Jonathan Clements's Blog, page 442

Unconventional Wisdom

IN THE 1990s, when I started working fulltime, conventional wisdom suggested two possible routes to a comfortable retirement: Find a public sector job that offered a traditional pension plan or, alternatively, join the private sector and set aside 10% of my salary each year in my employer’s 401(k) plan. I was led to believe that if I followed either recommendation, I could sit back, let compound interest do its magic and achieve a financially secure retirement.

For 20 years, I followed conventional wisdom, assuming such one-size-fits-all financial advice would serve me well. My first job was at a public education institute and I was fully vested in the pension plan after five years. Next, I took a job at a private school where, as part of my benefits package, I had access to an employer-funded retirement plan. An amount equal to 10% of my salary was contributed to the account each month. I assumed there was no reason for me to make additional contributions to a retirement account. I also assumed the money in my employer-funded account could be invested in fairly low-risk options and still achieve a high rate of return. I imagined my life would remain on the same trajectory, and I’d glide through to retirement.

The problem with conventional wisdom: It only works if you lead a conventional life.

The stock market collapse of 2008 wiped out all the earnings that my retirement fund had accumulated over the previous decade. A midlife divorce meant forfeiting half of my pension. Suddenly, my life had taken an unconventional turn, and I realized the importance of going beyond basic rules of thumb.

I needed to educate myself on investment strategies. I learned women are generally more financially conservative than men, including favoring less risky investments. I learned that setting aside 12% to 15% of my income toward retirement would likely be necessary if I was going to retire at age 65, and I’d need to save even more if I wanted to achieve my goal of early retirement. I learned I needed to embrace the inevitable ups and downs of the stock market if I was going to earn investment returns that outpaced inflation and significantly boosted my nest egg’s value.

These days, I contribute 25% of my income to a retirement account that’s invested primarily in stock mutual funds. When the stock market takes a dive—as it did last year after the Brexit vote—I view it as an opportunity to purchase more shares with the same amount of dollars. More important, I’ve learned to ignore conventional wisdom and settle on my own financial rules.

Kristine Hayes is a departmental manager at a small, liberal arts college in Portland, Ore. Her previous blogs include My One and Only and Say It Forward.

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This Week/April 23-29

SET UP A HOME EQUITY LINE OF CREDIT. Be sure to read the fine print. But typically, all that’s involved is paperwork and perhaps a $50-a-year fee. Ideally, you’d never use the credit line. But it could come in handy if you have a financial emergency and as a lower-interest, tax-deductible alternative to car loans and education loans.

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Ten Commandments

IMAGINE YOU HAD ONE SHOT at offering financial advice to a high school or college graduate. Your mission: Come up with 10 rules that’ll help your graduate succeed financially in the years ahead. What would you recommend? Here’s my list:

1. Question yourself. No doubt you’re entering the adult world with a slew of strong opinions—about what you want from life, what will make you happy, what you’re good at, what constitutes success and how to achieve it. These opinions likely won’t age well, and yet they will have a profound impact on the lifestyle you pursue, how you invest, how much you borrow and more. What to do? Some self-doubt—and a few days’ pause before major decisions—could save you unnecessary grief and a boatload of money.

2. Consider the tradeoff. Whenever you open your wallet, you’re voting for one thing, but also voting against something else. If you buy one item, those dollars can’t be spent elsewhere. If you spend it, you can’t save it. If you devote savings to one financial dream, those dollars can’t be put toward another goal.

3. Be an owner. That means favoring stocks over bonds and buying a home rather than renting. Admittedly, this isn’t without risk: Owners can suffer steep short-term losses, so don’t purchase a house or venture into the stock market unless you have at least a five-year time horizon—and preferably far longer.

4. Favor simplicity and low cost. Wall Street firms want to make money off you—and the greater the complexity, the more they’ll make. Does a financial product or strategy require more than 30 seconds of explanation? Just say no.

5. Save automatically. If socking away money were easy, every retiree would be a multi-millionaire. The reality: Most of us spend too much today and shortchange our future self, especially our future retired self. To force yourself to save, sign up for payroll contributions to your employer’s retirement plan, and also establish automatic mutual-fund investment plans.

