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My Biggest Retirement Fear

My biggest retirement fear is related to my last post about the coming changes to government retirement benefits. If you have not read my previous post, you can click on this link and read it now. However my biggest retirement fear is not caused by the expectation that these old age retirement benefits will be cut back in some way, my real fear is that these benefits MAY NOT be cut back enough or worse yet not cut back at all.

You may be thinking, “Why would I want my old age entitlement programs benefits reduced, wouldn’t that hurt my retirement?” Because if the federal governments’ old age programs are not reformed and the benefits as promised today are not changed, it means that the federal government has chosen another economic path for the country, inflation. And inflation is far more destructive for retirees. Let me explain how and why I think this destructive scenario could play out.

If you digest the fiscal data from my previous post, it should be obvious to anyone that the US will never be able to pay all the debts accumulated to date or all the future unfunded entitlement liabilities as promised. The total government liabilities are now so large and continues to grow annually at such a pace that the ability of the US economy to “grow” its way out of the problem is no longer possible. As such the US cannot continue to keep borrowing more and more money from foreign countries year after year. There will be an end to this borrowing at some time and probably in the not too distant future.

According to the Office of Management and Budgets (OMB), the interest payments made on the $15 trillion debt outstanding, currently consumes about $251 billion, or about 6.5% of the $3.83 trillion 2011 budget. Keep in mind that we are currently experiencing historically low interest rates. The OMB’s own forecasts indicate that by 2015, the debt interest payments will consume 13% of all federal expenditures or twice as much as today. If we keep up our current rate of borrowing and interest rates increase, I can easily see the percentage of our annual budget consumed by interest payments creep up to 20% to 25% or more in just a few short years. This leaves fewer funds available for all other government activities.

Of course, this budgetary situation will eventually require the politicians to make some cuts to many programs to help alleviate the problem. These cuts will be very painful for many Americans. And at some point, to keep “the full faith and credit of the US government,” the politicians will be put in the position of denying American citizens funding of entitlement programs in order to pay the interest payments on the debt owed to our creditors, e.g.,  Chinese, Japanese, and Middle Eastern Central Banks. How do you think the average American will react to that situation? I think they will react a lot like the people in Greece today are reacting to their mandated austerity plans. The US will not likely default on their outstanding foreign debt, but I think the US will default on their future entitlement liabilities. The only question is how will this default occur? Undoubtedly, there will be some major program benefit reductions, but I think the primary default scenario is that the Federal Reserve will devalue the currency. In fact, some currency devaluation has already occurred.

As shown in the above chart produced by the Federal Reserve Bank of St. Louis, since 2008 the US Federal Reserve has increased the money supply by over 200%, while the nation’s GDP has barely increased in that same time frame. This means that the economy has more money supply with essentially the same volume of goods and services. To date, due to the soft economy, this has only affected commodity prices. For example we have seen higher prices for oil and most food items in the last couple of years. But, eventually, this increased money supply will seep into the overall economy and raise the price of all goods, especially imported goods as the value of the US dollar declines.

Supposedly, the Federal Reserve is independent from the Congress and the US Treasury. However, starting with the 2008-2009 financial crises, the Federal Reserve and the US Treasury have been working together to manage the financial crisis. This collaboration has continued since the economy has not recovered very quickly and unemployment has stayed frustratingly high. I believe this close collaboration has caused monetary and fiscal policies, which are supposed to be independent, to be intertwined.

Let me provide one example. All the bond buying programs you hear about coming from the Federal Reserve (such as Quantitative Easing) are programs where the Federal Reserve buys US Treasuries from the big banks in the secondary market. The Fed does this for the express purpose of creating more demand for US Treasury bonds to keep their interest rates low to support the economy. The big banks, however, buy much of the new US Treasuries directly from the government.  Although it is not a stated goal, another consequence of these Fed bond buying programs is they, indirectly through the banks, enable the US treasury to continue their annual deficit spending binges increasing the national debt. Why is the Fed doing this? Because the Federal Reserve believes that deflation is the more immediate danger to the US economy. The Fed believes any hint of deflation will impede economic growth and job creation.

But where does the Federal Reserve get the dollars to buy the US Treasuries from the big banks? They simply increase the money supply; i.e., they, electronically, create more dollars out of thin air. In my opinion this short term crisis management approach may have longer term inflationary consequences.

So how exactly does all this affect the typical retiree or soon to be retired person? Retirees, as a group, have large savings and very little debt. When the Federal Reserve takes action that lowers interest rates, the income on a retiree’s fixed income assets go down. Everyone is aware of this end result. However when the Federal reserves’ policies increase the money supply without a corresponding increase in the GDP, each dollar in circulation loses value. This inflationary effect helps reduce the relative value of all fixed debts, which is good for debtors, but it also reduces the purchasing power of all dollars saved, which is bad for savers. In short, the Feds’ policies are helping debtors and hurting savers.

The de-leveraging process along with the slow economy the US is currently experiencing will dampen domestic price inflation for awhile due to soft demand. This will probably cause the Federal Reserve to continue their anti-deflation programs through further increases in the money supply. Eventually I think all these excess dollars will cause bouts of high inflation. This is my biggest retirement fear. This inflation will hurt those who have accumulated large dollar cash savings because these dollars will become worth less and less over time.

I see only two options available to our leaders in Washington about how to deal with the countries’ unfunded liabilities.

1. Either our political leaders will make the difficult budgetary choices and reform entitlement programs to make them sustainable over the long term. This option will require significant reduction in benefits in the federal old age programs that will greatly impact most people even people already getting benefits. (This will also create more deflationary pressure which the current Fed policy is trying to combat.)
2. Or, our political leaders will pressure the Federal Reserve to increase the money supply so that everyone gets their promised old age benefits (or something close to them). This will make people happy in the short term. Unfortunately this inflationary action will cause the price of everything we consume to go up. What does this mean? As an example, imagine you have the same income you have today, the cost of a few items might be:
   1. $12/gallon for gasoline,
   2. $600/month electric bill for a small 1 Bedroom Condo,
   3. $15 for a gallon of milk or a loaf of bread.

The first option requires the politicians to take several votes in Congress to reduce people’s benefits. This will not be popular with these politicians and they would likely be voted out of office. So I do not see the politicians going very far with option 1. Option 2, however, does not require any politician to take any votes. It just happens as a result of “independent” Federal Reserve policy. This will, undoubtedly, be controversial, but it will allow the politicians to deny being a part of this crippling policy.

I hope I am wrong about all this, but I just do not see any other realistic way out of the US’s entitlement liability dilemma. This is why I think it is a good idea for everyone to assume lower than promised federal old age benefits and to hold some precious metals (i.e., gold and/or silver bullion) as part of their portfolios to protect against currency devaluation.

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