Broke the Bank

Prices dropped last year. But we still need to invest to protect ourselves from inflation. That’s why our retirement plan investing needs an inflation “tilt.” You’ll understand why in a few paragraphs.

How bad will future inflation be? I don’t know. Neither does anyone else. It could be a “normal” inflation of 3 to 4 percent a year. It could also be a banana republic 10 percent a month.

What we know is that all governments make promises they can’t fulfill. Our government certainly has. Under both political parties, it has taken promise-making to a high art. This is not hyperbole. The figures can be found in regularly published government reports.

The figures exist, but they are ignored. News reports regularly inform us of the growing federal deficit--- projected at a stunning $1.75 trillion for fiscal 2009 and $1.17 trillion for 2010. But regularly reported, less-visible government obligations have been growing much faster.

In the four years between January 2004 and January 2008, the Medicare trustees reported that the unfunded liabilities of Social Security and Medicare grew by a stunning $10.4 trillion. The average annual growth was $2.8 trillion.

That’s well over the expected formal deficit of $1.75 trillion this year.

In the 2008 trustees’ report, the unfunded liabilities of Social Security and Medicare--- promises of future retirement and health care benefits--- total $42.9 trillion. In a few days we should be able to read the 2009 report. It’s a good bet that the unfunded liabilities will increase by $3 trillion in the new report.

Ironically, payroll tax payments are still large enough that the Social Security and Medicare programs don’t need every dime. The extra money goes into the program trust funds as Treasury debt. The actual cash is spent elsewhere. Basically, the employment tax has been subsidizing other federal spending. This has been going on since the 1983 reform of Social Security--- another disaster chaired by former Federal Reserve Chairman Alan Greenspan.

Last year’s Social Security trustee report estimates that OASDI (Social Security retirement and disability) and HI (Hospital Insurance), excluding book entry interest for the Trust funds, will have more revenue than expenses until 2015. If higher cost assumptions prevail, however, the last year of positive flow will be 2010.

That’s next year.

I am not making this up. It is public record. You can see for yourself by examining table VI.F9 on page 191 of the 2008 trustees’ report.

When Social Security and Medicare costs exceed their revenues, the Treasury will have to borrow still more money to cover the shortfall. When that happens, today’s stunning deficits will look small.

That’s why our future contains inflation, not deflation.

There is another way to see how serious our situation is: Compare the unfunded liabilities of Social Security and Medicare to the net worth of every household in America.

According to the Federal Reserve flow of funds figures for year-end 2007, our collective net worth as consumers was $62.7 trillion. By the end of 2008 the same figure had fallen to $51.5 trillion. Another year of growth for Social Security and Medicare liabilities would bring total unfunded government promises to $46 trillion. That’s nearly 90 percent of our net worth.

Going for Broke: How Unfunded Government Liabilities Stack Up Against Consumer Net Worth

This table compares the unfunded liabilities of Social Security and Medicare over the next 75 years, which is the standard measure, with the current net worth of all households in America.

Program 1/2004 1/2008 Change Projected 1/2009
Social Security and Disability: OASDI $ 3.7 trillion $ 6.6 trillion $2.9 trillion NA
Hospital Insurance: HI $ 8.5 $12.7 $4.2 NA
Supplemental Medical Insurance: SMI-Part B, doctors expenses, etc. $11.4 $15.7 $4.3 NA
Supplemental Medical Insurance: SMI- Part D, prescription drugs 8.1 7.9 ($0.2) NA
Total Unfunded Liabilities $31.7 $42.9 $11.2 $46.0 est.
Consumer Net Worth $51.9 $62.7 $10.8 $51.5
Unfunded Liabilities as % Consumer Net Worth 61.1 percent 68.4 percent NA 89.3
Sources: Social Security and Medicare trustees’ reports, Federal Reserve, author estimate

If consumer net worth fell another $5 trillion--- the same amount it fell in the last three months of 2008--- we’d be broke.

Yes, you read that right.

Government obligations for basic programs would exceed the net worth of every household and nonprofit organization in America.

We’d be Upside-Down Nation.

The only way out of this is to print more money, inflating the value of assets relative to the amount of debt.

Cutting the expense of investing through index funds alone won’t solve the inflation problem. In addition to cutting expenses, we have to invest a portion of our money in assets that give us a hedge against inflation: Treasury Inflation Protected Securities (TIPS), real estate investment trusts (REITs), and energy companies.

Will this be perfect protection? No way. It will only give our savings a fighting chance.

Next week: Exactly How to Build a Couch Potato Portfolio in Your 401(k)

On the web:

Federal Reserve Consumer Balance Sheet for 12/31/2008

Sunday, May 14, 2006: This Year, a $3 Trillion Lump under the Rug

2008 Annual Trustees Report for Medicare

Trustee estimates of OASDI and HI cash flow, ex trust fund interest, 2008 Social Security Report:

Economic Indicators: Times series on Federal revenue, spending and debt 1992-2010

Sunday, November 16, 2007: Government, the Big Magician