by Michael Shuman
posted Feb 14, 2012
Concerned about Wall Street’s devastating impact on communities? Then invest in yourself—the most local investment of all. Americans’ long-term savings in stocks, bonds, pension, life insurance, and mutual funds total about $30 trillion. But not even 1 percent of these savings touches local small businesses, the source of half the economy’s jobs and output. Is it possible to beat Wall Street’s 5 percent long-term performance by investing in your community? The answer is a resounding yes!
Co-op members who lent to the Weaver Street Market in North Carolina and to the Seward Co-op in Minneapolis earned well over 5 percent per year. Many outside investors who bought preferred shares of the Coulee Region Organic Producers Pool, a co-op of organic farmers, are still receiving an annual dividend of 6 percent. Equal Exchange has paid a dividend to its preferred shareholders averaging above 5 percent for 22 years. Investors who participate in New Markets Tax Credits automatically get a tax credit equal to 5 percent of their capital for each of the first three years and 6 percent for the next four—even if the investment generates no real return whatsoever. Burt Chojnowski’s returns have been good enough to convince outside investors to put more than $300 million into his local companies and projects over 25 years in Fairfield, Iowa. Most of LION’s deals in Port Townsend, Washington, are paying between 5 and 8 percent returns per year. Microlenders on Prosper.com are averaging an annual return of 10.4 percent. Jeff Haugland has paid the local shareholders of Community Grocers in Mount Ayr, Iowa, an annual dividend of 5.25 percent.
All of these profitable initiatives proceeded within existing securities laws. If, however, national or state governments were to implement sensible, simple, zero-cost reforms, the number, variety, and promise of local-investment opportunities could expand dramatically. The many examples in this book— and the thousands of others out there, some of which may be happening in your community right now—suggest that the universe of local investment is expanding faster than financial astronomers like myself can possibly keep track of it.
Not every local company, of course, will beat the 5 percent rate of return from existing markets. Betting on any one or two businesses, just like betting on any one or two NASDAQ stocks, is very risky. No one should read this book as suggesting that we each should pull all our money out of the stock market and put it all into our neighborhood diners or bookstores.
As models for local investment proliferate, the focus will shift to the quality of each investment and the quality of your local-investment portfolio. The country is about to travel up a steep learning curve to discern the best local businesses from the fraudsters and grifters, and how to build a local-economy infrastructure in our communities—replete with local purchasing, entrepreneurship programs, local business alliances, and public policy reforms—that will increase the probability of local businesses succeeding and local investments paying off. One modest step might be to move 5 percent of your money from Wall Street to Main Street each year. By the time you get to 100 percent in twenty years, the nation should have a thriving network of regional stock exchanges and local mutual funds.
But another vexing question about local investment I puzzle over is this: Does it make sense to invest in anyone else’s business, bank, project, or fund until I have thoroughly invested in . . . myself? Might I get a better than 5 percent annual rate of return investing in my own bank account, my home, my own energy-efficiency measures, and my education? Most of us ultimately have a significant portion of our wealth in these intimately close items. Getting these investments right might be the single best way to invest locally.
To beat Wall Street, investments in yourself must achieve not a 5 percent annual rate of return but a 7 percent rate. That’s because most of the options could not qualify for tax-deferred IRA or 401(k) investments, and the extra 2 percent … approximates the lifetime benefit of tax deferral.
Remarkably, though, the 7 percent goal is achievable—and in so many ways that many Americans, perhaps most, might never need to think about retirement accounts again.
1. Become Your Own Banker
There is one absolutely guaranteed place where you can get a rate of return well over 7 percent —in fact, often over 15 percent or 20 percent. Pay off the damn credit cards and stay out of debt! As the Sage of Omaha, Warren Buffett, says, “Nobody ever goes broke that doesn’t owe money.” Besides being expensive and self-destructive, credit card debt winds up sucking money out of your community and into the hands of distant banks, back offices, and collection agencies.
Here are some sobering facts about Americans’ relationship with credit cards. In 1990, the average American household had about $3,000 in credit card debt. It has since more than quintupled to $15,300. By the end of 2010, total credit card debt was expected to exceed $1.1 trillion. According to a recent survey by Consumer Reports, a third of Americans don’t have credit cards at all, but most of these folks are poor and therefore vulnerable to even worse depredations from payday lenders and loan sharks. About half the population pays its cards off every month. The rest of us have a problem—albeit one that can easily be fixed in a way consistent with the goals of a local living economy.
