The following is an edited version of “Where in the world is my retirement income?” a webcast held Aug. 26 and hosted by InvestmentNews deputy editor Greg Crawford. The guest was Robert J. Froehlich, Ph.D., a well-known economist, author and television personality who is better known as “Dr. Bob.”
InvestmentNews: So, Dr. Bob, how should advisers approach the idea of generating retirement income for their clients?
Mr. Froehlich: As we look at this global marketplace as investors and as advisers, we see that the world is constantly changing. I think one of the biggest challenges now is to worry more about what your questions are than what your answers are because really your questions are going to reveal what your biases are, what your beliefs are and really what you are worried about.
To me, we had better make sure we have the right questions before we are worried about the answers. Before we open this up to questions from everyone, I am going to frame for you what I believe in this current environment are the three most important questions that every financial adviser and every individual investor should be asking and should be focusing on trying to answer.
DO WE HAVE INFLATION?
The first question that has to be front-and-center, especially when you are thinking about, “Where in the world is my retirement income?” is, “Do we have inflation?” By the way, that answer is “Yes, we have inflation,” but many investors still aren't asking the question. When I say, “Yes, we have it,” I am emphatically saying we have inflation. The problem is the United States measures inflation with a flexible basket of goods. In other words, goods may be substituted in and out instead of a fixed basket. That means our inflation rate has the potential to be understated, which it actually is.
So inflation is actually worse than those headline numbers. Let me give you a really simplistic example to show you how we understate inflation in this country. Suppose the only consumer product used to measure inflation is beef. In my example there are two cuts of beef available; rib-eye and New York strip. The previous month when prices and inflation were measured, people only purchased rib-eye steak for $9.90 per pound even though the New York strip steak was only $9 per pound; 10% less. A month later prices increased 10% on both custom meats.
The rib-eye now costs $10.89 and the New York strip costs $9.90. If the CPI, or consumer price index, for my beef scenario is calculated as the increase of the cost of a constant basket of goods and services, the inflation rate will be 10%. This is essentially the way the consumer price index was originally calculated by the Bureau of Labor Statistics. This, however, is not the way we currently measure inflation in this country.
The current Bureau of Labor Statistics methodology of calculating CPI takes into account changes in consumer purchasing preferences. So in my beef example, all they do is substitute the New York strip steak for the rib-eye steak resulting in a CPI of zero. That is because last month we paid $9.90 per pound for beef — which was a rib-eye steak — and this month we are paying the exact same $9.90 per pound for beef for the New York strip. This is just absolutely unbelievable.
While the price of the rib-eye and the New York strip both just went up 10% due to the BLS method of measuring inflation with a flexible rather than a fixed basket of goods, the government's official inflation rate for beef is zero. You need to understand how this game is being played. You have to learn the rules of the game and then you have to play that game better than anyone else.
ARE RATES GOING UP?
I think the second most important question that every financial adviser and every investor needs to be asking is, “Are interest rates going higher?” Obviously, with the fed funds rate basically at zero, we know they are going higher but we need to figure out what is that final catalyst going to be. Here is something that is somewhat off the radar screen that I think could be a very unique catalyst.
I think the Federal Reserve Board has painted itself into a corner. Banks are currently sitting on $2.6 trillion of excess cash reserves but the Fed is worried if those excess cash reserves come back into the market too fast, we will have too much money chasing too few goods and it will be like adding fuel to the inflation fire. In order to stop that from happening, the Federal Reserve Board has decided to pay the banks not to lend. Now that may seem ironic, but we pay farmers not to farm, so I guess we should be able to pay bankers not to lend money.
It proposes to do this through a system of reverse purchase agreements known on Wall Street as “repos.” What this basically means is the Federal Reserve is attempting to trade bonds to the banks for their excess cash reserves. In this way it will temporarily sop up these excess cash reserves without actually shrinking the bank or the Fed's balance sheet.
Here is why I think this is a dangerous game. The banks will finally start using some of those excess cash reserves to help fund the massive mergers-and-acquisitions activity now taking place. Banks are doing that because they can earn more financing these deals than they can sitting in cash or by using this reverse repo where they are getting 8 basis points. This means that the Fed is going to be forced to raise interest rates on its repos if it wants to compete.
