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October 27, 2009

Stagger Retirement Dates Between Spouses

The Center for Retirement Research indicates that only 20% of couples retire in the same year -- 50% still have one spouse working two years after the other spouse has retired. Often, one spouse retires before the other due to health problems or a layoff, not necessarily because the spouse chooses to retire early. No matter what the reason, keep these points in mind if you are in that situation:

Try to minimize withdrawals from retirement accounts. Although you will only have one salary instead of two, it's best to minimize withdrawals while one spouse is working. It's a good opportunity to test your retirement budget and to try to reduce your expenses.

Utilize all available benefits from the working spouse's employer. One of the most significant retirement expenses, especially if you don't qualify for Medicare, is health insurance. So, before one spouse retires, find out if that spouse is eligible for health insurance benefits through the working spouse's employer. If that spouse is not currently on that plan, find out how he/she can enroll. Does he/she have to wait for the annual open enrollment period or will retiring qualify him/her for coverage immediately?

Delay Social Security benefits. Especially if you are retiring before full retirement age, it typically makes financial sense to delay Social Security benefits. For a significant number of married couples, the man is older, has higher earnings, and will not live as long as the woman. Because the surviving spouse can elect to receive 100% of the other spouse's benefits, it typically makes sense for the man to wait until age 70 to claim Social Security benefits, to provide his wife with the highest possible benefits after his death. On the other hand, there is usually no reason for the woman to wait beyond ages 62 to 66 to start Social Security benefits, provided she can claim benefits on her own earnings record. While the wife's benefits may be lower when her husband is alive, she will receive his higher benefits after his death.

Consider all defined-benefit plan payment options. If you are lucky enough to be covered by a traditional pension plan at work, make sure to consider all the payment options carefully before selecting one. Typically, you will have numerous options, but your choice will be irrevocable.

October 24, 2009

Organizing Your Financial Accounts

It's not uncommon to accumulate things over the years, without taking time to straighten them out periodically. That applies to our finances as well as to our possessions. How many credit cards do you carry? How many stocks and bonds, brokerage accounts, and individual retirement accounts (IRAs) do you own? It's not just a matter of finding time to keep track of all these different financial assets. Often, these assets are acquired without a clear-cut strategy, so you may own assets with similar investment objectives or that are not compatible with your financial goals. When organizing your finances you should consider these four steps:

• Make a list of all your assets and debts. List each one individually, so you have a sense of how many different accounts you're dealing with.

• Go through each one of your investments. Make sure you understand why you own each one. Are you really adding diversification to your portfolio or do you have overlapping investments? Assess the prospects of each investment and decide whether you should continue to own it.

• Look for ways to consolidate accounts. Try to get down to one bank account, one brokerage account, and one IRA. This can significantly reduce the time needed to review and reconcile accounts.

• Assess your outstanding debts. Do you really need all those credit cards? Consider keeping only one or two cards, so it'll be easier to monitor balances. Look for ways to reduce the cost of your borrowing. Is it time to take another look at refinancing your mortgage?

October 21, 2009

Bond Maturity Dates

All investments seem more volatile these days, including bonds. To help control volatility in your bond portfolio, carefully consider maturity dates before purchase. Bonds can be purchased with maturity dates ranging from several weeks to several decades. Before deciding on a maturity date, review how that date affects investment risk and your ability to pursue your investment goals.

Typically, yield increases as the maturity date lengthens, since you assume more risk by holding a bond for a longer time. Investors are often tempted to purchase bonds with long maturity dates to lock in higher yields, but that strategy should be used with care. If you purchase a long-term bond knowing you'll need to sell before the maturity date, interest rate changes can significantly affect the bond's market value. Two fundamental concepts about bond investing apply:

Interest rates and bond prices move in opposite directions. A bond's price rises when interest rates fall and declines when interest rates rise. The existing bond's price must change to provide the same yield to maturity as an equivalent, newly issued bond with prevailing interest rates. You can eliminate the effects of interest rate changes by holding the bond to maturity, when you will receive the full principal amount.

Bonds with longer maturities are more significantly affected by interest rate changes. Since long-term bonds have a longer stream of interest payments that don't match current interest rates, the bond's price must change more to compensate for the interest rate change.

Although you can't control interest rate changes, you can limit the effects of those changes by selecting bonds with maturity dates close to when you need your principal. In many cases, you may not know exactly when that will be, but you should at least know whether you are investing for the short, intermediate, or long term.

October 14, 2009

When Should We Worry About the Federal Deficit

A federal deficit occurs when the government's expenditures for the year exceed its income. The government then pays for those excess expenditures by borrowing money, adding to the national debt. With so much stimulus money being spent to prod the economy out of recession, the federal deficit will reach record levels this year. According to the Congressional Budget Office, the federal deficit will quadruple in 2009, from $459 billion last year to $1.845 trillion this year (Source: The Economist, June 10, 2009). While the president vows to slash the deficit in half within four years, the Congressional Budget Office estimates the deficit will still total more than $1 trillion per year by 2019. Are these huge deficits cause for concern? It's tough to decide, since opinions range from "deficits don't matter at all" to "deficits will ultimately result in federal bankruptcy." It might help to put the federal deficits in perspective.

In 1998, for the first time in 28 years, the federal government ran a budget surplus. Those surpluses lasted four years. During that time, concerns about the viability of the Social Security system seemed less urgent, and there was talk about what would happen to the bond market if the federal government paid off all its debt. These discussions were short lived. Following two tax cuts, the September 11 terrorist attacks, the Afghanistan and Iraqi wars, and a recession, the federal deficits were back and have not gone away since.

Of course, a federal deficit results in an increase in the national debt. Currently, the gross national debt is approximately $11 trillion. A significant portion of that debt is owed to the Federal Reserve and other government accounts. But the public holds $6.8 trillion, or 62%, of the total debt (Source: Region Focus, Winter 2009). China and Japan are the largest foreign holders of this publicly held debt.