6. Pay taxes later. The biggest investment cost is taxes. But with 401(k) plans and IRAs, you can defer those tax bills for decades, allowing you to use money earmarked for the government to earn additional gains for yourself.

7. Index. If you buy and hold a globally diversified portfolio of index funds, every year you’ll fare modestly better than most other investors. Over a lifetime of investing, that modest annual advantage will turn into a landslide victory, thanks to the power of compounding.

8. Never carry a credit card balance. Follow this one rule, and you’ll sidestep punishing financing charges and a heap of stress. Avoiding credit card debt should be a top financial priority, second only to funding a retirement plan with a matching employer contribution.

9. Protect against financial disaster. Think about the truly terrible things that can happen—losing your job, needing expensive medical care, dying young, suffering a career-ending disability. To fend off these threats, you need an emergency kit with a few simple items: some rainy-day money, health and disability insurance, life insurance if you have dependents, a will, and the right beneficiaries on your retirement accounts and life insurance.

10. Strive to be debt-free. Many of us assume a frightening amount of debt when we’re younger, thanks to student loans, car loans and mortgages. This isn’t necessarily a terrible thing—as long as we can get all this debt paid off by retirement and preferably far earlier. Shedding all debt lowers our cost of living, make it easier to pay for the kids’ college, retirement and other goals.

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Three Steps to Seven Figures

I LIKE LEARNING from successful people. If you want to be good at something, why not hear from somebody who’s actually done it?

Back when it was first published, I read The Millionaire Next Door and became fascinated with these folks. Over the next couple of decades, I applied the book’s teachings and eventually reached millionaire status myself.

Along the way, I started writing about personal finance, combining my interest in millionaires with my passion for learning from experts. I have now interviewed more than 30 millionaires to see how they accumulated their wealth. Here’s what most of them have in common:

1. They earned good incomes. You can become wealthy with a moderate and even a low income, but those instances are rare. Many millionaires select high-paying careers and then work to grow their careers and income, including owning their own businesses.

Earning more not only allows millionaires to accumulate wealth faster, but also provides a higher standard of living along the way. In addition, a high income covers a multitude of financial sins, providing an extra cushion when the inevitable emergency arises or they want to splurge a bit.

2. They saved a high percentage. Millionaires save a good amount of their high incomes. Some save as little as 20%—yes, as “little” as 20%—while others are much more aggressive. Savings rates among millionaires seem to average more than 30%, with some at 50% or higher.

The variation is mostly dictated by when they want to retire. Those who want to reach financial independence faster save a much higher percentage. Those who are more moderate take longer, but get to spend more along the way. Still, the common thread is an unwavering dedication to saving.

My savings rate was just over 36% for most of my working career. A high income allowed this, without sacrificing my standard or living or the donations I like to make to charity.

While a high income is great, saving is vital. You can make $50,000 a year, save 20% and make more financial progress than someone who makes $500,000 and spends $500,000. No matter what you make, you need to save. Millionaires know this and limit their spending accordingly.

3. They invested early and often. Very few people can become wealthy by saving alone. It just takes too long. To reach millionaire status in a reasonable period of time, you need your savings to be working hard for you.

Millionaires have different ways of doing this, but many choose to invest in low-cost stock index funds. This is my investment of choice as well. Index funds all but ensure that, after expenses, you outperform most other investors. Yes, it’s a boring way to invest, but millionaires don’t care. They value results over style.

Millionaires also take advantage of what’s been called the eighth wonder of the world: compounding. By investing from a young age and leaving their money to grow, they have compounding working in their favor for years and even decades.

Using the three steps above—earning, saving and investing, or ESI—there are many paths to millionaire status. I call this “working the ESI scale.” One millionaire might make a huge income and save 20%. Another might make an average salary, but save 60%. Very few are Warren Buffetts, so almost no one becomes a millionaire through investing prowess alone.

Becoming a millionaire isn’t rocket science. The concepts are quite simple—and yet it’s still rare to become a millionaire. Why don’t more folks succeed? There’s one additional ingredient you need, but many people lack: You also have to have great discipline.