I look at this like an arms race. It is about to start. The Federal Reserve Board is going to be forced to outbid borrowers to sop up that excess cash reserve and it is going to happen. This catalyst is not going away. The good news is we probably have a year left to prepare portfolios. So it is not going to happen this week or next month, but the Fed is not going to lose this game. They are not going to let too much money chase too few goods, so we know the rising inflation environment is just around the corner.
ARE WE GOING BROKE?
The third and final issue is, are we going broke? I want to lay these fears aside. We are not going broke. I actually should step back and say this really would be a three-part question when I say, “Are we going broke?” Is the U.S. consumer going broke? Are U.S. corporations going broke? Is our government going broke? Again I would use that same answer, “No, no and no.”
Let's start with the consumer. If you look at the Federal Reserve Board's U.S. household net worth, which is assets minus liabilities, last year it rose 14% to $80 trillion. Even adjusted for inflation, it is at an all-time high. But what really fascinated me is it really wasn't covered that much. So we have what I consider really good news — an all-time high in household net worth and it is sort of a non-news event. The Fed has been tracking this number since 1945. I can't even imagine the headlines if it were at the lowest level since 1945.
Basically the consumer is not going broke. Could they do better? Yes, but they are certainly not going broke. The second question is, “Are corporations going broke?” Are you kidding me? That is a crazy question. Corporate profits are at an all-time high. Corporate profit margins are at an all-time high. Corporate profits as a percentage of GDP have never been higher and if you let me strip out non-financial corporations — banks and leasing companies — the corporations that are left are still sitting on $2 trillion in cash. So the thought that corporations are going broke is ludicrous.
Finally, even if corporations aren't going broke and consumers aren't going broke, I know many people think our government is going broke. Look, I saved my best for last. The government is not going broke. I do tend to look at things a little bit differently. I am concerned and I am outraged that our national debt is $17.5 trillion. However, you can't look at it in isolation. You have to look at it in comparison to our national income and national assets just like if you looked at a business. We have $17.5 trillion in debt but if you think about what that compares to our national income it is right around the same number. It is right around $17 trillion.
It would be similar to a person with a $500,000 annual income having debt of $500,000. This person is not going broke. The bigger issue is if you compare it to our country's assets. Total national assets last year were $112 trillion. I can make it real simple. There is only one way to go broke. Your liabilities have to exceed your assets. We have liabilities of $17.5 trillion, assets of $112 trillion. The government is not going broke.
That doesn't mean that the debt isn't too high. It is. We have to get it under control. We have to get entitlements under control but the government is not going broke. Companies are not going broke and consumers are certainly not going broke. So to me those are the three most important questions that should be front-and-center of every investor's and every financial adviser's mind.
InvestmentNews: Any advice for those entering just retirement in this low-yield environment?
Mr. Froehlich: It used to be when you hit 65 you were supposed to get your Last Will and Testament together because you only had another year or two to live. Obviously that makes sense to put all of your money in bonds. Your life expectancy is now 86 in this country. So someone who retires at 65 is likely to have 21 more years to live. I don't think the old way of doing things really makes sense because with 21 years left, you do have ample time to withstand a couple of market corrections and still be OK.
So the first thing I would say to individuals is, "Don't think of this as you are entering your 60s as a two to three-year time frame. You need to look at this as a 20- to 30-year time frame and you will look at your asset allocation in a much different way. The second thing that I would say is that in this low-interest-rate environment — even though I firmly believe rates are going to start back up — I don't think they are going to get anywhere near our historic average of the fed funds rate.
The last 50 years, the historic average has been 5.85%. I think we are lucky to see it north of 2%. So even in that environment, traditional fixed income is probably going to underperform especially with inflation rising. I think it is going to create a unique challenge for investors to figure out not to take on more risk, but to figure out whether there are some categories of alternative investments that can serve as a surrogate for fixed income — whether that were something like oil and gas, whether that is some other component of commodities. The term alternative is almost a misnomer because it is so broad you could drive a truck through it. It is just like someone says, “Are all hedge funds bad?”
You can't answer that question. It is the same as, “Are all alternatives good or bad?” There is no answer to that and it is not right for everyone but I think in this current environment I think you are going to see more and more individual investors and individual financial advisers start looking outside the box and looking more at these alternatives as a way to supplement that income.
InvestmentNews: What role do alternative investments play in generating retirement income?
