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.

What's the Greenspan Squeeze?

The part of the Greenspan squeeze that deals with actual cuts in Social Security benefits has been getting a lot of headlines lately thanks to the Fed chairman's 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.

Chaining the Consumer Price Index

Put Greenspan's Social Security testimony together with the rest of the Fed's overt policy and public lobbying, though, and you have a formula for significant reductions in cash flow for most Americans who are looking to retire in the next 20 years.

For example, connect Greenspan's comments on lowering cost-of-living increases in Social Security payments to his longstanding preference for an inflation measure called the "chained" consumer price index. Unlike the version of the consumer price index used to measure inflation now, the "chained" index assumes that consumers spend less on things when their price goes up.

The effect is to lower the measured rate of inflation. Inflation as measured by the consumer price index has been 2.1% since 2001. Using the chained index, it was 1.8%.

Over time, that paltry 0.3% adds up. Over 10 years at 2.1%, a monthly Social Security payment of $1,600 rises to about $1,970; at 1.8% it climbs to just $1,912. That's a difference of $58 a month, or almost $700 a year. Over 20 years, the difference between the two inflation rates is $138 a month, or $1,656 a year.

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 Feds Can Play Games With Your Income, Too

See the squeeze? Wait, it gets worse.

Like any huge debtor, the federal government is interested in lowering its interest payments. But unlike any other debtor I can think of, the federal government keeps the numbers that control how much interest it pays out on inflation-linked obligations.

So, for example, the Bureau of Labor Statistics (BLS) has begun a study to see if the "true" rate of inflation in health care is lower than current measures. The idea is that the consumer price index doesn't subtract the improving quality of health care from any annual increase in the price of health care. We're getting an "improved" product each year: We're living longer. Thus, to correctly calculate inflation, you'd have to subtract that improvement in the health care product from any annual increase in the price of health care.

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.

A Huge Incentive for Lower Inflation Estimates

Alan Greenspan doesn't have anything to do with this kind of statistical legerdemain. But you don't need to be a conspiracy theorist to imagine that a government that's running huge deficits requiring constant financing would favor measures that show inflation is low.

And here's how this inflation number affects the other side of the equation. With government-measured inflation low, interest rates can stay low, and that means investors looking to increase their cash flow are facing yields of 4% on 10-year Treasuries and 0.95% on 3-month Treasury bills for a long time to come.

Which Assets Are Squeezed the Hardest?

The retirement problems Greenspan's squeeze causes will extend to investors who aren't counting on Social Security to provide anything for their retirement. I'd argue that the squeeze has an effect on asset classes from bonds to equities.

For example, would you buy TIPS from this government? Treasury inflation protected securities pay an interest rate that goes up with inflation as measured by the consumer price index. The principal value of a TIPS is also adjusted to compensate for inflation, again measured by the CPI. The U.S. Treasury will issue $40 billion to $60 billion of TIPS in 2004, up from $25 billion in 2003.

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.

Too Much Cash Is Chasing Yield

Investors, I'd argue, are taking on too much risk in their search for income. They're bidding the prices on some securities higher than what may be prudent. And that's likely to bring pain to at least some portfolios.

Finally, if the Fed is keeping interest rates at their current 40-year lows because of the way that the federal government calculates inflation, then isn't the stock market's high valuation more of a problem than it seems? (If inflation rates were higher, the Fed would, on past evidence, be more inclined to raise interest rates to head off an inflation problem.)

Low interest rates are the major justification on Wall Street for current stock prices. We hear this argument every day: Don't worry about statistics that show the current stock market is overvalued by past measures such as price-to-earnings ratios. This is a period of extraordinarily low interest rates. Adjusted for low interest rates, the stock market is reasonably valued.

Hmmm. There's that adjustment thing again.

Any time interested parties, whether it's the government or Wall Street, start arguing for adjusting the numbers, I start to worry.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at jjmail@microsoft.com.

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