If you’ve been watching the national news lately, one of the topics creeping back into the discussion is the federal debt ceiling. Our nation’s debt is expected to reach the current ceiling in early November if Congress doesn’t raise the current limit.
Since it’s a topic that seems to come up on an annual basis, I began thinking about what the ballooning federal debt means for the average American investor over the next 10 to 15 years. This article analyzes what the growing federal debt may mean for you, and some actions you can consider to hedge against these risks.
How Bad Is It?
First, let’s start with some sobering statistics about our nation’s finances. Then I will relate what this means for you as an individual investor.
According to TreasuryDirect.gov, the current U.S. debt stands at approximately $18.15 trillion. I have often seen this figure stated in terms of debt per capita, but that’s not an overly helpful ratio because the government’s primary way to raise revenue to pay for debt and the interest on it is by taxing wage earners. Only about half the country is in the labor force — approximately 156.7 million people.
That means there is almost $116,000 of U.S. debt per American worker!
Congressional Budget Office 10-Year Outlook
Now let’s look at the Congressional Budget Office’s (CBO) 10-year outlook for 2016-25. In the table below, I have summarized some of the key data:
The first number that jumped out at me is GDP growth. The CBO is banking on projected GDP growth of almost 4.4% per year, growing from just under $18 trillion currently to $27.3 trillion by 2025. If you have been following the news lately, we are struggling to get to 4% growth.
Next, take a look at the tax-to-GDP ratio. If we use GDP as a proxy for the nation’s total personal and corporate income, then the tax-to-GDP ratio gives us an overall effective tax rate for the economy. Right now it is a little more than 18% and is projected to stay there.
However, if we look at growth of federal expenditures and the ratio of federal expenditures to GDP, we can see our spending rate is projected to grow from 20.6% of GDP currently to 22% in the next 10 years, with annual projected deficits reaching $1 trillion by 2025.
That means the gap between the effective tax rate and the effective spending rate for the country is projected to continue to widen from a little more than 2% currently to about 4% by 2025, and that’s if the economy can grow GDP at a robust rate. This projection shows a potentially dangerous path, because at the point in time when the gap between the tax rate and spending rate exceeds GDP growth, it means our debt level in relation to GDP will be on a path to unsustainability.
The doomsday scenario at some point in the future would be loss of confidence in the federal government as a credit risk, significant devaluation of the dollar, and hyperinflation.
On the optimistic side, several things could occur to prevent such a scenario. One obvious solution is that our policymakers in Congress have the ability to act to prevent such a result, either through cutting spending or raising taxes.
Most of the future spending increases relate to social welfare programs (i.e., Social Security, Medicare, and Medicaid) due to the entire baby boomer population reaching Social Security retirement age in the next decade.
Therefore, my opinion is that it will be much more likely that we’ll see tax increases before spending cuts, because I doubt that members of Congress (many of whom are also baby boomers) will cut benefits for themselves or a large group of their voting constituents. Potential tax increases obviously have implications for you as an investor, which I will discuss below.
Another way to get out of our path to unsustainability would be through unexpected GDP growth. This translates to a larger tax base and therefore increased tax revenues. That could happen either through unexpected gains in worker productivity, such as from breakthrough technologies that are unforeseen, or from a higher-than-expected expansion of the workforce, i.e., population growth of working-age people.
Hedging Against an Unknown Future
With Congress’ approval rating below 15%, my guess is that if you’re reading this article, you probably don’t have a lot of confidence that Congress will get its act together and solve these policy issues any time soon. So how do these issues relate to you as an individual investor, and what are some actions you can consider to hedge against a doomsday scenario in our country’s finances?
Protecting Against Potentially Increasing Taxes
Let’s start with the most obvious implication for you — taxes. If we look back at the table above, in order to balance our nation’s budget, the overall effective tax rate would need to increase from its current rate of 18.2% of GDP to 20.6%. That equates to an increase of 13.1%.
Looking at the table again, if we keep kicking the proverbial can down the road, then the CBO is projecting that taxes would need to increase from 18.2% of GDP to 22% in 10 years. That would equate to a tax increase of more than 20% in order to balance the budget.
As I highlighted in one of my previous articles, investors have the majority of their retirement savings in tax-deferred accounts. This means that all of the money in those accounts will be subject to the ordinary income tax rates in place at the future time you withdraw the money. Based on the data currently available to us, if I were forced to bet whether ordinary income tax rates will be higher or lower 10 years from now, I would bet higher, and possibly significantly higher.
That’s why I urge investors I meet with to hedge some of this risk and consider paying the tax on a portion of that money today. If you do, you can convert a traditional IRA into a Roth IRA account, which will then be tax-free from that point onward and insulated from future tax hikes. I discuss this option, sometimes called the backdoor Roth IRA, in greater detail in this post.