Mr. Froehlich: If you think about the traditional allocation — I am taking cash out of the equation completely because some people like to have 5% or 10% or whatever. I am just talking about investible assets here. So when we get to 65, the basic portfolio would have 60% in fixed income, 40% in equities. I think the new world order is, you take that 60% in fixed income and you slice it in half. You keep the 40% in equity.
So instead of a 60/40 it becomes a 40/30/30. I think when you hit age 65 and you have 21 more years to live, your biggest exposure still needs to be equities. So I would have 40% equities. I would give 30% in fixed income and then I would have a whopping 30% in alternatives. I think it is the new age of investing. I think in this low-interest-rate environment, done the right way, you actually can keep your risk level the same or maybe even tweak it down a little bit and have a greater chance to get that income.
RISK OR DE-RISK?
InvestmentNews: I think also that when a lot of people hear the term alternatives they automatically think that means more risk because so many alternatives use derivatives and leverage and certainly jack up the risk in your portfolio, but a lot of alternatives are actually designed to hedge risk and to minimize volatility and the downside potential of the portfolio, right?
Mr. Froehlich: That is exactly why the endowments and big institutional investors created them. They were the driving force of having Wall Street create these products to do just that. So it is again an education process. As I said earlier, just like there is still this perception that because one hedge fund went under every hedge fund has to be bad — and that couldn't be further from the truth. Some of the greatest investment vehicles out there are hedge funds yet they have this noose around their neck that because they are a hedge fund they have got to be bad. Just because it is an alternative doesn't mean it is going to add more risk. In many cases it is going to add less risk especially to your overall portfolio.
InvestmentNews: What are your thoughts on the liquid alternatives movement as a vehicle to kind of get that alternatives exposure, in something that is maybe a little less costly than some of the traditional “alternatives?”
Mr. Froehlich: I think it is a good step. I think it is 10 years too late. I think this should have been what we were doing 10 years ago, so I think as an industry we are really behind the curve. It is very difficult to get mainstream investors to invest like institutional investors, especially in areas where they don't have access — there is not as much liquidity as they are used to. So that is what I think made this very difficult.
To me, if we could have packaged this early on with having liquid alts and having the traditional alternatives and then the discussion doesn't become, “What should I put in alternatives?” The discussion should be: “Of the 30% I am putting into alternatives, what should be in liquid alternatives and what should be in non-liquid alternatives?” That is really the discussion we should be having, but because it took so long to launch the liquid alts, we weren't able to have that. Instead the discussion we had, which was the improper discussion, was: “Should we be in or not be in alternatives?”
WAY BEHIND THE CURVE
The reason that this discussion was there was because they were illiquid. I think the fact that we are doing it now we are way behind the curve. It is going to be a huge education process and the other thing is you want to have a balance between liquid alts and non-liquid alts because, keep in mind that especially those individual investors that are going it alone, tend to make the worst mistake at the worst possible time. So we say we want this investment to be liquid but really what that means when we say your investment is liquid is that we are allowing you to buy high and sell low.
Sometimes illiquidity can actually be the single greatest thing that ever happened to an individual investor because when they are panicking they are calling, they are screaming, they find out they can't sell for another 30 days and 30 days from now, the whole world has turned around and they want to buy more. I think a balance of those two is really the way I would look at it.
InvestmentNews: What about the stock market? Is it overpriced?
Mr. Froehlich: Here is what I learned in my 35 years. Stuff doesn't go up forever and stuff doesn't go down forever. Are we in for a correction? Absolutely. I mean, we are at an all-time high. What should individual investors be doing? It is basic. Every six months you should be taking a look. You should be taking some profits off the table. If markets are moving,,you should stay with your asset allocation that you want and you should be re-balancing. To me it is not so much a matter of stocks going to an fall-time high. We know there is going to be a buying opportunity for stocks because they can't go up forever.
Every six months, whatever that allocation is, have the discipline to be able to reallocate, meaning you are getting out of some of your winners and getting into some things that are maybe losers and having a longer-term — you have to have discipline to be a good investor instead of trying to guess where the market is. I still think the market is fairly priced. I still think there is some upside.
And when you lock in that profit you can be high-fiving yourself, but you didn't make a thing. I think investors need to realize they have to have the discipline every six months to re-balance that portfolio, to lock in those profits, to regroup, meaning maybe they're going to buy some things that may be out of favor but as they move in, they're going to think they are the next Warren Buffett.
