TIMELY TOPICS

An Occasional Publication of Caves & Associates

April 27, 2006
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 INFLATION STATISTICS, HEDONICS, AND RETIREMENT
              

Inflation is measured in the U.S. by the Consumer Price Index (CPI), with 211 item categories and 38 index geographic areas. It is used to benchmark social security payments and to adjust lease payments, wages in union contracts, food-stamp benefits, alimony, and tax brackets. Hedonics is a statistical technique used to account for the changing quality of products when calculating price movements. For example, if a 27 inch TV has the same price of $330 from one month to the next, most people would say the price has not changed. However, if the TV had improvements in the picture quality or screen shape the second month which were valued at $135; hedonics would conclude that the price had dropped 29%.

By way of background, in 1995 former Federal Reserve Chairman Alan Greenspan, testifying before the Senate Finance Committee, said that he thought the CPI was biased upward by as much as 1.5 percentage points. The political response was immediate: If inflation was lower than supposed, it would be possible to rein in deficits without cutting spending or raising taxes. That’s because the lower inflation rate would translate into smaller payments to Social Security recipients, smaller downward adjustment of tax rates to offset inflation, and lower costs for other big-ticket items paid by the government such as employee raises. After a Congressional panel agreed with Greenspan, a push began to apply hedonic techniques more broadly to CPI calculations.

Critics of hedonics argue that the hedonic method is distorting the picture of what is going on in the economy. They argue hedonics is too subjective and fear it helps keep inflation figures artificially low.

These arguments have implications for macroeconomic policy and for retirement planning. Regarding the former, the Fed may be lagging in its inflation-fighting mission. Regarding the latter, the would-be retiree must consider that if inflation is actually higher than reported by the CPI, and if Social Security payments are lower than they would have been without the application of hedonics, retirees will need to save more money now to meet their needs throughout retirement.

I remember well my dad’s lamentations frequently heard while he was in his 70’s, well into his retirement years: “Pres, everything costs so much.” Admittedly, he was not well-prepared for retirement. Nonetheless, it was not particularly relevant from his perspective of scarce dollars and a tight budget that the replacement car he and Mom needed would be higher quality (they just wanted transportation), that the new TV would have built-in stereo and more lines of resolution; that a new shirt or blouse would be wrinkle resistant, etc.

I’ll never forget my Dad’s plight. When it comes to retirement savings, we must error on the high side; we must have significantly more than enough.
 
TEACHING CHILDREN AND GRANDCHILDREN ABOUT MONEY
  Parents (and grandparents) need to take an active role in educating children about the value of money as well as the importance of budgeting and saving. Discussions about money and investing fall between sex and drugs as the least talked-about subjects with children under 18, according to a survey by Charles Schwab & Co. In fact, more than 53 percent of all respondents agreed that their parents felt talking about money was "too personal" according to Mellody Hobson, President of Ariel Capital

Management in an ABC News report about ways to teach your children about money.

Ms. Hobson stressed the importance of being up front with your children about the family finances. Your kids should have a basic understanding of what your family can and cannot afford. Consider sitting down with your children and explaining what you earn and how much of it needs to go toward housing, food, utilities and other staples. This exercise introduces them to the basics of budgeting and helps them better understand the difference between necessary expenses and discretionary spending.

Ms. Hobson continued with suggestions on how to structure a child’s allowance and teach children to budget, when and how to obtain a credit or debit card for teens, and how to get teens to save. The complete article can be found at http://abcnews.go.com/GMA/AmericanFamily/story?id=125051&page=1

Several other websites providing useful suggestions are:

