Jonathan Clements's Blog, page 420

This Week/July 16-22

PONDER WHEN TO CLAIM SOCIAL SECURITY. Start with the calculator offered by United Capital. Many folks are inclined to claim benefits as soon as they retire, but often it makes sense to delay. To understand why, learn more about Social Security, including the advantages of delaying and the different strategies that couples might use.

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Fooled You

WANT TO EARN the derision of the so-called smart money? Here are 12 ways to get yourself labeled a financial rube:

Express optimism about the stock market.
Stick with capitalization-weighted total market index funds.
Pay off your mortgage early.
 “Arnott vs. Asness? Missed that one. Was it on pay per view?”
Shun alternative investments.
Buy and hold.
Have no opinion on the economy and market valuations.
Dollar-cost average.
Own a target-date retirement fund.
Never cite Ben Graham, John Maynard Keynes or Warren Buffett.
Favor stocks that pay dividends.
Buy on dips.

What if you persist with such foolishness? Contrary to what the smart money would have you believe, there’s every chance you’ll end up wealthy. And, no, it wouldn’t be dumb luck.

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Retirement: 10 Questions to Ask

SAVING ENOUGH FOR RETIREMENT, and then turning those savings into a reliable stream of retirement income, together constitute our life’s great financial task. Want to make sure you’re on track? Here are 10 questions to ask:

Are you shortchanging your retirement by devoting too much of your income to other goals? For instance, can you truly afford private school for the kids? Do you really have the financial wherewithal to buy a second home?
Are you putting enough in your employer’s 401(k) or 403(b) plan to earn the full matching contribution? Failing to collect the full match ranks as one of the most foolish financial mistakes.
If you’re in the workforce, are you socking away at least 12% of your pretax income toward retirement? Add up how much you’re saving, including any matching employer contributions to a 401(k) or similar plan.
How much income will your savings generate? First, use an online calculator to project how much you might amass by the time you quit the workforce. Then divide the resulting sum by 25 to see how much income your nest egg might generate each year.
Do you have enough in stocks? Even after you quit the workforce, you could easily live 25 or 30 years in retirement, which is plenty of time to earn healthy stock market gains. You will likely need those gains, because 25 or 30 years is also plenty of time for inflation to do hefty damage.
If you are retired and we got a repeat of the 2007–09 stock market collapse, when the S&P 500-stock index fell 57%, how would you cope financially? This is a reason to keep at least five years of portfolio withdrawals in short-term bonds and cash investments, so you can ride out a long bear market.
Does your retirement plan reflect how long you might live? Find out your life expectancy using the calculator at SocialSecurity.gov. Keep in mind that as you grow older, the average age to which you’re expected to live also rises—and, of course, there’s a 50% chance you’ll live longer than this average.
When will you claim Social Security? If you answered, “when I retire,” think again. Social Security is a hugely valuable income stream, so it often makes sense to delay benefits to get a larger monthly check, especially if you were the family’s main breadwinner.
Should you buy an immediate fixed annuity once you retire? Annuities aren’t a popular product—but they can be a good choice if you’re looking to squeeze a healthy amount of income out of your retirement nest egg.
Once you quit the workforce, what will get you out of bed in the morning and give a sense of purpose to your retirement? You should view retirement not as an endless vacation, but as a chance to take on new challenges.

This is the first in a series of blogs devoted to major financial topics and the key questions you ought to ask.

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Getting Schooled

SETTING OUT INTO THE BUSINESS WORLD, I was age 27 with a negative net worth. Among life lessons, there are many strong contenders, but nothing introduced me to “adulting” like debt. For that, I had undergraduate and graduate school expenses to thank.

Having secured a good job out of business school, I started to rebuild my finances. My grad loans had a relatively high principal amount and an interest rate of 6.8%, so I prioritized that debt over my undergrad loans, which were much lower in principal and charged just 3%.

I was acutely aware of the dangers of increasing my living standards overnight. Going from ramen to sushi wasn’t in my best interest. I continued to live like a grad student.

These choices gave me more cash to deploy toward three goals—debt reduction, retirement and building a cash reserve. Not wanting my debts to derail my other goals, I decided on a hybrid approach. I contributed the amount needed to get my full employer 401(k) match, and also set up a monthly automatic contribution to a Roth IRA. After I paid myself via my 401(k) and Roth investments, I focused on developing an emergency fund. My goal was to build this up aggressively until I hit $10,000.

With this bit of liquidity to fall back on, I felt better about directing more toward my graduate loans. I set my retirement contributions to increase annually in conjunction with my annual raises. My bonuses went toward grad debt, retirement and everyday savings. My life wasn’t exactly sexy in materialism, but it was rich in discipline.

My strategy of not letting the perfect get in the way of good worked for me. I managed to pay off more than $65,000 of graduate student loans in two years, while slowly inching toward my other goals. Those small, deliberate actions compounded nicely.

Anika Hedstrom’s previous blogs were Site Seeing (Part IV),   Upping the Ante   and   Home Economics. Anika is a financial planner with  Vista Capital Partners  in Portland, Ore. She loves to nerd-out and, when given a dollar, will save 96 cents.