ANNUITIES AS INCOME
InvestmentNews: What are your thoughts about using annuities to generate retirement income?
Mr. Froehlich: I consider annuities one investment vehicle. I don't believe that they are the savior for everything that is out there nor do I think they should be necessarily avoided. I think as investors you have to go into this annuity discussion with eyes wide open. If something seems too good to be true, that means it is. Run the other way.
There is a reason why this one is paying so much or has all of these bells and whistles on it and that means when it comes time to start receiving that annuity, that insurance company is probably no longer in business. Sometimes the best provision or the highest yield isn't the best thing out there. To me, it is about looking at the annuity, looking at the underlying company and getting some great comfort just like you are buying a stock. When you are buying the annuity, you are buying that insurance company. Is it going to be there when it comes time to pay it or to receive that annuity?
InvestmentNews: Right. Certainly in the pages of
InvestmentNews, we have had a few stories about insurance companies changing the terms, leaving advisers scrambling to get the word out to their clients who have annuities. It causes a whole raft of issues for advisers and their clients. So the other thing that people need to be aware of is that, as you say, if it looks too good to be true, chances are it is. If it looks so good there may be a chance that the company could change the rules of the game down the road. So that is another issue you have to worry about.
Mr. Froehlich: That is a great point. What ends up happening is that if they don't change the rules halfway down the road, they probably go bankrupt. So you lose either way. You lose if they go under. You lose if they change the rules of the game. Do your homework and find that middle-ground thing that will help augment your overall portfolio. Look at an annuity as one piece of your whole sort of investment asset allocation puzzle, not the piece that is going to solve everything for you.
IMPACT INVESTING
InvestmentNews: Impact investing seems to be gaining some momentum right now. What do you make of that?
Mr. Froehlich: I take my hat off to George Kell who is the head of the United Nations Global Compact. Five or six years ago, as a result of his vision, they launched the Principles of Responsible Investing. The principles took socially conscious investing one step further — instead of being a negative screen, which is the way we have always looked at this, investors have guidelines for investing in a way that makes a positive impact on the environment or society. Before, you were never given any idea what to invest in. You were told only what you weren't allowed to invest in.
People in this country don't like to be told what they can't do. Tell them what they can't do and that is all they want to do. So as soon as you say, “You can't invest in alcohol. You can't invest in tobacco. You can't invest in defense companies or defense stocks,” that is all investors want to do is invest in those. That is why the initial launch of this was a failure because this country is great and don't tell us what we can't do.
I think George Kell said, “Let's develop these principles of responsible investing and let's focus the money to places that it is going to have the greatest impact.” So instead of telling you what not to do, you can focus instead on things that will help a more sustainable environment, such as companies that take care of their carbon footprint. I think it has been a much better approach of instead of telling you what not to do. I think Wall Street has finally embraced this — let's all get on the same page for better corporate responsibility and better environmental responsibility. I don't think it is a trend. I think it is the wave of the future.
INVESTING IN THE FUTURE
That is the way we are going to be investing. Ten years from now, I don't think money managers will be included in a big institutional search if the company hasn't signed off on the Principles of Responsible Investing. That will be one of the first questions that is asked in the due- diligence process. So I think it is a very exciting and I take my hat off to George Kell at the UN Global Compact. I think they have done a phenomenal job.
InvestmentNews: Let's turn the conversation to fees. How should advisers look at the fee components for some of these investments?
Mr. Froehlich: That is a great question. A lot of advisers and a lot of individual investors didn't look at fees at all. It was not an issue when fees were a lot more exorbitant than they are now. I think fees are an important element, but they are not the reason you should invest or not invest. I think that as an adviser with fiduciary responsibility or as an investor investing on their own, you first have to get comfortable with the investment thesis and what is going on with what you are investing in.
AN ADVISER'S VALUE
If you are using a financial adviser, what service, what value are you getting out of that financial adviser for what you are paying? Then look at fees. Do you feel you get what you are paying for? Making a decision simply on fees — just because something has a low fee doesn't mean it is a good investment and conversely, just because something has a higher fee doesn't mean that is something you should run away from. I think you should go into this with eyes wide open. Don't be afraid to ask the question, “What is the fee I am paying for this? Why am I paying this fee? This fee seems to be a little bit higher. Why is it higher?”
