Financial Lessons Unlearned

If the 20th Century – concluded only a couple of decades ago – is to be remembered for any notable achievement, one will stand out prominently. It’s the mobilization of the vast mass of ordinary Americans, with no great wealth or financial expertise, into a formidable array of investors. Perhaps most significant of all, this did not occur in a haphazard fashion with individual aspirants seeking to emulate prosperous celebrities of the time, but rather with the mass of middle-class, middle-income citizens, induced to participate, almost involuntarily, in pre-formulated programs few if any of them truly understood.

The financialization of the nation occurred in three distinct and overlapping programs, in some ways augmenting one another. The first constituted nothing more than a government scheme instituted solely as a reelection device by then-President Franklin D. Roosevelt as a part of his 1936 reelection campaign, known as Social Security. In its essence, it established by decree the requirement all employers and employees contribute annual sums into a federal fund which, upon each employee’s retirement, resulted in a small monthly retirement payment. Although widely publicized and lauded at the onset, the amounts involved proved miniscule. The practical effects at the time seemed to be of no consequence.

The second program developed with no governmental input whatever. It resulted in the slow but steady acquisition by the workers of America of corporate securities through a holding device known as the mutual fund. First appearing in 1924, and promoted by a growing cadre of financial advisors, massive numbers of modestly endowed individuals were convinced this sort of investment represented the road to prosperity. It became, for all practical purposes, the middle-class investment by default.

The third and final program was a governmental stratagem, first introduced in the Employee Retirement Income Security Act of 1974, known as the Individual Retirement Account (IRA). It’s a portable retirement account allowing contributions from workers independent of any employer involvement. Its touted benefit is the ability of the contributor to claim the investment as an up-front tax deductible expense. As you’d expect, the IRA is remarkably popular, largely the result of intense marketing efforts by the securities industry. Most certainly we all want a tax deduction.

With these three investment devices regularly utilized by millions of persons, it seems only reasonable our middle-income earners and retirees are becoming increasingly prosperous, if for no other reason than systematic savings and investment must result in profit ... to which I’ll now add: If only it were so. The question coming immediately to mind is: How can it be, with tens of millions of Social Security recipients, and tens of millions more mutual fund owners, and still more well established IRA funds, the majority of Americans cannot – as recently reported – produce $400 to resolve an unexpected emergency expense?

Why also, in 2018, did 39.6 million persons receive SNAP (the equivalent of food stamps), with 73.6 million on Medicaid (free medical)? Specifically, why aren’t the vast majority now profiting from the investment programs functioning these past many decades? I harbor a few thoughts on the subject.

Social Security: Although the Social Security system developed as little more than an electoral afterthought, it grew to become one of our nation’s most massive economic projects. For those of you whose recollection actually dates back to its initiation, you’re aware it was never intended to become a meaningful source of retirement income … merely a cleverly crafted sop to suggest to the millions of victims of the Great Depression that the Roosevelt administration empathized with the downtrodden and therefore deserved to receive their votes in the coming election.

Federal programs distributing financial largesse of one sort or another tend to morph in size and scope. As more persons receive ever more benefits, the demands become increasingly incessant, along with the political pressures to institutionalize the system by vested interests. This is where Social Security is today. It’s a political grab bag wherein the benefits will be increasingly limited by the nation’s unwillingness to fund them.

In 2018 the average monthly Social Security payment became $1,404, which included a 2% cost-of-living increase from the prior year. By contrast, an employee earning $132,900 in salary this year will generate $20,333.70 in FICA taxes. It is quite clear no one will ever become independent by relying upon a Social Security payment. It’s equally clear a person’s spare investment income can be wiped out by FICA taxes.

Fund Investment. Most Americans have few choices as to what they can invest in. As bank accounts, bonds, and CDs no longer pay meaningful interest, they’re unsuitable. The acquisition of corporate securities requires knowledge and a sense of confidence – a rare commodity among aspirants. The ownership of rental real estate, as well as mortgage lending, requires substantial cash and continual involvement; this rules it out for most persons.

The exotic items regularly promoted, such as precious metals, annuities, raw land for speculation, initial public offerings, timeshare investments, work-at-home projects, futures, vehicles tied to derivatives, and all sorts of other scam-like offerings normally generate nothing but losses. So, as few possess investment expertise, they’re relegated to the recommendations of the financial planning industry … and the choice is invariably the mutual and/or exchange traded fund.

The program is simplicity itself. The investor gives his money to a financial advisor. As a typical client you’ll simply be sold into a number of funds, usually index funds. Whether the funds relate in any way to your financial expectations is incidental. This is partly because most advisors possess little understanding as to what constitutes a sound investment and largely because generating fees and commissions is the primary consideration in the recommendations.

Spokespersons for the industry contend that, as typical index funds grow in value about 10% per year, the investor will profit handsomely over the decades. They rarely mention, however, the repetitive fees skimmed from each fund, together with the advisor’s fee, plus regular rebalancing of the portfolios, actually result in an annual return of less than 4% – this is assuming no serious losses occur due to poor fund selection. Thus, as you see, few fund investors will accumulate enough assets to become truly prosperous.

The IRA. At this point a testimonial is in order. In the mid-1970s my wife and I opened IRA accounts to take advantage of the deductions offered. I admit to giving minimal thought to it. About eight years later, when I finally took the time to see how the numbers appeared to be working out, I was dismayed. Clearly the deduction benefits thus far received in no way equaled the costs to be likely incur in the future … and the longer we lived, the less well we’d fare. It became obvious the actual intent of the law wasn’t to benefit the taxpayer, but to feather the government’s nest in future decades.

As you might guess, we cashed out of both IRAs at year’s end, took our lumps by paying the taxes and penalties, and never looked back. It’s now more than three decades later, and every so often one of my friends or associates will complain about the taxes their IRA distributions are costing them. I merely smile and wish them well.

A final thought: As I suggested at the beginning of this article, the programs promoted by government and the financial industry to assist the average American in becoming prosperous can only be described as fallacious.

The three I’ve described here were clearly designed and are now operated for a single purpose: to systematically milk the clients and taxpayers of their assets. Whether we as a society warrant the shellacking we’re receiving is debatable, for I’m not certain if persons who chose not to look out for their own interests deserve to be taken advantage of. What’s your opinion?

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience.

Al can be contacted at al@abjacobs.com