

The risk of the stock market can be mitigated by proper use of basic investment principles such as diversification and dollar cost averaging. Modern Portolio Theory tells us how to manage risk by owning index mutual funds covering a wide array of company types. A portfolio containing a mix of domestic and foreign stocks, large and small company stocks, growth and value stocks, and some amount of bonds can produce the same level of return as one individual stock in the S&P500 over a long period with about half the volatility. That is an accomplishment. While Modern Portfolio Theory has been called "rocket science" you don't have to figure it out yourself. Every mutual fund comapany I know offers suggested portfolios, and even provides balanced funds which put a fully diversified portfolio into a single fund. And retirement saving naturally involves small deposits on a regular basis, weekly or monthly when you are paid, which gives you the benefit of dollar cost averaging, because you buy more shares when the market is down, lowering the average cost per share.

So if you elect Democrats, this is what you can expect. More taxes, loss of tax-sheltered retirement options, government taking more control of your life, and government solutions rather than free-market solutions for every problem.

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