Listen to the justification. If you buy it, then you can figure that out. If you have an investor that puts a portfolio together and says, “I am just going to put a portfolio together where I don't have to pay any fees,” they may be paying the biggest price of all because they may end up going down the road by themselves with no financial advice and a couple of years from now it probably will be the worst decision they could ever have made.
InvestmentNews: Since we are talking about retirement income, what are your thoughts on how advisers should factor in Social Security into a client's retirement portfolio?
Mr. Froehlich: I will tell you the financial advisers that I have worked with — and the ones that I consider the cream of the crop — look at a client and, if that client is 40 years of age and younger, they run a scenario that says you shouldn't be counting on getting anything in Social Security. They are basically saying 25 years from now we have no idea what is going to happen.
In fact, we think, from a financial planning standpoint, you should view that as icing on the cake. It doesn't matter that you put so much money into that. There is that great of a likelihood that within 25 years, you might not be receiving that.
InvestmentNews: We have a question that has come in and it relates to the fee discussion we were talking about and some of the alternatives products that are out there: nontraded REITs and master limited partnerships. They have gotten a bad rap for not being tremendously transparent and yet giving brokers high commissions. There is a push from the industry to try and increase the transparency on some of these things which presumably may lower the fees they are being charged. The question is whether greater transparency will erode their popularity.
Mr. Froehlich: Look, I am a firm believer that whenever we can improve transparency, it is a good thing. But transparency alone isn't going to bring fees down. That said, I think there is some connection between the amount of transparency and the fee level. So, if more companies embrace transparency of fees and better disclosure of how those fees are calculated, there will be downward pressure on fees across the board.
There isn't an investment vehicle out there today that isn't under pressure to lower fees. To me, it is not justifying your fees. That is not what the name of the game is. But be transparent. Show what the fee is being used for. If investors don't want to invest there, they are going to go somewhere else.
InvestmentNews: Stepping back to the area of investing in equities, what are your thoughts on investing in companies that are paying decent dividends?
Mr. Froehlich: I think it is the best strategy out there. Earlier on when we started this and we were talking about the model portfolio for durable income and I said, “40% in stocks,” of that 40% stocks I would have more than half of them as dividend-paying stocks.
I like dividend-paying stocks for two reasons. One, there is a basic reason why companies pay a dividend. It is because they can. It is never a bad answer.
So we always want more from companies, always would like to see a better track record of dividends but at the end of the day — and I know this isn't an exact science, but with companies you have to trust them. If you are investing in a company, you have to trust management. You have to trust that they are going to do the right thing. You are going to have to trust that is a good investment. What I love about dividend-paying stocks is I really only have to trust them for 90 days because at the end of 90 days they are either going to give me a dividend or not and then it is time to re-think things — as opposed to a company that has this grandiose plan for the next four or five years. To me it is a nice way to keep corporate America accountable. Tell me whatever you want, but we are going to take a look at this again in 90 days and we will see what you do. It enables you to still be a long-term investor but with a short-term report card.
KEY TAKEAWAYS
InvestmentNews: Any key takeaways for advisers looking to generate retirement income for their clients?
Mr. Froehlich: I would like to leave people with two things. I think the two biggest disconnects that individual investors have today is their lack of exposure outside of the United States. Let me give you a couple of facts because I think they are really eye-opening. Ninety-four percent of the land in the world is outside of the United States, 96% of the people are outside of the United States, 98% of the jobs are outside of the United States, 77% of the global economy is outside of the United States.
WHY ONLY 10%?
Basically all of the land, all the people, all the jobs, all of the economic opportunity and most investors want 10% of that exposure. It is a huge, huge disconnect. The second disconnect is the lack of exposure to alternative investments. People still want to invest just in stocks, bonds and cash. The ironic part to me; that would be like someone going to Las Vegas and saying, “You know what? I am going to play five-card stud. I am going to put all of my money on the table but just give me three cards.” The dealer says, “What are you crazy? This is five-card.”
“No, no. Just give me stocks, bonds and cash but everyone else you get the stocks, bonds, cash, real estate, commodities.”
Even if you win a hand you are not going to win in the long run. To me, as we search for this durable income, I would say make sure that search includes investments outside of the United States and make sure that search includes alternative investments. Those are the two biggest disconnects for most individual investors today.
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