The "Greenspan squeeze" is ready to put your retirement income in a vise. This is my name for a series of moves orchestrated by Federal Reserve Chairman Alan Greenspan and embraced by a spineless, budget-busting Congress that will reduce the cash flow that just about everyone will have in retirement. At its worst, the Greenspan squeeze has the potential to turn a modestly comfortable retirement in old age into poverty. But if you start planning now -- and if you're lucky -- you could avoid having your retirement goals caught in the wringer. In this column, I'll try to explain where the squeeze is coming from and which assets are going to get pressed hardest.
Feb. 25 testimony before the House Budget Committee. Greenspan started off with some unpleasant facts: The country faces huge annual budget deficits as far as the eye can see, and an even larger bill for retirement and health care benefits for the soon-to-retire baby boom generation. The Social Security Trust Fund, the pool of IOUs and current tax payments that funds monthly Social Security checks, is forecast to hit red ink in 2018 and be exhausted by 2042. Over the next 75 years, total unfunded Social Security benefit liabilities come to about $26 trillion, according to the Cato Institute. Of course, if Congress put money in the trust fund now, it would have to cough up a much smaller amount of cash -- about $5 trillion. But given that the federal budget is already in deficit, raising taxes would be the only way to do that. That, says Greenspan, would put the economy at risk and reduce future growth. (Which would, of course, make it even harder to balance the federal budget.)
So Greenspan urged Congress to cut benefits rather than raise taxes, a cynical ploy because we all know Congress has no appetite for increasing taxes, especially in an election year. Greenspan left the recipe for cutting benefits rather vague. He did talk about extending the retirement age again; it's already set to rise to 67 for anyone born after 1960. And he spoke about the need to reduce cost-of-living increases in payments. So what's the big deal? There's nothing especially shocking about what Greenspan said: It's well known that the trust fund will run out of money. His suggested "benefit cuts" resemble those in the 1983 Social Security reform package. Maybe he was cynical in even suggesting that Congress would consider raising taxes, but cynicism about Congress is an honorable tradition that goes back to the drafting of the Constitution.
Chump change, you say? If it were a difference in the value of the assets in a retirement portfolio, I'd agree. But it's not. This is a difference in cash flow. Income. And therefore this relatively modest annual difference represents a much bigger swing in the portfolio assets that an investor must own to produce that cash flow. In other words, to replace that $1,656 in annual income, you'll need an extra $20,700 in your retirement fund. To get that number, I'm assuming the portfolio yields 8%. Of course, who can get an 8% yield these days? That's where the other side of the Greenspan squeeze kicks in. The 10-year Treasury note is paying just 4.01%. At that rate, you'd need an additional $41,297 in your retirement fund to replace the lost Social Security income. If the consensus projection on future equity returns is correct, forget about making up the difference by buying stocks. Stocks are likely to return only 8% in the next decade, the majority opinion now holds. And if you follow financial planning advice, you'll only cash out half that gain in any year so that you won't outlive your money -- or about a 4% again.
The BLS has been using methods like this for years to measure inflation in the cost of things like cars and computers. The BLS performs other interesting mathematical feats when it calculates inflation as well. For instance, the bureau measures inflation in the cost of housing not by how much the price of a home goes up, but by how much the cost of renting a similar house has increased or decreased. That worked until rents and housing prices began to diverge in the 1990s. Grant's Interest Rate Observer has calculated the current inflation measured by the consumer price index at 2.2% using rental rates would now be 3.6% if home prices were substituted in the inflation calculation.
Would you buy high-yield bonds, affectionately known as junk bonds, when investors are being squeezed to find extra income? Maybe not. On Oct. 12, 2002, the spread -- bond-market speak for the difference between the yield on higher-risk junk bonds and Treasuries with, theoretically, no default risk -- was 10.6 percentage points. By Jan. 26, 2004, that spread had shrunk to 3.4 percentage points. I know corporate profits have been getting better. With low interest rates, companies have been able to repair their balance sheets to a degree. Yet the difference of 3.4 percentage points between the yield on a risky junk bond and on a U.S. government Treasury seems a rather skimpy return for assuming that extra risk. According to the models run by Martin Fridson, editor of LeverageWorld, that Jan. 26 spread between riskless debt and junk was almost 2 percentage points less than it should have been to adequately compensate for risk.