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This Week/July 9-15

SUPPOSE YOU LOST YOUR JOB. How long could you go before your financial life unraveled? This isn’t an issue for retirees—which is why they need little or no emergency money. But if you’re working, your plan for unemployment might include a cash reserve, slashing discretionary spending, a home-equity line of credit and withdrawing Roth contributions.

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Stocking Up

IT’S ANECDOTAL EVIDENCE, so take it with a grain of salt. Still, I’m once again hearing a dangerous argument—that you should always carry the largest mortgage possible, so you have extra money to stash in stocks.

During the roaring bull market of the late 1990s, and during the booming market for stocks and real estate in 2005 and 2006, readers regularly wrote to me, making the same argument. The strategy isn’t without logic—and it isn’t necessarily a sign that stocks are about to crash. Nonetheless, I consider it wrongheaded, for three reasons:

1. You’re making a leveraged bet on stocks. To be sure, it isn’t like buying stocks in a margin account, where you could get a margin call if stocks fall far enough, possibly compelling you to sell shares at fire-sale prices. Still, the mortgage-to-buy-stocks strategy makes your finances far more perilous.

Imagine two choices. With option A, you have $100,000 in stocks and a mortgage-free $100,000 home. With option B, you have $180,000 in stocks, plus a $100,000 house saddled with an $80,000 mortgage. In both cases, your initial net worth would be $200,000. But if stocks fell 50%, your net worth would drop to $150,000 with option A—and plunge to $110,000 with option B.

I readily concede option B will likely generate greater wealth over the long haul, provided you diversify broadly, keep investment costs low and stay the course. But how many folks really would stay the course? Even if you don’t panic and sell when your stocks are down 50%, you might be forced to sell—because you lose your job during the accompanying recession and need to cash in stocks to pay the mortgage.

2. Paying down a mortgage offers a guaranteed return—one that will likely outperform high-quality bonds. Today, you can get a 30-year fixed rate mortgage at 4.1%, which seems like cheap money. Who wouldn’t want the largest mortgage possible? Problem is, paying 4.1% to others doesn’t seem so cheap when you can only earn 2.4% by buying 10-year Treasury notes or just 2.8% with intermediate-term corporate bonds.

Yes, your mortgage interest should be tax-deductible. But Treasury bond interest is taxable at the federal level, and corporate bond interest is taxable at both the federal and state level, so the tax argument is pretty much a wash.

What if you bought your bonds in a tax-deductible or Roth retirement account? Your tax-adjusted return might be higher than your gain from mortgage prepayments. But remember, you’re limited in how much you can invest in tax-deductible and Roth accounts each year. If you’re an aggressive investor, you will likely want to use those tax-favored dollars to buy your highest-returning investment, which should be stocks.

A digression: It’s been argued that, if you buy stocks in a traditional retirement account, you convert gains—which would have been taxed at the lower long-term capital gains rate—into retirement account withdrawals that will be taxed at the higher ordinary income tax rate. But there’s another—and, I believe, more accurate—way to think about the tax issue: No matter what you buy, your gain should be effectively tax-free. With a Roth, that tax-free growth comes as part of the package. But with a tax-deductible retirement account, you can also end up with tax-free growth, because the initial tax deduction pays for the final tax bill. I explain the math in HumbleDollar’s online money guide.

The bottom line: Maintaining the largest mortgage possible might make sense if you have nerves of steel and you’re fully committed to a leveraged 100% stock portfolio. But if you have any inkling to hold bonds along with your stocks, you’ll likely find a better combo is paying down your mortgage with taxable account savings, while using your tax-favored accounts to buy stocks. Eventually, with the approach of retirement and the need for a more conservative portfolio, you may want to hold some bonds in your retirement accounts. But until then, your top priority with your conservative dollars should probably be paying down debt, including mortgage debt.

3. Buying a home locks in housing costs—and paying off the mortgage dramatically reduces them. Housing is the single biggest expense for most American families. Indeed, lenders will typically allow you to take on mortgage payments, including homeowner’s insurance and property taxes, equal to as much as 28% of pretax income.

But once you’ve bought a house, that percentage should shrink over time, if only because your income is driven higher by inflation. Arguably, that’s the big advantage of homeownership. While renters often see their monthly payments climb as quickly as their paychecks, the housing costs incurred by owners should slowly decline as a percentage of their income—and, once the mortgage is paid off, those costs will fall sharply.

That’s a magical moment. Suddenly, your fixed living costs are so low that it becomes much easier to pay the kids’ college bills and save for retirement—and you might even discover you can quit the workforce entirely. Indeed, for many folks, making that final mortgage payment is the signal that retirement is finally affordable.

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Go Fish

WHEN AN INVENTOR GOES ON RECORD stating that his invention is “a monster” that he’d like to “blow up,” you know there’s a problem.

Such is the case with Ted Benna, who back in 1980 created the first 401(k) retirement plan. Since then, his invention has grown to become the dominant retirement vehicle for millions of Americans.

