The essence of debt serfdom is debt rises to compensate for stagnant wages.

I often speak of debt serfdom; here it is, captured in a single chart. The basic dynamics are all here, if you read between the lines:

1. Financialization of the U.S. and global economies diverts income to capital and those benefitting from globalization/ "financial innovation;" income for the top 5% rises spectacularly in real terms even as wages stagnate or decline for the bottom 80%.

2. Previously middle class households (or those who perceive themselves as middle class) compensate for stagnating incomes and rising costs by borrowing money: credit cards, auto loans, student loans, etc. In effect, debt is substituted for income.

3. The dot-com/Internet boom boosted incomes across the board, enabling the bottom 95% to deleverage some of the debt.

4. When the investment/speculation bubble popped, incomes again declined, and households borrowed heavily against their primary asset, the home, via home equity lines of credit (HELOCs), second mortgages, etc.

5. The incomes of the top 5% rose enough that these households could actually reduce their debt (deleverage) even before the housing bubble popped.

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It’s a multi-dimensional question.

The left says yes — income inequality has soared in recent years, and the way to address it (supposedly) is to tax the rich and capital gains at a higher rate. The right says no — that the rich already create more jobs and wealth, because they spend more money, and why (supposedly) should they pay more tax when they already pay far higher figures than lower-income workers?

Paul Krugman made the point yesterday that the tax rate on the top earners during the post-war boom was 91%, seeming to infer that a return to such rates would be good for the economy.

Yet if we want to raise more revenue, historically it doesn’t really seem to matter what the top tax rate is:

Federal revenues have hovered close to 20% of GDP whatever the tax rate on the richest few.

This seems to be because of what is known as the Laffer-Khaldun effect: the higher rates go, the more incentive for tax avoidance and tax evasion.

And while income inequality has risen in recent years, the top-earners share of tax revenue has risen in step:

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At current rates, in excess of 2.5 million dollars invested in a balanced portfolio is required to generate 60K income for life.

Last week, the Canadian government announced a reduction in eligibility for the Old Age Security Benefit from age 65 to 67 starting in 2023. This means all Canadians age 54 and younger today will receive less retirement income from the federal government. We should expect more of this to come as pensions worldwide struggle with mounting deficits, thanks to poor investment management and insufficient contribution levels over the past 15 years. Now deficits are compounding thanks to zero-bound interest rates courtesy of central bankers everywhere.

This week one of the largest Canadian pension plans, the Ontario Teachers’ Pension plan, announced a 9.6 billion shortfall in capital needed to fund pension obligations. In response Ontario’s Finance Minister advised that the cash-strapped government is not prepared to increase employer contributions to the teacher’s plan: “We are saying benefits have to be cut”, was his official statement.

This is the inevitable outcome of more than a decade of can-kicking in the pension management area. The demographic cost of the aging boomers was easy to predict and calculate. But the numbers were simply not attractive to those looking to spend their way to prosperity.

The solution of choice was for employees and employers not to increase contributions, but to hire investment managers who promised to make a mountain out of a mole hill. I am reminded of some pension presentations I was asked to give over the past 10 years, where my recommendation was to discard static allocation models, lower equity exposure to control risk and lower return targets to a more realistic level in the 5% range. No pension boards hired our firm after these presentations. All the managers who were happy to promise higher returns got these jobs.

Assumed annual returns of 8%+ were plugged in and everyone hoped for the best. Except 12 years into this secular bear in stocks, investment returns have been under-performing target for more than a decade. The deficits are finally getting too large to overlook. Benefits are likely to be reduced for future recipients, as well as pushing out eligibility triggers.

Yesterday I met with some long-term clients who are members of OMER’s another large Ontario pension plan.  After more than 30 years, they are now eligible to retire on full pensions of 60K a year, indexed. I pointed out that these were incredibly valuable assets: at current rates, one would need to have in excess of 2.5 million dollars invested in a balanced portfolio to generate that kind of income for life.

They were surprised as few people understand the math of how much capital it takes to generate livable income today. I assured them that they and their co-workers were very fortunate to have this rare asset in a world where few defined benefits plans still exist. “But I am the only one in my department to still have a pension” she replied. “Remember 5 or 6 years ago when our employer offered us the option of cashing out a lump sum commuted value? Everyone in my office took that option and gave the funds to financial advisors. They all told me I was crazy for not doing it.  But they have all lost money and now most have just thousands in their retirement accounts.”

“Even $500,000 today may sound like a lot, but at current yields, 500K will give you a maximum of about 15,000 a year of income”  I said. “Thank God you were smart enough not to cash out. “Well”, she smiled, “don’t you remember–you told us not to–we have always taken your advice.”

Sorry for the self-indulgence here, I need it to make this point.  This was a highlight of my day.  But I also felt sad and frustrated for my clients’ co-workers who had taken the advice of the financial sales force and cashed out their life savings into the peak of yet another stock market bubble in 2006-2008.  I had seen many teachers harmed by the same bait in the late 90′s.

Over more than 20 years of advising, I have been a party to many financial decisions that make a huge difference to personal fortunes in the end.  Many of these recommendations add value not captured in the annual performance reports of our investment accounts.

Sound financial advice over time is incredibly useful to those who are willing to hear the truth and execute accordingly.  But it takes wise, unbiased counsel (those not paid to sell products) and disciplined clients to win this race. It is not always easy to do the right risk management things, but over time I have seen that it is incredibly rewarding for real life families. Once again, I am heartened and grateful for the gift of valuable work.