Asymmetrical Information - Megan McArdle

12.03.12

Ask the Blogger

You ask, I answer

Dear Blogger:  

I have some Facebook 'friends' that have been promoting a new OWS strategy of buying up consumer debt and forgiving it:  

I have a feeling this is a dumb strategy (mostly because it is, again, OWS), but I'm unable to put my finger on exactly why. Would you care to delve into what is happening here?  

Occupy Facebook

Dear OF:  

It's not dumb, exactly, but it's limited.  The most crushing debt people are worried about, like subprime mortgage loans, has been securitized.  Getting loans out of those securities would be a little tricky.  And in the case of mortgages, there's a house securing the debt, which even in the worst-hit areas, limits the write-down that the bank is willing to take; except in extraordinary circumstances, you're not going to get a mortgage for a few pennies on the dollar.  The second biggest debt many people face, student loan debt, is usually guaranteed by the federal government, which means that it is similarly unlikely to be sold at a huge discount.  So we're mostly talking about unsecured debts, mostly medical, auto balance, and credit card, which have gone to collections.  

There's another limiting factor, which is that under the current tax code, debt forgiveness is taxable.  There's good reason for that--if it weren't so, we'd all get paid in "loans" that would then be "forgiven".  But that means that the debtor will be on the hook for somewhere around 25% of the forgiven debt.  OWS has argued that their tax-free status somehow magically makes this obligation go away, and that anyway, it's a tax-free gift.  But there are some problems with this strategy, and even if it works, there's a $13,000 annual limit on tax-free gifts.  And I certainly wouldn't rely on the assertions of well-meaning activists that my debt forgiveness wasn't taxable; I'd get a ruling from the IRS.

So the best-case scenario is that some people will have small amounts of debt paid off.  That's very nice, but it's not going to be revolutionary.  And if the IRS rules against OWS--as I suspect they will--it won't even be nice. The IRS is very, very aggressive about collecting what is owed, and it has a lot more power to do so than some bottom-feeding collection agency.  

Dear Blogger: 

I am in my early forties, married, and with two young kids.  I am fortunate enough to have income that puts me in the top 1% and I already max out every type of tax-advantaged retirement savings for which I am eligible.  The vast majority of my life insurance is in the form of term insurance that is convertible to whole life insurance without evidence of additional insurability.  If it matters, the company is highly rated (Northwestern Mutual).  I am trying to decide whether I should convert some or all of my term insurance into whole life insurance.  My question is whether whole life insurance is worth it for someone who is looking to save/invest additional money after having taken full advantage of all other tax-advantaged savings vehicles.  In other words, are the tax advantages of a whole life policy better than investing in a non-tax-advantaged manner?  Assume that if the money wasn't used to buy the insurance policy it would be invested conservatively in a mixture of cash savings (e.g., CDs or money markets) and bonds.  If not, can you give an example of a scenario in which whole life insurance would be worth it?  

Saving For My Whole Life?  

Dear Lifer:  

I know it's distressing to cut the government enormous checks every year, but there is such a thing as worrying too much about taxes.   And I think this may be what you are doing.  Whole life is a bad deal: it's a lousy investment account packaged with an expensive term life insurance policy.  While there are tax benefits that can make these investments look attractive to the 1%, beware: the transaction is often a good deal only if you hold the policy until death.  If you need to tap the money sooner, you'll probably end up wishing you had just put the money in a bond fund.

In other words, this is an estate planning strategy, not a savings strategy--and if you need the money sooner, it could be a quite expensive one.  If it were me, I'd put the money in a regular trading account, in a mix of equity and bonds, and whenever I was tempted to grumble about the tax bill, I'd remind myself that it could be worse--I could be giving even more money to a whole life insurance company.  

Dear Blogger:

I am a government employee and I was lucky enough to get a reasonably high grade--although pretty standard for the DC area--at a pretty young age (I'm 33).  My wife is a public school teacher in Virginia.  Both of our positions have, as part of the benefits package, a defined benefit for retirement.  My back-of-the-envelope projections indicate that (assuming everything plays out as in current law--see question 1, below) our combined pensions would be about 75% of our current (i.e., 2012) income--which seems like a pretty incredible base from which to start and possibly enough to live on in retirement.