Sometimes I get pushback on this issue for a couple of reasons. One is that many investors don’t want to pay any taxes until they are absolutely forced to do so.
Another reason is that some investors believe that by delaying the tax they can grow the account to a much bigger value. This is true until you have to pay the tax in the future. In other words, if it turns out that the tax rate doesn’t change, then there is no difference in the outcome. Let me illustrate:
Suppose I have $100,000 today. It will grow at a 5% rate for the next 20 years, and I can either pay a 20% tax on it now or a 20% tax on the future value in 20 years. If the tax rate stays the same, then the net after-tax money available stays the same regardless of which option is chosen:
- If I pay the 20% tax now and convert the money to a Roth IRA, then my account starts at $80,000. If I compound $80,000 at 5% for 20 years, it grows to $212,264, at which time no further tax is due.
- If I instead wait to pay the tax, then the $100,000 grows to $265,330 in 20 years — at which time I would need to pay the 20% tax on that amount. It still winds up at $212,264.
I also get pushback because many people are convinced they will be in a lower marginal tax bracket and thus have a lower overall effective tax rate in retirement than they have now. This may be true, especially if you are a high-income earner falling in the 28% marginal bracket or above, but a well-thought-out calculation does need to be done.
For example, after my previous article discussing Roth IRA conversions, I spoke to a gentleman in California who is a solid income earner and who is certain he and his wife are going to retire in a state other than California. In that situation, it probably is wise to continue deferring all taxes because California has some of the highest state tax rates in the nation on top of the federal rates. The states they are looking to retire in have much lower tax rates.
When you analyze your own tax situation for your projected retirement, be sure to take into account required minimum distributions from your IRAs as well as your Social Security income. For many people, up to 85% of Social Security income will be considered taxable income.
If you fall in the 25% marginal tax bracket or below, you should at least consider hedging a portion of your future income tax exposure.
Protecting Against a Devaluation of the Dollar
Another risk presented by weakening government finances is the potential for a significant devaluation of the dollar.
In my opinion, the easiest way to hedge against this risk is to have a portion of the portfolio devoted to owning a basket of international stocks. There are hundreds of such funds available in the marketplace.
That way, you own a basket of growing companies all around the world in multiple other currencies, you receive dividend income along the way, and you participate in world growth. If the dollar does suffer a crisis, then those international holdings will increase in value purely because of the currency exchange.
The great part of this strategy is even if the dollar doesn’t suffer a crisis, there are still benefits of having a diversified portfolio containing a basket of international stocks. The U.S. is a mature, developed economy, whereas the international emerging markets have future prospects for higher growth.
On top of that, because international stocks have suffered a beating in 2015, they also currently offer more dividend income than the S&P 500. Many international funds are paying a 3% dividend rate or more right now.
Why I’m Not a Fan of Gold as a Hedge Against the Dollar
Some people hedge against a doomsday scenario for the dollar by owning gold in their portfolio. I am not a fan of this strategy for several reasons.
One is that gold is typically just a tiny portion of a person’s portfolio and therefore is not significant enough to do much to counteract the effects of a crisis in the dollar in the remainder of the portfolio.
Second, gold is just a piece of metal. There is only so much of it in demand in industrial and manufacturing processes. The remaining value of gold is purely due to its speculative value and history as a medium of exchange before state-sponsored currencies came into widespread use.
I would rather own a worldwide basket of growing businesses that pay me dividend income along the way than a piece of metal that only has speculative value because of its use as a historical relic.
Warren Buffett also offered some good commentary on gold in his 2011 Annual Letter to Berkshire Hathaway shareholders. Here is a small portion of that commentary:
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future.
* * *
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor productive. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
Social Security Risk
And finally, a brief comment about Social Security.
There is an interesting cultural phenomenon in our society with Social Security. For many of the baby boomers (currently ages 55 to 70), retirement is solely possible because of Social Security. However, when I speak with people age 40 or younger, I don’t believe I have met a person yet in this age group who believes Social Security will be anywhere close to its current form by the time they hit 65 or 70.
If you carefully read your annual Social Security statement that projects how much your benefits will be when you reach full retirement age, the fine print in the statement states that benefits aren’t guaranteed and could change at any time.
If Congress does start reducing Social Security benefits, one of the easiest cost-saving measures would be to eliminate the annual cost of living adjustment (known as COLA). Therefore, when I speak with baby boomers, I suggest to them that a prudent retirement projection should assume that Social Security benefits could become a static level payout and may not increase with inflation in the future.
For those of us falling in the 40-and-under age group, I happen to agree that it is prudent to plan for retirement assuming Social Security will be nowhere close to its current form, or possibly even nonexistent.
Tim Van Pelt is a financial planner. You can reach him at email@example.com or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investing, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisors before engaging in any transaction.