by Archie M. Richards, Jr., CFP^®
January 14, 2002

Rhoda, a Texas reader, asks what a preferred stock is. She also wonders whether the high-yielding K-Mart $3.875 Preferred is a good buy.

Preferred stocks have some of the income potential of bonds, Rhoda, and some of the gains potential of stocks. Let's say a public corporation wants to raise capital for business purposes. It doesn't want to increase its permanent debt. But neither does it want to increase the number of shares of its common stock, because if the company's net earnings stay the same but the number of common shares increase, the earnings per share would fall. Executives prefer their earnings per share to rise, not fall.

The corporation therefore sells to the public an issue of preferred stock. Preferred stocks have relatively high dividends and only modest appreciation potential. Most of them can be converted later into common stock. The company hopes that by the time the conversion occurs, the earnings will have improved enough so that, even though the number of common shares rise, the earnings per share will nevertheless be enhanced.

In the event of bankruptcy, preferred shareholders have priority over common shareholders regarding liquidation payments.

The dividends on preferred shares are fixed. The dividend on K-Mart's preferred stock, for example, is set at $3.875 per share, payable in four quarterly installments.

K-Mart sold its preferred stock to the public at $50 a share. But the price has been falling, especially recently. It's now only $16.22. The $3.875 dividend represents a yield of 23.9 percent.

This is too good to be true. I expect the company to discontinue paying the preferred dividend soon.

A stock analyst recently suggested that K-Mart file for bankruptcy. This would make it earier for the corporation to get out of the leases on its stores and warehouses that are performing poorly and to build new facilities in more promising locations.

But even with these improvements, K-Mart may not survive in the long run. Wal-Mart's competition has been more than K-Mart could handle, and might well remain so.

A recent personal tax planning brochure prepared by one of the big five accounting firms, Deloitte & Touche, reads as follows:

"Thus far, Congress has never tapped the entire Social Security surplus in any fiscal year."

How could Deloitte & Touche promulgate such nonsense? In truth, every penny of revenues from Social Security taxes are spent immediately. Here's how Social Security itself describes what happens:

"Tax revenues are deposited in the trust funds. Social Security benefits are paid from these funds, and any money not needed to pay benefits is invested daily in U.S. government bonds."

This means that money not needed to pay current Social Security benefits are spent immediately on whatever Congress is spending money on that day.

Social Security refers to its government bonds as "Reserve Funds." They are no such thing. Twenty or thirty years from now, only two workers will be available to support each Social Security beneficiary. The workers will refuse to pay taxes high enough to cover the Social Security benefits equivalent to a half-retired person in addition to supporting their own families. Any Congressman who votes for Social Security taxes this high would be whisked out of office in the next election.

When you and I invest in corporate bonds, we try to pick the ones that will be repaid. The bonds acquired by Social Security have virtually no possibility of repayment. Other Treasury bonds will be paid off, yes, but the bonds held by Social Security are a special case. They're worse than junk.

In a ponzi scheme, funds paid in are not invested in productive enterprises. Instead, the contributions of early participants are paid out to later participants. Ponzi schemes in the private sector are considered fraudulent. Social Security is the most colossal ponzi scheme in world history.

The American people have no property rights over their Social Security benefits. They fork over hundreds of billions of dollars and allow 535 people in Washington to do with the money whatever they please.

Saying that "Congress has never tapped the entire Social Security surplus" is cockeyed. Deloitte & Touche ought to know better.