So, questions.  (1) What percentage of that projected pension figure do you think I should count on in my planning to account for the possibility of changes in the pension system?  Given the recent problems with state pensions, I'm figuring I should discount my wife's pension by half to be safe.  But the federal retirement benefit?  I've heard folks arguing that it'll never be touched and others that say it will literally disappear if there's ever unified GOP control of government (which, given that I'm looking at 30 years or more until retirement, is bound to happen sometime).  (2) Does it make sense to max out the 401k (i.e., the "Thrift Savings Plan") if you have a pension?  The TSP seems pretty conservatively managed and I'm thinking that contributions beyond the match might be better put to use in a brokerage account of some sort, particularly since we're fairly risk-tolerant this far out from retirement.


Pensioned Off or Pensioned On?  

Dear POPO:  

Being a government employee is certainly more secure than, say, being a journalist.  But as you have noticed, it's not as secure as it used to be.  The City of San Bernadino is gearing up for a big legal fight with the California state pension system over whether the city will make its pension payments.  A few towns and cities have forced cuts to benefits for existing retirees, or ended pensions entirely.  

In theory, any benefits you've already accrued in your pension should be 100% safe: the government, like private companies, is supposed to accrue assets that will cover the bill for retirees.  However, there are some problems with this theory.  If workers live longer than expected, there won't be enough assets.  If the market underperforms, there also won't be enough assets.  And unfortunately, the market is almost guaranteed to underperform, because as Joshua Rauh has been explaining for several years, public pensions use absurdly rosy projections of their future investment returns.  This reduces the bill to current taxpayers, which politicians (and taxpayers!) love.  But it means that when the bill comes due for your retirement, there's probably going to be a gap.  A recent study from Pew found "serious concerns" with Virginia's pension funding.

So the question is, what happens when there's a shortfall?  Either the government covers it, or the government defaults.  

How likely is this?  No one knows.   It probably can't happen outside of bankruptcy, and there's currently no mechanism for state governments or the feds to go bankrupt.  (Municipalities have a special bankruptcy chapter, but it's only for local governmnet).  

We're entering uncharted territory here.  But my best guess is that if the problem gets really serious--and it's going to--the government is going to find a way to weasel out of at least some of its obligations.  In general, the larger the entity you work for, the safer you are: big companies are safer than small, and bigger governments are safer than smaller ones.  But no one is safe, so you should discount both your pensions somewhat.

That doesn't mean you can't afford some more risk--you're young, and you're right that your retirement is pretty far away.  But two years of business school was enough to teach me that it's very difficult to understand all the risks in a stock, or the market, even if you have some time and basic skills to study the matter.  Even very smart people who do this all day, every day, do not, on average, outperform the market. And you have a day job.  That's why I stick to index funds . . . which is basically what the TSP "C" "S" and "I" Funds" provide.  So my advice is to save more than you would if your pension were really a 100% guarantee from God--and leave it in the TSP, in a mix of domestic and international index funds, where you'll get the benefit of tax-deductibility.  

Dear Blogger 

Like many working stiffs today, I’m pushing 40 and wondering what the best bets are for (hopefully) being able to retire at some point in the distant future.  I make decent money, but like most people my age, I also have fairly sizable financial obligations to satisfy with that income.  I contribute 4% to my 401(K), make regular deposits into a savings account (though not nearly enough), and have a 529 plan for my 12 year old, and while I have credit cards, I pay them off every month.

I fully realize the demographic realities facing this country, and by extension the stock market and housing market as well.  My question is: would it be wiser to pay down existing debt (mostly owed on a mortgage for an upside down house – no, strategic  foreclosure is not an option), or continue to save my meager amount every month in these various vehicles with the near certainty that the coming demographic and tax tsunami will probably make the savings less than worthless?  Is there another way to save that doesn’t involve canned food and ammunition?

FWIW, here is a rough draft of the financial picture:

·         $7084/month income

·         $12,331 in a rollover IRA

·         $6327 in a 529 plan($150/month contribution)

·         $481 in my current 401(K)

·         $1540 in a savings account

·         $235,000 owed on a house (currently a rental – I make a miniscule profit on it after expenses) in Phoenix that could probably sell for about $200K – there are 2 loans against this house – both are HELOCs at about 4.25%.  Arizona is a recourse state for that type of loan, so assuming I have anything the banks can go after, I’d probably be sued if I defaulted.