While the dollar amounts of the deficits and national debt are enormous, these numbers are often presented as a percentage of gross domestic product (GDP) to compare to past deficits and debt levels. The 2009 deficit of $1.8 trillion is 13.1% of GDP, twice the post-World War II record of 6% set in 1983 (Source: Fortune, June 22, 2009). The Congressional Budget Office's estimate of a $1.2 trillion deficit for 2019 would represent 5.7% of GDP, an extremely high number for a healthy economy.

In 2008, federal borrowing totaled 42% of GDP, about average for post-war years. By 2019, it could reach 82% of GDP, close to double the current level. At that point, one out of every six dollars the government spends will go to interest payments (Source: Fortune, June 22, 2009).

The consensus is that the government needs to spend money now to stimulate the economy out of the current downturn. Without running deficits, the recession is likely to last longer and become more severe. When recessions cause a rise in unemployment rates, people spend less, which causes more people to lose their jobs, precipitating a downward spiral in the economy. Using short-term deficits to stimulate the economy helps reverse this cycle.

The problem is that even if the short-term deficits lift the economy out of recession, projected increases in Social Security, Medicare, and Medicaid expenditures make it difficult to envision a scenario where the government can operate without deficits. Spending is growing astronomically, while revenues as a percentage of GDP are basically flat. Spending is primarily driven by entitlements, such as Social Security, which are projected to grow enormously as the population ages. Revenues, on the other hand, are based heavily on the individual income tax, which typically rises and falls with GDP.

What impact will these huge deficits have on the economy if they continue? No one knows for sure. But perhaps the federal government should pay special heed to what got us into the current recession in the first place -- consumers living beyond their means, incurring debt to support a lifestyle they couldn't afford. Will the government be next?

October 7, 2009

How the Federal Government is Dealing with the Recession

As detailed in the 1978 amendment to the Federal Reserve Act, the Fed's goals when setting monetary policy are "to promote maximum sustainable output and employment and to promote stable prices." Monetary policy has historically been implemented through three main methods:

Raising or lowering the fed funds rate -- This is the Fed's preferred method. The fed funds rate is the interest rate charged to banks for overnight borrowing from banks with excess reserves. Lowering this rate makes it less expensive for banks to borrow money and loan it out, while raising the rate has the opposite effect. Typically made at Federal Open Market Committee Meetings (FOMC meetings), changes in the fed funds rate are widely reported and are viewed as a public signal of the Federal Reserve's monetary policy. While the fed funds rate applies to a relatively small volume of borrowed reserves, it has broader implications. Other interest rates typically change in response to changes in the fed funds rate.

Purchasing or selling U.S. Treasury securities in the open market -- If the Fed wants to increase reserves at member banks so more funds are available to lend to customers, it purchases government securities in the open market, paying for the securities with a Federal Reserve check. Since this check is not issued by a commercial bank, the entire banking system has more funds available when the check is deposited in a commercial bank. To reduce the supply of funds, the Federal Reserve sells government securities.

Changing reserve requirements -- Each bank is required to keep a certain percentage of deposits on hand, which cannot be loaned out. Changing the requirements allows the Fed to change the amount of money available on a large scale.

How Is the Fed Responding to the Current Situation?

During the current recession, the Fed has responded to the large increases in the unemployment rate by aggressively cutting the fed funds rate, lowering it from 5.25% to essentially zero. Over the past two decades, the Fed has set the fed funds rate by lowering it 1.3% when core inflation decreases by 1% and lowering it by close to 2% when the unemployment rate increases by 1% (Source: FRBSF Economic Letter, May 22, 2009). During 2007 and 2008, the Fed's reduction of the fed funds rate by 5.25% was in line with this formula. However, the situation has worsened in 2009, meaning the Fed would need to reduce the fed funds rate to negative 5% by the end of 2009 to follow this formula. Obviously, they can't reduce the rate below zero percent, so they have had to resort to other methods to stimulate the economy.

Based on economic forecasts of the Fed's FOMC, the fed funds rate should be near zero for several years. Due to the severe depth of the recession, it will take several years of significant growth for the economy to eliminate all slack. Although it has not said exactly how long it expects the fed funds rate to be near zero, the Fed has said that it "anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The Federal Reserve has also implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets, which has significantly increased the assets on the Fed's balance sheet. As of May 2009, the Fed's balance sheet has doubled in size to just over $2 trillion, with commitments for further increases by year-end (Source: FRBSF Economic Letter, May 2009).

The first set of tools, which are closely tied to the Fed's traditional role as lender of last resort, involves providing short-term liquidity to banks, other depository institutions, and other financial institutions. Because of the global nature of banks, the Fed has also approved bilateral currency swap agreements with 12 foreign central banks to help them provide dollar liquidity to banks in their jurisdictions.

A second set of tools provides liquidity directly to borrowers and investors in key credit markets. The Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility fall in this category.

As a third set of instruments, the Fed has expanded its traditional tool of open market operations to support the functioning of the credit markets through the purchase of longer-term securities for the Federal Reserve's portfolio.

When credit markets and the economy begin to recover from the current financial crisis, the Fed will need to wind down some of its various lending programs and eliminate others. The Fed's balance sheet can be reduced relatively quickly, since a substantial portion of the assets are short term in nature and can simply mature. The Federal Reserve also holds significant quantities of longer-term assets, such as agency debt and mortgage-backed securities. Although these longer-term securities could be sold, the Fed will likely not dispose of more than a small portion in the near future. As the size of its balance sheet and the quantity of excess reserves in the banking system decline, the Fed should return to using the fed funds rate as its primary tool to implement monetary policy.


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