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Welcome to the risk economy
The current economy has shifted risk to the individual. We shoulder more burden for our retirements, our paychecks and our insurance than previous generations. No wonder were anxious.
By Jim Jubak
Will I be better off than my parents? Will my children be better off than me?
Those are extraordinary questions for those of us living in the United States to ask. At least since the Great Depression, and even further back if your family immigrated to this country in the last half of the 19th century, each generation has done better economically than the previous one. Economic progress from one generation to the next has been the foundation of our society.
Were asking those questions now because were all part of a big economic change that I call the risk economy."
That the questions are even being raised indicates just how anxious many of us feel about the future. Most efforts to analyze this anxiety have focused on the numbers -- specifically, will we be better off, on average, than the preceding generation? That misses the point, and can be too easily influenced by the researchers bias.
Instead of averages, real people worry about worst-case scenarios while hoping for best-case scenarios. The average doesnt keep us up at night.
And that, Im sure, explains our heightened economic anxiety. Because so much economic risk has shifted, and continues to shift, to individuals, many people fear the worst-case scenarios (serious illness, fraud, irreplaceable loss of income) are possible, if remote. A good part of the certainty that characterized our parents economic life has turned into a set of variable outcomes for this generation.
On the plus side, by taking on more risk, the best-case scenarios for the current generation, though they are less certain than the outcomes our parents generation achieved, result in more wealth and well-being than our parents achieved. But on the downside, taking on that risk and uncertainty results in a potential worst-case scenario that puts us in an economic position very much inferior to theirs. And its the risk of that worst case that makes us so anxious right now.
Let me give you some examples that show The Risk Economy at work. (This is the second part of an occasional series on The New Economy. For the first part, click here.)
Retirement: A much bigger potential nest egg but far less certainty
My dads retirement income comes from Social Security, a company pension, dividends from some shares of Exxon Mobil (XOM, news, msgs) he inherited and a portfolio split between corporate bonds, high-yield stocks and U.S. Savings Bonds.
When I retire, my income will come from Social Security (if its still around), my IRA and my 401(k).
The odds are Ill have a lot higher monthly retirement income than my dad. But it wont be nearly as certain. My dad can count on every dollar of retirement income he gets this November coming in next December and the next December and the December after that. I could sit down right now and project my dads monthly retirement income with considerable accuracy for 10 years from now.
Mine? Well, the folks at the Social Security Administration just wrote me that I can expect $1,829 a month if I continue working and retire at 66. (Pardon my skepticism but . . . Yeah, right.) But all the rest of my future retirement income depends on such circumstances as stock-market performance, future interest rates, inflation and the rise or fall of the dollar. Will the next decade show the returns of the 1990s (19.4% compounded annually for growth stocks, according to Ibbotson Associates) or even the 1980s (14.7% annually)? Or will the next decade look like the 1970s (when growth stocks returned an annual 3.8%)? It makes a bit of a difference. At 14.7% compounded annually, $100,000 grows to $394,125 over 10 years. At 3.8%, it grows to just $145,202.
And thanks to the bear market of 2000-2002, that difference isnt the worst-case scenario many investors can imagine. From March 9, 2000, to Oct. 9, 2002, the Standard & Poors 500 Index ($INX) fell by 44%. Many of us know from bitter experience what that did to our 401(k)s and IRAs. The thought of that happening again just as were about to retire is enough to keep many of us up at night.
Privatized stress
Most of the discussion about these differences between the generations, such as the arguments over President Bushs proposal to allow workers to put part of their Social Security taxes into private investment accounts, have focused on the pitiful returns generated by Social Security and the question of how to pay for a transition to a private system without bankrupting the current system. If I work until the current Social Security retirement age of 66, Ill have paid $141,000 in taxes and my employers another $141,000. At the current rate of benefits, it will take me 12 years of retirement payments to equal what Ive paid in taxes.
Of course, if Id put that $282,000 into a private account earning 8% a year and drew down the same level of benefits, Id still have $243,323 left after 12 years. At that rate it would take me 32 years -- until I was 98 -- to draw down my Social Security balance to zero. And, in a private account Id have the option of drawing out more each year than the government is set to pay me. So I could have more retirement income for fewer years, if I chose.
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But ignore the pot of gold in this 8% scenario and think about what would happen to your retirement income if a bear market wiped out 44% of your privatized Social Security account the year before you retired. Now even with 8% annual returns, you exhaust your Social Security account in 10 years of the same benefit payments.
Or imagine other worst-case scenarios. You wind up putting your retirement money in your employers stock and then the company goes belly up. Or the private retirement investing plan you use charges really high fees for truly lousy vehicles. Or you listen to an advisor who is more interested in churning your account for commissions than in earning you profits. Cant happen? The short history of 401(k) plans is full of examples of this and worse.
None of this is to say that you wont be better off with 401(k)s and some kind of privatized version of Social Security than with the current system under most scenarios. But the certainty in such a system is much, much lower; the risk of a seriously bad outcome much, much higher; and the accompanying anxiety much, much more intense.
Your paycheck: Riskier than you think and getting more uncertain
Ignore the risk of getting fired or being outsourced or downsized. Just look at trends in how compensation is calculated. To decrease their fixed costs, which can drown a companys bottom line in red ink when sales slump, more and more employers are moving toward a system that combines lower base pay with variable incentives such as bonuses. In good times, these flexible systems can actually pay workers more. In slow times, however, the incentive pay just about disappears, leaving workers with just that lower base. In 2003, nearly 80% of companies had some kind of variable pay plan, according to Hewitt Associates. Thats up from 59% in 1995. Put that increase in variable compensation together with the trend toward lower raises -- 3.4% in 2003 and 2004, according to Hewitt Associates -- and Id say you have a recipe for greater uncertainty and risk on your electronic pay stub.