·         $20,000 owed on a truck (3.6%) that I plan to drive for the next 20 years, assuming these California drivers don’t total it sooner.  

Stretched to Save  

Dear Stretched:  

Financial engineers will disagree, but I say that paying off debt is always a great way to save.  Sure, your truck and real estate are at a low interest rate, but who's offering you a guaranteed return of as much as 3.6% right now?  Debt adds risk, and risk is something that few of us need more of in our financial lives.  

Paying off debt also gives you some discipline.  Few of us are immune to the siren calls of awesome stuff (or just a better school district for the kids).  Paying cash on the barrel--or reducing your debt balances--raises the pain of acquiring the stuff.  And that pain is good; it's telling you what the true cost of that stuff is.  

But in your case, as you clearly know, you're also way undersaved.   The first thing you need to do is boost that emergency fund to at least six months of expenses.  Set an aggressive goal of under a year to get that savings account beefed up.  That will make it easier to attack task two, which is raising your 401(k) contribution and paying off your debts: first car, then rental property, and then your house.  You should have an ultimate target of saving 15%-20% of your income.  I know that's going to hurt.  But it's precisely because there seem to be few good savings options that you need to put some margin in your financial life: our generation can't rely on high stock market returns to bail us out.  A high savings rate does two things: it cuts down on your consumption, so you need less money in retirement to replace it; and it raises your asset base.  

The good news is that you have the income to do this, if you're willing to live below what you make.  If you really start attacking that debt, you'll find that pretty soon, there's a snowball effect: paying off the truck frees money to pay down the HELOC, and paying down the first HELOC gives you more money to pay down the second HELOC.  In not so many years, you can have a paid-off rental property, a nice, big pillowy 401(k), and a paid off home.   And an emergency fund big enough that even if those crazy California drivers total your truck, you'll be able to handle the expense.  

Dear Blogger:  

I'm a recent university grad, working full-time. Now that I've got a job, I'm actually in a pretty good position - I managed to get out without student loans, and my parents are letting me live with them rent-free. However, for obvious reasons I don't want to keep living with my parents forever, and so I'm planning to move out within the next year. But for the time being, I have a lot of income and zero expenses. I've seen a lot of people in this position succumb to temptation and spend everything, but I'm trying to do better than that. 

My current financial plan is basically to save an amount equal to my hypothetical living expenses, which I'm estimating at $800/month rent(reasonable for the smallish city I live in) and $500/month for food/bus pass/internet/whatever else, and spend the rest on all the stuff I didn't buy while I was a broke student. The idea is that this way I can move out without taking any real hit to my standard of living, while at the same time building up a good-sized nest egg in the interim for things like first/last, a car of my own if I wind up leaving town, or any unforeseen expenses or job loss. I'm six months in, and so far I've put $8000 away(in tax-sheltered index funds, 60% stocks/40% bonds), so I've even managed to keep to the plan. 

I'm curious as to your opinions of this setup - do you have any suggestions for ways I can improve upon it? 

Fortunate Son  

Dear Son:  

You are almost frighteningly prudent for a new college graduate.  I am tempted to ask whether you did enough drugs in college.

I jest.  Well done!  Your plan is basically sound, though I would up the savings rate a little bit, to say $1500 a month, because you need a budget for unforeseen expenses.  Here's how to break it down:  

3 months emergency fund $4500

Deposit/First month's rent: $1600  

Decorating and moving expenses (you will want some furniture and probably a microwave): $1500-3,000 depending on your tastes

Car: However much you want to pay cash for a car.  Yes, I said cash.  Jobs go away; car payments don't.  And a repo will trash your undoubtedly sterling credit record.  

There's only one problem with your plan, which is that according to you, you are saving this in a tax-advantaged account.  Tax advantaged accounts typically cannot be accessed for these types of expenses.  That's not a huge problem--indeed, congrats on getting a jump start on your retirement saving.  But if you have been stashing this money in an IRA or 401(k), you are going to have to start over, because 401(k) loans are bad news.  


Ask the Blogger appears on Monday afternoons.  Email questions to mcmeganmoney@gmail.com.