Economist Urges 'Safety First' Investing Approach

The way economist Alan Blinder sees it, we're standing at a fork in the road. One way leads to a happy-days-are-here-again recovery, the other to continued economic enervation. But both paths are strewn with hazards that can trip up retirees' savings if they aren't careful.

Blinder's so worried about those risks that he's spreading the gospel, particularly to the older investors he thinks are most vulnerable. "This is a dangerous time, especially for retirees and near-retirees who need to think about safety first," he told the AARP Bulletin in a recent interview.

Blinder's views are worth hearing. A widely respected economist, he has been vice chairman of the Federal Reserve Board, a White House adviser to President Clinton, Albert Gore's chief economic policy adviser during the last presidential campaign, chairman of Princeton University's economics department and author or co-author of 13 scholarly books. Now 57, he teaches half time at Princeton and is launching a financial consulting company. The man knows his economics, and this is what he sees.

First, the good news: Blinder is betting on a recovery. He believes the nation is poised for economic growth that could top 4 percent in the second half of this year. That would create new jobs and send stocks and interest rates soaring. "That's bad news if you want to refinance your mortgage but good news if you live on interest income," says Blinder.

It may be dangerous news for investors who took a lot of money out of the stock market and put it into long-term bonds (those lasting 10 years or longer) or mutual funds that specialize in long-term bonds.

"There is … [the] quite large risk that people who are heavily into long bonds will be sitting on large capital losses," Blinder frets. If interest rates on 10-year Treasury notes rise from 4 percent to 6 percent, for example, the value of those notes will drop by almost 14 percent. "You can have a sizable loss, and that's not well understood," he says.

And those are the risks of having a healthy recovery! If, instead, the United States takes the road not expected—toward what Blinder calls "deflation, job destruction and continued underperformance"—then interest rates would continue to fall, stocks would do poorly and investors wouldn't have any place at all to earn money on their money. Stockholders would be punished more, and that's a frightening environment for older investors. "If you're 80 or 70, you have a lot less time to recoup stock market losses if things turn sour," he warns.

What to do? Blinder has a three-part prescription that he says should keep retiree portfolios safe and still offer some earnings to grow on. His plan, for people who can't afford to put a lot of money at risk but need to live on their savings, goes like this:

(1) Keep at least 50 percent of your money relatively liquid and safe, in very short-term CDs or Treasury bills; (2) use those funds to build a ladder of longer-term Treasuries or CDs; and (3) put a portion of your money into low-cost mutual funds that specialize in dividend-paying stocks, if you can stand the stress.

Blinder prizes liquidity above everything else right now because he believes the economy will recover. "The byword is to stay liquid," he says. "If interest rates go up, you want to be able to redeploy your assets into higher yielding instruments, and not have them stuck in a 10-year bond paying 3.5 percent, for example." He notes that investors could stay liquid by keeping their money in money market mutual funds, but those are currently paying less than 1 percent a year in interest.

Savers can gin up those returns a little bit by building what's known as a "ladder" of CDs or Treasury bills, says Blinder. If, for example, you have $40,000 to put away, divide it into eight equal portions of $5,000, and use the various portions to buy a series of Treasury bills or CDs that mature in three-month intervals over the next two years. For example, put $5,000 in a three-month CD, $5,000 in a six-month CD, and so on, all the way out to two years. You could extend the far reaches to three or five years, he suggests, as long as you start at three-month intervals in the short term.

As each CD or T-bill matures, you can reinvest it for the longer term, say, by buying another two-, three- or five-year CD. Eventually, you will build a revolving portfolio of safe instruments earning three- or five-year rates, but with some money coming due every three months to reinvest. This strategy locks in some money against interest rate declines and keeps you liquid. "If you have money coming in every three months or every six months, then you're in a relatively good position to take advantage of rates as they go up," he says.

This is a good place to interject that Blinder is in a position to make some money on the CD market. His company, Promontory Financial Group, mainly caters to banks. And one of its subsidiaries has just created a CD exchange that allows banks to offer FDIC insurance on more than $100,000 in deposits from individual savers. But savers who want to pursue the laddering strategy that Blinder recommends don't have to use banks that belong to his exchange. Investors who have brokerage accounts can effectively do the same thing by buying CDs through their brokers.

The dividend-paying stock funds are great investments for the long haul, Blinder says. But you have to be able to stomach the downside risks. "History suggests that stocks are a good investment, but history also tells you that there are periods of 10 to even 20 years in which they prove to be a bad investment," he says.

He cautions investors who can't afford to lose any money to stay away from stocks and stock funds. "If you're going to have to sell your house or do without health insurance if you lose money, the downside risks are too great," he warns. "If this is going to stop you from sleeping at night, it's not worth the anxiety. But if you're a more relaxed person … then it makes sense, because the expected return is higher."

Those expected returns are especially higher now that Washington has enacted the Jobs and Growth Tax Relief Reconciliation Act of 2003, the new tax law. [See related article: A (Less) Taxing Time.]

That tax law also carries both good news and bad news, says Blinder. It includes child credits, tax cuts for married couples and across-the-board rate cuts that will provide "real fiscal stimulus" that makes the economic recovery more likely. "Real people are going to get real dollars in their pockets, and being Americans, they're going to spend them," he says. It will help produce that short-term bright outlook.

But as an economist and a life-long Democrat, Blinder sees bad in the bill, too. "The way this bill phases things in and then sunsets them out … [makes it] … an accounting embarrassment," he says. "A company that did this to its books would be under extreme scrutiny by the [Securities and Exchange Commission] if not in fact put in handcuffs and taken away."

The accounting gimmicks in the bill will eventually cause two problems, says Blinder. First they make a messy tax code even messier, and that erodes public trust in the tax system. "The tax code has just grown so complex and so ugly, like an unkempt hedge or lawn that never gets mowed. Everybody thinks that the other guy is beating the tax code, and they're being suckered. They are the schnooks, and the other people are getting away with it," he said.

Problem two may be even more worrisome: Once Congress fixes all the accounting gimmicks, the deficit will balloon, at about the same time that the baby-boom generation starts to collect on its Social Security and Medicare promises. "We're creating a fiscal burden down the road that will need to be addressed, and it's not that far off. I'm afraid that what's going to happen is that we'll wind up doing something only when our backs are to the wall," Blinder says.

"We've been singing this song for a long time," he adds. "If we start early, we won't have to do anything that's that painful, whereas if we wait until the wolf is at the door, we're going to have to do some nasty things. I'm afraid that we're headed to the wolf at the door."

Linda Stern is a freelance writer in Washington, D.C.