"Needed - Incentives to Invest"

Sydney M. Williams

Thought of the Day

“Needed – Incentives to Invest”

August 17, 2011

The most important story of our generation is that the coming flood of retirees happens to coincide with the growing realization that entitlements promised have been based upon phony accounting. That fact requires a far greater need for savings and investments than currently exist. To put that in perspective, if every one of the 75 million American baby boomers had $500,000 to invest that would amount to $37.5 trillion, a little more than half the size of today’s total U.S. capital markets. Warren Buffett’s 400 highest earners, with aggregate income of $90.9 billion in 2008, are obviously well provided for, but tomorrow’s average retiree is woefully underfunded today.

The modern welfare state began in Western Europe in the aftermath of World War II. Population growth had been slow during the 1930s and through the war years. Millions of young men throughout Europe between the ages of 18 and 30 died as a consequence of the war. The Continent had experienced two devastating wars in less than a generation. As rebuilding began, during the late 1940s, birth rates surged. By the time the late 1970s arrived the war generation was beginning to retire, and the millions born in the post war years were approaching their peak earnings’ years. The next twenty years would prove to be a golden age for the welfare state – a large working population and a small retirement group. That age is at an end. Western Europe is now faced with an inflated and growing retirement force and a smaller and shrinking number of workers to support them, and much of Europe is experiencing declining populations to boot.

In the U.S., conditions were similar, though less extreme. (And, of course, the U.S. continues to have population increases.) Four countries – Germany, France, the UK and Italy – lost just over 4% of their population to the war, or about nine million people, with Germany the biggest loser with almost ten percent of the population killed. Losses in the United States were, on a relative basis, less. The U.S. experienced 413,000 deaths, or about 0.32% of the 1940 population. Nevertheless, there were similarities – rising expectations and costs, combined with an increasingly small number of workers for every retiree, as the ‘60s and ‘70s morphed into the ‘80s and ‘90s.

Entitlement reform is obviously based on concerns about these trends. What had been a third rail of American politics has become a much discussed (though yet little action) issue, in large part because of Congressman Paul Ryan’s “Roadmap for America” first introduced in 2008. At the time, even Republicans distanced themselves from Representative Ryan. Yet yesterday, even President Obama, on his tax-payer funded bus tour through the Midwest, acknowledged the need for entitlement reform.

But what has been missing has been its corollary – the need to implement tax reforms in such a way that average Americans are encouraged to save and invest. Entitlement reform means that individuals will bear the consequences of their actions. Entitlement reform necessitates tax reform. Warren Buffett, in his op-ed in Monday’s New York Times wasted valuable space in simply calling for higher taxes – perhaps a necessary symbolic gesture – but saying nothing of tax reform. Perhaps Mr. Buffett’s taxes are too low, but to infer, as he did, that taxes are too low on capital gains and dividends for average Americans – both already taxed at least once – is to discourage, not encourage, investments and savings.

The “nanny” state effectively and definitionally removes any sense of accountability and responsibility from the individual to the state. A country that no longer has the means to honor the promises it has made explicitly restores that responsibility back to the individual. But, in so doing, the state must encourage the individual to save and invest. Even so, the process will be difficult and will not seem fair, as those in the private sector discovered when the bell tolled for defined benefit plans thirty years ago. The fact that the Defense Department has floated a trial balloon, suggesting the replacement of a pension system based on the average of the last three years pay for those who have served for twenty years with a 401k-type plan, is an indication of the need for reform. Change is never easy, but people adapt. Congress has an obligation, in terms of tax reform, to facilitate this transformation.

The economy and markets have a way of adapting to changing situations. Michael Barone, a senior political analyst at the Washington Examiner, wrote an op-ed in yesterday’s Wall Street Journal in which he contrasted what he calls the “Michigan model” to the “Texas model.” The Michigan model was driven by the farm-to-factory migration that lasted from about 1890 to 1970. It found its footing in the concept of big companies and big unions. It was assumed by many 1950s and ‘60s liberals to be the wave of the future. But, as Mr. Barone wrote: “History hasn’t worked out that way. In 1970, Michigan had nine million people. In 2010, it had ten million. In 1970, Texas had eleven million people. In 2010, it had twenty-five million. The Texas model was driven by lower taxes, encouraging entrepreneurship and, once the South was delivered from state-imposed racial segregation, attracting foreign manufacturers and non-union labor. “The Texas model,” Mr. Barone concludes, “may be sweeping the Midwest, not vice versa.”

Markets also adapt. Ironically, at a time when the U.S. is carrying its heaviest load of debt (as a percent of GDP) since World War II, investors are clamoring to buy Treasuries with yields on the Ten-Year less than trailing twelve-month inflation and at or below the dividend yield on the S&P 500. Investors, to thrive, must adapt to opportunities that present themselves. While total returns to safe assets have matched or slightly exceeded those of risky assets since the market lows nine years ago, the more important question is the outlook for the next ten years. No one can predict the future. Nevertheless, safe assets (Treasuries) are priced far richer than they were nine years ago, suggesting investors are more risk averse today than they were in the years leading up to the credit crisis. The surprise, therefore, should favor riskier assets (equities and Corporates) over the next decade.

But government must recognize the necessity of people to save and invest more; Congress must keep that need in mind as they debate tax reform.