Another consideration underscoring the value of keeping a modest reserve of cash is that we are entering turbulent times. In the last few years, both the stock market and the housing market have tanked and many serious analysts fear that both could crash again, perhaps even more catastrophically. Some predict a perilous period of deflation ahead, where falling prices convince consumers to delay spending and trigger deep recessions. Others fear inflation, given the enormous size of the U.S. deficit and rising oil prices. In either case risk-averse lenders might cut off loans or credit cards, raise rates, or both. Since Sam doesn’t like to gamble, he will create a hedge against uncertainty so he can control in his own federally insured bank account.
This proposal is hardly original. Listeners to AM talk shows may have heard about a similar scheme, called “Bank on Yourself,” which encourages you to invest in a specialty life insurance policy that also can serve as your low-risk bank. Frankly, since your savings have to live somewhere, whether it’s under your mattress, in a money market account, or embedded in a gold stockpile, these options are all worth considering. But given the importance of keeping your money close to home and supporting local businesses, you should probably put your cushion in a locally owned bank or credit union, not a distant insurance company.
The bottom line is this: If you create a slightly larger cushion than you think you’ll need, you’ll never need to worry about credit cards or consumer loans again. What wouldn’t millions of Americans (including me!) do to redo their early years with this kind of approach. At some point, you then could move into the next level of investing. That would not be going into the global stock market. It would be buying your own home.
2. Become Your Own Landlord
Investing in your own home strengthens your community. While the evidence has been debated in recent years, the degree of home ownership in a neighborhood does seem to correlate with many other quality-of-life indicators, such as educational achievement, low crime, civic participation, public health, and property values. This led recent presidents as diverse as Bill Clinton and George W. Bush to push for “an ownership revolution” in the housing market. And if you are diligent about getting your mortgage through a local bank or credit union, where you’ll find the most competitive rates anyway, you can rest assured that your interest payments will be recycled through your community through additional local loans.
A home purchase really delivers two different kinds of valuable rewards. One is that you’ve got a place to live. Hey, you have to live somewhere! Instead of paying a landlord every month, you effectively become your own landlord. Yes, you enter a debt with your mortgage (hopefully, again, with your local bank), but as you pay it down, you grow an asset that ultimately eliminates rent payments for the rest of your life. The second reward is that you now have an asset that you can draw upon for your retirement. At some point, if you need the cash, you can sell your home and move into a smaller one. Or you can enter a “reverse mortgage” with a local bank that pays you an income stream and gradually works you out of ownership. The reality is that most Americans use their homes as their piggy banks for retirement anyway.
Once you’ve saved enough for a down payment, investing in your local home is unquestionably a smarter investment than investing in the nonlocal stock market. Working in your favor is the quirky federal tax code, which allows you to claim a tax deduction for interest on your mortgage. If your federal tax rate is 21 percent, then every dollar of interest you pay can be discounted by 21 percent. This especially helps you in the early years of a mortgage, when nearly all your payments are interest. In other words, your rent is effectively 21 percent lower per year, in addition to the benefits of growing an asset.
Home investment gives a local investor one huge, indisputable advantage. As the custodian of your home and as a participating member of your community, you actually have the ability to increase the probability of your investments succeeding. You can improve your house through repairs, additions, and tender loving care. You can help create a fabulous neighborhood spirit. You can contribute to the success of your public schools. And once you own your home, free and clear, no knuckleheaded politician or CEO can take it away from you. Being an active investor, holding a real deed to real property, means you’re less vulnerable to the next generation of Bernie Madoff–like fraudsters. In contrast, when you place your retirement money on Wall Street, you can only watch and pray.
3. Become Your Own Utility
The typical U.S. household is spending about $3,500 per year on electricity, fuels, and water. If you’re trying to get a 7 percent return on investment or better, you could spend $1,000 on dozens of kinds of efficiency measures that would save you more than $70 on your energy bill each year. You could use your $1,000 to buy a new high-efficiency refrigerator, oven, or washer and dryer—plus you get the bonus of a brand-new appliance. Indeed, you probably can do much better than a 7 percent return. According the U.S. Environmental Protection Agency, customers participating in many utility- or state-sponsored efficiency programs are saving 10 to 20 percent of their energy bills. If Americans took full advantage of the more efficient appliances and took steps to improve the efficiency of their homes and buildings, they could cost-effectively save 10 to 30 percent on their energy bills per year.
