National Policy, Personal Choices

Friday Reflection | August 28, 2020

National Policy, Personal Choices

In the midst of the Republican National Convention this week, Joe Biden put forth a radical proposal to change tax incentives for retirement savings. Meanwhile, Fed Chairman Jerome Powell introduced a shift in the Fed’s thinking on monetary policy that would explicitly tolerate more inflation than it has in the past. They have committed to low interest rates for longer as a way of supporting a recovery in economic growth, reducing unemployment, and avoiding investment asset value declines. The only downside: consumers and investors both worry about inflation.

Inflation isn’t necessarily a bad thing – just as spending isn’t necessarily a bad thing.  Like Goldilocks’ porridge, though, it needs to be just the right temperature.

Effectively, the Fed has decided to make money cheap (by keeping interest rates low), but allow goods to cost a little bit more. In recent decades, the Fed has raised interest rates when economic growth was strong as a strategy to keep inflation under control; higher rates make borrowing more expensive and slows down corporate investment activity. In addition, higher interest rates reward savers, and allow them to earn enough income to offset – you guessed it – inflation.

Inflation matters to consumers because it has a material effect on quality of life.  When prices rise, you need to earn more to be able to buy the same set of goods and services. If prices rise faster than your income, then you are losing “purchasing power” – and you cannot purchase as much as you had previously. To live “on a fixed income” is considered a difficult situation for exactly this reason.

All kinds of things can push up the costs of basic goods, whether food, fuel, or more durable consumer goods like vacuum cleaners or televisions. Increasing expectations of innovative products that provide higher quality or additional features can push up prices, leading a particular product or service to jump 5-10% or more in a given year, far above the 3% long term average inflation rate in the US. An offsetting downward price pressure comes from technical advances that, over time, allow production of the same product at a lower price.

Expectations of increased capacity and new features, however, can lead to a higher price and consumer acceptance of a higher priced product. An early example from last century is vacuum cleaners. When vacuum cleaners began to be mass produced, it was no longer acceptable to have a dusty rug in your parlor that you only took outside to beat clean twice a year. Vacuum cleaners not only required a lot more time invested, but they cost a lot more than a broom.

In recent decades, health care spending has been nearly double the general rate of inflation, and in this sector there has not been an equivalent benefit of technical innovation bringing down prices. To prevent further increases in premium cost for their employees, employers (or individuals on their own behalf) have instead been choosing higher deductible plans. This has led to people delaying or refusing care that they can’t afford. Technical advances in data sharing and in the shift to telemedicine may offset this somewhat, but the net cost increase in medical care is an example of the sort of inflation that can truly reduce our quality of life by putting good health out of reach.

Employer sponsored retirement plans have been one of the most powerful ways that many Americans have been able to save towards retirement. Still, median balances are not high. A 2017 study by the Government Accountability Office (GAO) found that for people between the ages of 55 and 64 – just ahead of the commonly expected retirement age of 65 – their median retirement savings totaled $107,000. Biden’s policy idea is to heavily weight tax incentives via credits or matches to lower income workers, and thus help them save.

All decisions to save money, to set it aside and not exchange it for goods and services today, are still essentially spending decisions: they are allocations to future spending. Commonly people will save money today and forego spending in order to be certain of having it in the future – a down payment on a house, living expenses while on an extended parental leave, college expenses for a child, and the biggie, retirement. In a world where prices increase over time, the value of savings needs to keep up, or there will be no incentive not to just spend it now. From the perspective of social policy, promoting retirement savings – and appropriate investment options until those savings are needed – is a key element of ensuring a stable standard of living for retirees, and avoiding the “fixed income” that can force a gradual reduction in quality of life and care as we age.

Regardless of tax incentives, the benefit of saving money is the simple act of savings itself. It is the habit you develop, the ability to pick and choose when to spend, and the commitment to setting aside something every paycheck, every month, every year.

While savings may simply be future spending set aside for a limited period of time, human psychology sometimes wreaks havoc with that intention. Delaying gratification by going without something you’d like to buy isn’t easy, and it takes willpower. Over time, most people develop a sense of pride in accomplishment as they see savings accumulate, and that translates directly into a sense of increased security.

As habitual beings, we feel a lot of discomfort in retirement when we have to reverse our behavior, and start spending our savings for living expenses. We are convinced that savings are not to be spent, and it is hard to feel okay depleting the pool of assets you worked so hard to accumulate.

Additionally, the uncertainties we face in retirement differ significantly from those of your working years, perhaps raising children or helping care for elderly parents. Now your own health is starting to show some wear and tear, and once you stop working to earn an income, your flexibility is reduced. Having a substantial pool of savings, and learning the new habit of managing those savings becomes your financial focus

We are living in a time of perhaps greater uncertainty than most historical moments, awaiting better medical solutions to a pernicious and poorly understood virus. We can’t know what policy changes may offset inflation or support retirement savings in the coming years, although we know there is a bipartisan commitment to supporting that savings.

Regardless of policy, each one of us needs to develop our own clarity about current spending choices – and future spending hopes. Knowing why you are saving gives meaning to each act of delay or thrift, and helps keep us focused on what is most essential on our particular path. Wealth is not a matter of amount – it is a matter of knowing what spending – and when spending – will bring you the most value.