Click to enlarge.
Let's assume that inflation averages 2.5% per year for the next 20 years. That's what the bond market believes. This can be seen by subtracting the 0.64% real yield on the 20 year TIPS from the 3.14% rate of nominal 20 year treasury bond. You end up with 2.5%.
Now let's assume that you earn 3.14% per year in interest over the next 20 years and that you are in the 28% tax bracket. That leaves you 2.26% as an after tax return. Since inflation is 2.5% that means that you will lose 0.24% per year in purchasing power.
If investors are willing to lock that in as an alternative to being in the stock market, then what does that suggest about the long-term stock market performance over the next 20 years?
June 22, 2011
Can Investment Assumptions Worsen the State Pension Fund Crisis?
Well, no. Investment assumptions themselves don't worsen the crisis, but as we explain in our story on Rhode Island on Wednesday's broadcast, decisions about pension fund investment assumptions can mean higher taxes, lower pensions and bitter politics. Why? Because the lower the assumed rate of return, the greater the official underfunding of the retirement plan, the more that taxpayers or workers must contribute to make up the shortfall that would arise from a more sober assumption.
For what it is worth, my assumed real rate of return is extremely low (-2% after taxes) and has been since 2004. I based it on a 1970s scenario that would never end. There is nothing written in stone that guarantees that after tax returns must be positive.
The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. - Alan Greenspan (1966)
Source Data:
FRB: Selected Interest Rates
US Treasury: Interest Rates
You have the best graph annotations!
ReplyDeleteGYSC,
ReplyDeleteWell, it certainly isn't a REAL prosperity channel! D'oh! ;)
"There is nothing written in stone that guarantees that after tax returns must be positive. "
ReplyDeleteWhadda mean? It's in the Bill of Rights ya know.
In other news, I suggested to a friend that instead of making her contribution to her 403b (with lousy investment choices and no match) that she buy 10k of ibonds. No sale. Seeing that 0 percent return (even with the inflation adjustment) flipped her out. Preservation of capital is not a popular move.
I just put some of my IRA money into an issue that pays 70-80% of the stock market return, with no (nominal) downside risk. My guaranteed rate of return over 6 years is 0.00%. I'm feeling pretty good about it.
ReplyDeleteInteresting quote from the young Greenspan. Clearly, the welfare state has failed. Of course, so has democracy.
WASF,
JzB
fried,
ReplyDeletePreservation of capital is not a popular move.
Picture where we would be if everyone was as into preserving capital as we are.
Jazzbumpa,
ReplyDeleteYour primary risk is rooted in the stagflationary 1970s (the stock market goes nowhere while inflation eats up your purchasing power).
Let's hope we don't go there again, but I think the odds are increasing every month (as can be seen in this chart).