According to energy-efficiency expert Greg Pahl, “Home energy efficiency retrofits are probably the best returns on investment you’re going to get, as opposed to putting a windmill in your backyard. The home energy efficiency retrofits can pay for themselves, depending on where you happen to live and what the credits/incentives may be, in just a couple of years. Dramatic savings are realized very quickly. The money that you will be saving on your energy costs from these retrofits will make any further renewable energy system installations much more effective, and much more cost-effective.”
Of course, not every $1,000 investment in energy-efficiency equipment will make your house $1,000 more valuable upon resale—you may not be able to preserve all the principal invested. Some investments, like those in greater insulation, will increase your home value, while others, like appliances with a limited lifetime, won’t. Economists sometimes call the latter a “wasting asset,” which means it loses value over time, perhaps even immediately.
The entire discourse about energy-expenditure savings is oddly disconnected from that of long-term investment for retirement. Household efficiency measures are spoken of in terms of years of payback, with the investment assumed to contribute nothing to the long-term value of your house. If you install a thermal blanket around yourhot-water heater that costs $200 and saves you $100 per year, it is said to have a two-year payback. Many regard paybacks beyond, say, five years as farther out on a limb than consumers are willing to go. A payback of six, seven, or ten years is too uncertain, too unreal, to be taken seriously. Yet in the world of 401(k)s, we are essentially asked to prioritize investing in a 44-year payback.
The McKinsey Global Institute (part of McKinsey& Company, one of the nation’s most respected business consulting firms) estimates that, world- wide, there’s $170 billion of energy-efficiency investments possible by 2020 that could each generate an internal rate of return of at least 10 percent. The average rate of return of all these investments, McKinsey believes, would be 17 percent.
If consumers had to make all these replacements themselves, even slam-dunk investment opportunities might be difficult to take advantage of. Who has time to study the options, shop for energy-efficiency devices, and make all these complicated calculations? But across the United States are private and public institutions ready to help. New Jersey residents participating in the statewide program to replace inefficient heaters and air conditioners are saving $63 per year. Pennsylvania is weatherizing the homes of low-income families and saving them $300 per year. New York State offers homeowners rebates on their investments in more efficient appliances, typically saving them $600 per year. And according to Energy Trust of Oregon, customers participating in its programs have collectively saved nearly $800 million on their energy bills.
As was true for becoming your own landlord, you bump into limits on this investment strategy. Once you’ve become super-efficient, you again need to look for another place to put your money. Since the typical American household is spending $3,500 per year on utilities and $2,700 on gasoline, it will hit this ceiling once it invests $38,750 to become energy self-reliant.
But there may be ways to go beyond this $38,750. Right now, many U.S. utilities pay you to generate electricity for the grid. Put up your own wind- electric machine or photovoltaic array, and the utility will pay you for the surplus you sell back. Subdivisions and neighborhoods that work collectively to get themselves off the grid and get into the power-generation business may find themselves having a nice income supplement every month. The catch on this, for the moment, is that most utilities will allow you to run your meter back to zero but not negative. Many European governments, in contrast, have mandated “feed-in tariffs,” where the utility not only must buy back your surplus but do so at a higher rate than your electricity bill. This has created a huge incentive for households, neighborhoods, and small businesses to get into the energy-production business. If U.S. states start to reform their utilities in this way, there may be no practical limit to how much you can invest in simple, renewable energy technology that easily will last as long as your house.
The logic of seizing every invest-in-yourself option that delivers better than a 16 percent rate of return can of course extend to other kinds expenditures. It’s worth investing $1,000 in water-efficiency measures, if you can bring down your annual water costs by$160. Or $1,000 in a home-based greenhouse, if you can bring down your food expenditures $160 per year. Or $1,000 in a great bicycle, if it reduces your driving costs by $160 per year. Or $1,000 in an Italian espresso maker, if it shrinks your Starbucks habit by $3.08 per week. But why stop there?