Why is Benna so negative on his creation? The problem, in a word: complexity. According to Benna, the first 401(k)s were a model of simplicity. They offered just two investment options, a stock fund and a bond fund, and they were offered in fixed percentages. That meant that workers needed only to choose from a total of five possible combinations (0% stock/100% bond, 25% stock/75% bond, and so on).

Today, by contrast, the typical 401(k) menu offers nearly 20 fund choices—and without the restriction of fixed percentages. As a result, the possible combinations of funds and percentages is astronomically large.

Trying to choose investments for your own 401(k)? I suggest the following three-step process to cut through that complexity:

Step 1: Opt for the easy choice. Today, many employers offer target-date funds. The key advantage of these all-in-one funds is that they adjust automatically to your age, becoming more conservative as you get older. They aren’t perfect—age, after all, isn’t the only determinant of one’s needs—but they are far better than an arbitrary selection of funds. If your company offers a target-date fund, that’s an easy choice. Just be sure to select your target date carefully, so it matches your retirement timetable. If your company doesn’t offer a target-date option, proceed to Step 2.

Step 2: Fish in the right pond. Your 401(k) menu may be long, but it’s important to know that most funds fall into just a few basic categories, such as stocks and bonds. While you want to make the best choice within each of those categories, research has shown that the category itself drives 90% or more of your results. In other words, if you fish in the right pond, that’s much more than half the battle. You might want some help with this process, but the basic idea is to allocate your portfolio to stocks when you are young and then slowly incorporate bonds as you get older.

Step 3: Cast a wide net. Once you’ve decided which types of funds you need, you have to choose specific funds. Here, the key is to go for funds that offer broad diversification at low cost. To continue the fishing analogy, once you’re in the right pond, just cast a wide net. The easiest way to accomplish that is with index funds. The data clearly show that this approach offers the best odds for success.

Anyone who has ever struggled through a 401(k) menu can sympathize with Ted Benna’s frustration. But, by following the three steps above, I believe you can significantly simplify the process.

Adam M. Grossman’s previous blogs include  Site Seeing (Part III), Footing the Bill   and Trust Issues. Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers.

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Baby Steps

SHORTLY BEFORE MY FIRST CHILD was born some two decades ago, I read a newspaper column urging parents to begin saving for college early in their children’s lives. Today, my son is not far from getting his bachelor’s degree in engineering, debt-free and (fingers crossed) with a bit in the bank for his master’s degree. My daughter starts college this fall and is on track for the same outcome.

I feel like we’ve been a real life middle-class experiment, showing what happens when a family starts saving for college while little ones are still in diapers. As I’ve watched children of other families grow up around me through Legos, robotics teams and college applications, I’ve seen alternative outcomes—where families didn’t start early. Having lived this journey, here’s what I’ve learned:

Being bright doesn’t guarantee a full ride. I’ve witnessed families who didn’t save for college because their children were truly bright, often at the head of the class or even the entire grade. I met one such father in the grocery store recently. As our talk turned to our little darlings, he grimaced, put his hands to his face and said, “I don’t even ask any more about her student loans. I don’t want to know how much debt she’s in.”

His daughter, brilliant at math, was her high school’s salutatorian and he had assumed that merit scholarships would fully cover college. As it turned out, scholarships did cover her tuition. But then there’s the pesky matter of living expenses: dorm room, meal plan, transportation, laptop, cell phone and more. It adds up over six years. Yes, six years: Most bright kids today don’t dare stop at a bachelor’s degree and plow right on through to their master’s.

You’d be amazed what $25 a month can do. Soon after our first child’s birth, we started saving $25 a month in a Coverdell account at our local credit union. As soon as we could carve $50 a month from our budget, we moved up to a Vanguard 529 account. We put the money into a basic index fund covering the U.S. stock market. Later, we got fancy and added an international index fund. We never looked at the ups and downs. We just left it alone and kept adding to it with monthly automatic contributions.

If you start this early, you will be so thankful of the options that your precious child has upon graduating high school. You will also bear witness, sometimes heart wrenchingly so, to the options available to your child’s high school friends whose parents didn’t save. Starting with just $25 a month, you will be absolutely amazed at how this little bit of money adds up in the end, especially as you increase your monthly contributions over time.

Amy Charlene Reed is a science and energy writer who lives near Oak Ridge, Tenn.

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Our Top 10 Blogs

WHAT DOES IT TAKE to attract readers? Lists are almost always popular. Humor helps. Folks are fascinated by the topic of happiness, and also deeply interested in helping their kids. And, of course, it’s always a plus if a blog gets mentioned by someone with a large following on social media.

All of which may explain the list below—HumbleDollar’s 10 most popular blogs through 2017’s first six months:

Courtside Seat
Ten Commandments
Next to Nothing
Nothing Better
The Good, the Bad and the Ugly
Did I Say That?
Site Seeing (Part I)
Take It to the Limit
Prosperity’s Pitfalls
Another Darn List

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This Week/July 2-8

CONSIDER A TARGET-DATE FUND. Financial advisors push the notion that every investor needs a customized portfolio—and, indeed, we all like the idea that we have an investment mix specially designed for us. Yet most of us, whether we’re investing on our own or through an advisor, would likely fare just as well, if not better, with a target-date retirement fund.

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