Http://life.familyeducation.com/finances-and-money/parenting/36332.html

http://www.extension.umn.edu/distribution/youthdevelopment/DA6116.html

http://www.icfe.info


 
THE IMPACT OF SOARING HOUSING COSTS ON SAVING FOR RETIREMENT
 
Are your finances on track? Look below.
AGE
SAVINGS TO
INCOME
DEBT TO
INCOME
30
0.1
1.70
35
0.9
1.50
40
1.8
1.25
45
3.0
1.00
50
4.5
0.75
55
6.5
0.50
60
8.9
0.20
65
12.0
0.00
Saving for retirement should be a priority for everyone, yet the ability to build wealth can be seriously impaired by the cost of purchasing a home at a time when real estate prices are soaring. The proportion of mortgage debt to income may become dangerously high, resulting in an inability to contribute sufficient amounts to retirement plans and savings. Additionally, if “moving up” to a larger home, with high mortgages comes not only the costs for additional furnishings, but also increased homeowner’s insurance and property taxes and higher gardening and cleaning service expenses. All of these further reduce cash available for savings.

Are you ready for the ugly math? Charles Farrell, a financial consultant in Medina, Ohio, has created a table that effectively provides targets regarding the ratios of income to debt and to savings in preparing for retirement. “There is a fundamental relationship between what you earn, how much debt you have, and what you can afford to save,” Mr. Farrell says. “If you’re servicing too much debt, you can’t hit your savings target.” The table is based on age in five-year increments beginning at 30 and tells you how much retirement savings and how much total debt you should have, relative to your income, at differing ages. Accordingly, if you are fifty years old earning $200,000 per year, your savings should represent 4.5 times your income, and your debt should be no more than .75 times your income. Thus, savings should be 4.5 times income of $200,000, or $900,000, and debt should be no more than .75% of $200,000, or $150,000. If the numbers in the table don’t reflect your current situation (for your age), you may be headed for trouble.
  We have reviewed all of Mr. Farrell’s assumptions that underpin the table, and they provide a reasonable framework for planning. Among other key parameters, the table assumes that 12% of an individual’s pretax income will be put into savings every year from age 30 to 65. Further, the calculations target replacement of about 80% of earned income at retirement. Though you might scoff at the results of his factors, especially the one for debt, we think his targets are minimum targets, and that individuals should probably aim higher to compensate for the ebbs and flows of securities markets, increasing life expectancies, etc. Given low U.S. savings and savings rates and high debt, it is clear a significant number of people are dangerously far from achieving the targets necessary for even modestly comfortable retirement and will need to consider some distasteful alternatives.

Looking at another example, let’s say you are forty with an annual income of $100,000, and you have the requisite $125,000 in debt and $180,000 in retirement savings. However, if you pay a significant amount in the recently red hot housing market for a larger property (or a second home) you don’t really need, you may increase your indebtedness to $300,000 and decrease your savings to only $50,000. To get on track according to Farrell’s underlying assumptions, you would need to contribute 20% of your pretax income every year for the next 25 years. This rate is much higher than Farrell’s “standard” rate of 12%, and the increased requirement could be impossible, because higher mortgage payments and taxes could consume more than 40% of your income. So, if your savings rate is currently adequate but you are considering moving to a more expensive property, you may want to reconsider. The increased house size or preferable location may not be worth the sacrifice of post-retirement comfort that would otherwise be assured by sufficient, ongoing contributions to your retirement savings.

A serious misconception held by many is that the booming housing market will ensure that wealth currently tied up in real estate will be available to provide the needed income upon retirement. This kind of planning for the future is risky because it assumes that the cost of real estate will continue to climb, which is not guaranteed. Further, the presumed built up equity may be there, but accessing that equity has risks, costs, and possible undesirable consequences. Finally, if the strategy assumes you “move down” in retirement, that may be fine, but will you really be willing to do so when the time comes?

Is your debt higher and your savings lower than the table suggests? There are ways to divert more cash to retirement savings, but the choices aren’t pleasant. “Maybe you should trade down earlier, using the proceeds to bolster savings and increasing your on-going savings deposits thanks to lower mortgage and housing-related costs,” Mr. Farrell says. “Maybe you need to delay retirement. Maybe you should talk to the kids about taking out loans for college. Maybe, if one spouse doesn’t work, it’s time to get a part-time job and then sock away all of that extra income.” Finally, if your savings are not what they should be, you might examine your ongoing living and recreation expenses, and discover ways to cut back in order to direct more cash toward retirement.
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