4. Invest in Your Potential
Warren Buffett says, “Generally speaking, investing in yourself is the best thing you can do—anything that improves your own talents. Nobody can take it away from you. They can run up huge deficits and the dollar could become worth far less, you’re gonna have all kinds of things happen. But if you’ve got talent yourself and you’ve maximized your talent, you’ve got a terrific asset.”
Think of how many educational courses you could take, how many new skills you could acquire, or how many new degrees you could complete that would increase your earning power. Forget about enrolling in an expensive private university. Suppose you spend $10,000 per year over three years taking a bunch of classes to broaden your skills. If that $30,000 investment generates more than $4,800 in additional pretax income, your education will generate the needed 16 percent rate of return to do better than your tax-deferred IRA. Adrianne McVeigh, a management consultant and clinical psychologist in Atlanta, tells her clients that “the most successful executives and managers invest time and energy in their own self-development.”
Even if you’re not prepared to change careers, there may be subtle tweaks of your lifestyle that could generate better than a 16 percent rate of return. Everyone knows that prevention of health problems is more cost-effective than treatment. The assumptions required to work out the cost–benefit numbers are admittedly rife with speculation, but there are plenty of low-cost ways most of us would agree would save us more than 16 percent per year. If you’re a smoker, for example, investing several thousand uninsured dollars to quit can pay off in years of longer life with fewer maladies and health-care costs, as well as immediate savings by eliminating hundreds of dollars of cigarette purchases each year. There are similar, if perhaps less dramatic, payoffs by investing in whatever it takes—nutrition classes, exercise programs, spending more cooking healthy meals—to reap the myriad benefits of a healthier you.
Hey, Wait a Minute!
Have I gone too far with these arguments? I can imagine two objections. The first is something I’ve hinted at throughout this chapter—that smart investors will do everything on my list, plus save funds in their tax-deferred retirement accounts.
But I hope I’ve made it clear how far you can go before you should even think about a retirement account. Let’s review: $50,000 to $100,000 for your own bank, $1 million for real estate, $38,750 for energy efficiency, who knows how much for your own education and earning potential—this is well beyond what 90 percent of American families ever dream about saving for their retirement. The average American household has an after-tax income of just over $46,000, and few will retire with anything approaching $1 million to their name.
The second objection might be that I’m comparing apples and oranges. Money saved is not the same as money invested—and ultimately, you do need cash or some kind of income-paying asset to live on when you retire. Your reduced electricity bill will not pay your grocery bill after you turn sixty-five. To make this analysis work, you have to be committed to capturing your savings and placing them into some kind of savings account or asset that ultimately pays you an income stream. But, again, there’s no reason why that asset cannot be your home. And each year, you can take your savings and plow them back into home improvements. When you’re ready to retire, sell the home, move into more modest digs, and then place your savings into very safe, low-risk, local securities.
Whatever you think of strategies of investing in yourself, there’s one overarching advantage to them over every other local-investment strategy discussed thus far: You are the person principally responsible for whether or not the investments pay off. You have the ability to improve your home, to tweak your energy-efficiency systems, and to upgrade your own personal earning power through the right class. You can bring down the risks of your investments going sour. You are the star of your own investment firm.
And it’s in this spirit that I present one final tool to consider, what’s effectively the secret weapon of local investors—namely, the self-directed IRA. Even though the tool is mainstream enough that a "for Dummies" guidebook has been written on it, 99 percent of Americans—even 99 percent of sophisticated investors—appear to be unaware of it.
5. DIY Retirement Funds
Tom Anderson is the founder of PENSCO, one of the largest providers of self-directed IRAs in the country, and until he recently retired he served as its CEO. “After twenty-two years of operation I’m proud that PENSCO has an A+ rating from the Better Business Bureau,” he boasts, “and we’ve got $3.5 billion under administration. From a customer satisfaction standpoint, we’re performing better than some of the top banks in the country.”
Anderson is also the president of the Retirement Industry Trust Association (RITA). “We almost exclusively handle self-directed IRAs and retirement accounts as custodians, which means we provide the means to hold IRA and individual pension plans under the laws governed by the Internal Revenue Service. We hold their assets in custody, execute our clients’ investment instructions, and report the value of their holdings—on an annual basis to the IRS and on a monthly basis to our clients. We also provide all the other traditional services, including Internet access to your account, and your ability to do all kinds of transactions, purchases, sales, transfers, and distributions. Basically we do everything that’s required to keep your plan compliant with the law. And that’s about it!”