Insurance: What does it actually insure?
The average employee is paying $1,288 in health-care premiums this year and Hewitt Associates projects that figure will rise to $1,481 in 2005. With that higher premium comes more exclusions and higher deductibles. And the possibility that some future hike in premiums will push an already overstretched family budget to breaking and the chance the employee will have to drop coverage entirely. You can find similar problems in long-term care insurance, where future premiums may be so high the elderly will have to cancel policies just when they need them. Or in homeowners insurance, where insurers have been writing policies with tighter exclusions or raising premiums for previously routinely included coverage.
You can count on an increase in uncertainty
I could go on, but you get the idea. The degree of uncertainty in our economic lives is rising. This isnt a new trend: IRAs and 401(k)s began this process years ago in the retirement field. But the trend now affects more and more people in more and more aspects of their lives. And it shows no signs of coming to an end.
Im not arguing that we should fix this risk problem by going back to earlier solutions with their greater certainties. Id like the opportunity to manage my own Social Security funds because I think I could increase the amount of money I have in retirement, for example. And theres a lot to be said for breaking out the costs of specific insurance coverage in more detail so I can buy just what I need and more -- or less. (I cant think of an argument in favor of 3.4% raises, I readily admit.)
But I do think the economy has been ingenious at inventing vehicles that increase the potential future best-case payoff, such as 401(k)s or the adjustable mortgages that let people afford bigger houses and will save home buyers money under many scenarios.
But its been very slow to invent products that address the uncertainty and risk that these changes have produced. What about the worker who is unlucky in his retirement investments in this brave new economy of risk and uncertainty? What about the homeowner with the adjustable rate mortgage who bets wrong on interest rates? What about the retiree who suddenly faces a serious long-term illness and cant afford to keep up those long-term care premiums?
What do we as a society say to that worker? Sorry you lost your nest egg. Now please go away and starve someplace out of our sight. To the homeowner do we say, sorry you believed Federal Reserve chairman Alan Greenspans praise of adjustable rate mortgages? Maybe you can find someplace to rent. To the ill retiree do we say, well, you can always spend down your kids inheritance and then throw yourself on the mercy of the government?
Right now were short on risk education. Were even shorter on ways of measuring and explaining risk. And were short on financial vehicles that will let us hedge these uncertainties. (If you want a peek at what some of these vehicles might look like, take a look at economist Robert Shillers book, "The New Financial Order: Risk in the 21st Century.")
I think our current anxiety will be with us until weve invented ways to hedge those uncertainties and turned those innovations into products that the average worker, homeowner and retiree can understand. Thats not impossible. Remember, the money market account was once a radical idea.
But Im afraid we can all count on some sleepless nights until we find better ways to manage the uncertainties in the new risk economy.
New developments on past columns
3 ways to capture the September effect
Not even the stocks of companies Im buying to protect my portfolio from inflation are immune from inflation these days. On Sept. 27, Newmont Mining (NEM, news, msgs), the worlds largest gold producer, announced third-quarter earnings of 29 cents a share, 4 cents a share above the Wall Street consensus. Sales soared to $1.2 billion, an increase of 32%, as the average price of gold sold climbed to $404 an ounce, up 10% from the third quarter of 2003. But the company would have done even better if the cost of just about everything that Newmont Mining uses to produce gold hadnt climbed by 28% to $871 million from $683 million in the third quarter of 2003. In the quarter, the cost of producing an ounce of gold climbed to $233. Going forward, Newmont Mining expects average cost for all of 2004 to average $230 to $235 an ounce; the price of gold, the company said in its conference call, should stay between $400 and $475 an ounce for the next 12 months to 15 months. As of Oct. 29, Im keeping my December 2004 target price of $55 a share. (Full disclosure: I own shares of Newmont Mining.)
Changes to Jubaks Picks
Buy EMC
EMC Corp. (EMC, news, msgs) is back. The company, one of the leaders of the technology sector in the heady days before the 2000 bubble broke, has spent the good part of three tough years cutting costs, shoring up existing product lines and continuing a shift from hardware to software as a driver of company profitability. That all seems to be working now, thanks in good part to a recovery in spending on information technology. Total storage-software-industry revenue is likely to grow by 17% in 2004, according to IDC. EMC, the market leader in this industry with about 33% of industry revenue, is projected to grow its storage software revenue by almost 31% in 2004. Overall company revenue should grow by about 29% in 2004, and 18% in 2005, according to Standard & Poors. And just as significantly, gross margins -- a post-2000 problem for the company -- are growing again. As of Oct. 29, Im adding EMC to Jubaks Picks with a May 2005 target price of $17 a share. (Full disclosure: Ill be buying shares of EMC three days after this column is posted.)
Sell Pentair
I bought Pentair (PNR, news, msgs) for Jubaks Picks on July 23, 2004, because recent acquisitions had moved the company closer to a pure play on clean water, though it still traded at the lower price-to-earnings ratio of a less-focused conglomerate. Well, the almost-20% gain in the stock since July has erased that discount: The stock, which traded at a price-to-earnings ratio of 16, has moved above the pure-play water industrys average PE of 20. Though its only November, that has already put it within striking distance of my $39 a share target price for May 2005. Im selling the shares from Jubaks Picks with an 18% gain since I bought them at $31.55. (Full disclosure: I will sell my personal position in Pentair three days after this column is posted.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Newmont Mining and Pentair. He does not own short positions in any stock mentioned in this column.
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