John Danger is a pseudonym. He’s an early retiree who achieved financial independence and now shares what has worked for him at ESI Money.com. To learn more about his philosophy, check out his free ebook, Three Steps to Financial Independence.

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Slip Sliding Away

WHILE TALKING RECENTLY to an estate-planning client about investments costs, she showed me a letter from her financial advisor stating that he charges her 1% of assets a year. Maureen didn’t understand that she also pays each mutual fund’s annual expenses, a portion of which is also paid to her advisor. Her fund expense ratios average 1.14%, which includes a 0.25% 12b‑1 fee that her advisor pockets. Result: Maureen’s total cost is 2.14% a year, with 1.25% going to her advisor.

Investors who need an advisor face myriad possible fee structures. Some advisors charge fixed or hourly fees. Some take sales commissions that reduce the overall amount invested or returned. Others charge a percentage of assets under management. Yet others levy some combination of these. When Maureen was younger, with a small but growing portfolio of $25,000, paying an advisor 1% of assets, equal to $250, was an efficient way to get a few hours of an advisor’s time. Now, 30 years later, she has a portfolio closer to $1.5 million. The 1% fee generates $15,000 a year for her advisor. Maureen suspects that a flat annual or hourly fee would be fair to her advisor without being unfair to her.

While Maureen may be able to negotiate a lower advisory fee, she can only influence the expense ratios on her mutual funds by changing funds or buying a different share class of her existing funds. The major components of expense ratios are management fees, 12b-1 distribution fees (if any) and other administrative costs, such as those for accounting, legal work and shareholder reporting. Management fees are the amount retained by the fund sponsor for selecting the securities that make up the fund. Marketing and distribution 12b-1 fees are annual payments of between 0.25% and 1%, and are typically paid to financial advisors and others whose clients invest in the funds. Another cost borne by investors, though not included in the expense ratio, is the transaction costs incurred by the fund when it buys and sells securities. The higher the fund’s turnover rate, the higher the cost that the fund’s investors effectively pay.

There’s wide variation in expense ratios and their component parts. Expenses tend to be higher for stock funds than bond funds, and higher for actively managed funds than index funds. Maureen’s expense ratios average 1.14%, with management fees at 0.72% and administrative costs at 0.16%. According to the Investment Company Institute, average asset-weighted stock fund expense ratios fell from 1.08% in 1996 to 0.84% in 2015, as investors flocked to lower-cost funds. But investors have plenty of room to cut expenses further—and lowering costs could dramatically increase how much their money grows over time. How low can expense ratios get? At Vanguard Group, renowned for its low-cost funds, expense ratios average 0.18%.

Matthew Sullivan is a Boston-based lawyer, consultant and entrepreneur who has been captivated by personal finance for nearly 30 years. He enjoys cycling and international travel.

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This Week/April 16-22

THINK OF YOUR ASSETS AS INCOME. If you retired today, how much income would your nest egg generate? One rule of thumb says that, in the first year of retirement, you can withdraw 4% of your portfolio’s value, equal to $4,000 for every $100,000 saved. It’s a sobering way to assess your retirement readiness—and it might prompt you to save more, postpone retirement or work part-time in retirement.

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Nothing Better

NO DOUBT YOU WOULD DRAW UP a somewhat different list. But here’s what I consider life’s greatest pleasures:

Talking to my wife over a glass of wine at the end of the day
Losing myself for a few hours in an interesting piece of work
Walking in nature
Spending time with my kids
French fries
Waking up after a great night’s sleep
Knowing I did the right thing
Wrapping up work on a Friday
Making love
A raucous dinner party
Feeling physically spent after a good workout
Finally sorting out a long-simmering problem
People watching
Taking a nap
Ending the day with a sense of accomplishment

To me, these are among the finest things life can offer—and they have a common element: You don’t need to be rich to enjoy any of them. Not sure I’m right? Draw up your own list of great pleasures. You might even post it below. How many of the items on your list necessitate great wealth?

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Upping the Ante

MY SISTER JUST HAD A BABY, our family’s first grandchild. That officially makes me a PANK: a Professional Aunt, No Kids. This often-overlooked demographic takes an active role in the lives of children they’re close to. They spend not only time, but also money: 76% of PANKs lavish more than $500 a year on each of their nieces and nephews, resulting in some $9 billion in annual purchases.