The difference, of course, is what you can invest in. “Unlike broker-dealers or traditional banks, we’re dealing with myriad asset types those institutions don’t handle. For example, a broker-dealer like Schwab or Merrill Lynch generally will just handle traded assets like stocks, bonds, and mutual funds, and those assets are essentially processed electronically these days. Our systems and personnel are very specialized as every transaction is unique—sort of like a handmade shoe.
“We can do anything that is not prohibited by law,” Anderson asserts confidently, “from buying 40 head of cattle and putting ear tags on them in the name of your IRA, to buying a property underwater off the coast of Miami. There are only three asset types that a self-directed IRA can’t buy: collectibles (antiques, artwork, a 1957 Corvette, alcoholic beverages, et cetera), life insurance, and the stock of a sub-chapter S corporation. So, for example, we have bought fishing rights in the state of Alaska, which is just a map of the ocean that allows somebody to fish, in this case for black cod, over a period of time, who then rent out these rights to smaller fishermen. We have helped start thousands of traditional businesses through early-stage capital, either at the very beginning like start-ups or with mezzanine financing. At this time there’s very little credit out there for new-business innovation, and service providers like us are stepping into the gap.”
You could use a self-directed IRA to put tax-deferred dollars into almost every local-investment option discussed in this book. The one prohibition is on personal use of the funds. You can’t invest in your daughter’s house, for example, or a business in which your spouse has greater than 50 percent ownership. But you can invest in almost every other type of local investment discussed in this book. That means that you can support a friend or neighbor’s personal project. You even can invest in your neighbor’s house. In Canada, where the rules around self-directed retirement funds are very similar to those here, a company in Calgary is being formed to enable groups of neighbors to invest in one another’s homes, enjoy the tax benefits of mortgages, and avoid the high interest charges of mortgage banks.
Suppose you know someone who wants to borrow money to buy furniture or put her kids through college. You know she has plenty of assets, but they’re tied up in the house or in a typical pension fund, so you’re confident about getting paid back. You could use a self-directed IRA to loan her the money at, say, 5 percent annual interest—or whatever interest rate you preferred. And taxes on your gains would be entirely deferred.
Anderson wishes that more Americans knew about self-directed IRAs. He believes that most retirement accounts are dangerously undiversified. In fact, according to most current statistics available from Investment Company Institute (ICI), more than 95 percent of all IRA assets are invested in the markets in one fashion or another. “These are an individual’s most valuable portfolios due to their tax-deferred or tax-free status, and if any portfolio should be diversified it should be your retirement account.”
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On the flip side, self-directed IRAs provide a great source of investment capital and support innovation through the launch of new businesses. “The most significant success we had at PENSCO,” recalls Anderson, “involved a group of entrepreneurs who came into our office in 1999 and wanted to start a business on the Internet. They were going to use a traditional IRA, but I suggested they use Roth IRAs because the gains would be tax-free. So they started this company, and the lead investor put in $1,800, because he didn’t have any more. The limit at the time was $2,000. The others put in a certain amount, most of them the maximum contribution amount. Approximately three years later they sold the company to a national firm, and the CEO, the guy who put the $1,800 in, now had multiple millions in his Roth IRA. Then he took those millions in his Roth and became a lead investor in a whole bunch of other start-ups, which grew his IRA to hundreds of millions. All from his $1,800 investment!”
So why don’t more people use this technique? Anderson thinks most Americans don’t believe they are capable of handling their own finances. “People are accustomed to the normal contributory IRA. They get a solicitation from their bank in April just before tax time to take a deduction, they fill out a little form, and put $2,000 or $4,000 into an account, and it just sort of sits there. They don’t pay a whole lot of attention to it. The whole process is relatively passive.”
The custodian of a self-directed IRA, in contrast, cannot be the decision maker. That’s what self-directed means: It’s up to you.
Michael Shuman is research director for Cutting Edge Capital in Oakland, economic-development director for the Business Alliance for Local Living Economies (BALLE), and a fellow of the Post Carbon Institute. An economist, attorney, author, and entrepreneur, Shuman has previously authored, coauthored, or edited seven books, including The Small-Mart Revolution and Going Local (1998).