The opportunity to buy adorable items for baby Henrik is not lost on me. I’ve had the past nine months to ruminate over what being an aunt actually means, and the role I want to play in our family village. I am aware of the limited ROI—return on investment—of frivolous gifts. I would rather share values with my nephew—values that will serve him well throughout his life.

The challenge: Defy the shrewd marketing initiatives of brands that have tweaked their messages in an attempt to capture my PANK dollar, and instead focus on what truly pulls at my heart strings. Would it be possible to replace every holiday’s physical gift with an equivalent deposit into a 529 college savings plan?

Once Henrik is old enough, I will share the letter of intent drafted for his 529. This plan outlines the ideals which, I believe, will benefit him throughout the years, including the importance of discipline and education. The plan also includes monetary incentives to encourage his financial education. Henrik, of course, will initially fail to see the virtue in these virtues. I hope I survive the “why” stage.

My commitment to Henrik, and this plan, is a bit self-serving. I’m always looking for accountability partners, and now I may have the cutest one yet. It’s a good thing I will have time to try and figure out how to explain to a toddler why I don’t bring shiny gifts, and instead would love to talk to him about compound interest. Let’s just say aunt-of-the-year award isn’t on the table for a bit. When he applies for college, however, a simple view of the scoreboard—as reflected in his 529 account balance—will show complete and utter PANK dominance.

In this grand plan, there remains one unavoidable source of jealousy: While I may be a PANK, my husband gets to be a PUNK.

Anika Hedstrom 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. Her previous blog was Home Economics. Her nephew Henrik’s middle name is Olaf—named after his grandfather, who was born on April 13, the same date this blog was published.

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My One and Only

MY FAVORITE DIVORCE QUOTE, if one can have such a thing, comes from comedian Louis C.K.: “No good marriage has ever ended in divorce. If your friend got divorced, it means things were bad. And now, they’re better.”

For myself, these words certainly ring true. But “better” comes at a price: Being a divorced, middle-aged woman means looking at financial matters from a different perspective than my married friends. Since I no longer have a spouse, financial security rests squarely on my shoulders. I don’t have the luxury of knowing there’s a second income, in the event of a job loss or other financial emergency. Because of this, I made establishing an emergency fund a priority. I used the proceeds from the sale of my house to set up an account with enough money to cover at least nine months’ worth of living expenses.

My insurance needs also differ from the typical two-income household. Having both a short- and long-term disability plan is critical. I have access to long-term disability insurance through my job. It would provide 60% of my monthly income, in the event I wasn’t able to work for a period of more than 180 days. Since I typically set aside approximately 25% of my gross wages each month for retirement savings and would cut that back if I were disabled, I feel confident I could live off the proceeds from this single policy. For shorter-term illnesses, I maintain a balance of ten weeks of paid sick-leave. I could also use my accumulated vacation days to cover a medical emergency, if necessary.

Because I don’t have any dependents—my corgi Zoey doesn’t count in the eyes of the IRS—there’s no reason to carry a life insurance policy. But having no children or a spouse also means I have fewer options when it comes to long-term care. I recently learned I’m eligible to purchase a long-term-care policy through my state’s public employee retirement system. This unexpected benefit is available to me because my first job out of college was at a state educational institute. By purchasing a policy as a member of a larger pool of participants, I’d pay less than if I purchased a policy individually.

So is Louis C.K. right? Yes, for me, life after divorce is better—much better. But it took a coherent financial plan to recover my sense of financial security.

Kristine Hayes is a departmental manager at a small, liberal arts college in Portland, Ore. She enjoys competitive pistol shooting and hanging out with Zoey, her corgi. Her previous blogs include  Say It Forward and Wanting for Something .

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This Week/April 9-15

CAP ALTERNATIVE INVESTMENTS. How much do you have in alternative investments—everything from gold to commodities to hedge funds? As a rule, keep your allocation to 10% or less of your total portfolio’s value, and favor simpler, less expensive options, such as funds that focus on gold stocks and on real estate investment trusts.

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