Jonathan Clements's Blog, page 443

Social Insecurity

SOCIAL SECURITY RETIREMENT BENEFITS may eventually get cut. But it shouldn’t influence when today’s retirees claim benefits.

I have argued frequently that it makes sense to delay Social Security, especially if you’re the family’s main breadwinner. By postponing benefits from age 62 to age 70, you can lock in a lifetime stream of inflation-indexed income that’s 76% or 77% larger. That income stream could salvage your retirement if you outlive your nest egg, while also providing a handsome survivor benefit to your spouse, assuming you’re married and you predecease your husband or wife.

But many folks disagree, in part because they figure they should get every dollar they can before the politicians slash benefits. Yet this doesn’t appear to be a risk: Even Republican presidential candidates, who have addressed the thorny issue of how to fund Social Security, aren’t proposing to shrink the monthly checks of existing retirees.

For instance, New Jersey Governor Chris Christie has proposed raising the Social Security retirement age starting in 2022, which means it would affect those currently age 55 and younger. Similarly, Senator Marco Rubio wants to raise the retirement age, but he says he’d like to do so without affecting those currently over age 55. The implication: Today’s retirees shouldn’t rush to claim Social Security, because they fear their benefits are on the chopping block. 

Turning the Page

WITH 2016 RAPIDLY APPROACHING, I’m gearing up to put out the next annual edition of the Jonathan Clements Money Guide. It’s the same drill as last year: I wait for the markets to close, spend the next few hours updating a slew of numbers throughout the manuscript, send off the files to Amazon and Barnes & Noble—and, fingers crossed, the book is available for sale the following afternoon.

I’ll go through this exercise twice, first on Nov. 30 and again on Dec. 31. The Nov. 30 edition will only be available as a paperback—I’m hoping folks will buy it for the holidays—while the Dec. 31 version will be available as a paperback, Kindle e-book and Nook e-book. You can now pre-order the Kindle edition, which costs $9.99. The book’s Amazon page says it will be auto-delivered on Jan. 15 but, barring technological glitches, it should be out Jan. 1.

Mistakes Compounded

UNDERSTANDING COMPOUNDING is fundamental to managing money. Without a good grasp of the way money grows and shrinks over time, folks can’t fully appreciate the value of starting to save when they’re young, the damage done by large investment losses or the true cost of carrying credit-card debt.

Yet I fear compounding isn’t well understood. This has dawned on me over the past month, as I’ve been teaching an undergraduate course on personal finance. Many of my students repeatedly make the mistake of adding together investment returns. For instance, if an investment earns 10% this year and 10% next year, they think the cumulative gain is 20%. But in truth, you would make 21%. The reason: In the second year, you earn 10% not only on your original investment, but also on the money earned during the first year. Thanks to compounding, if you earn 10% a year, you double your money roughly every seven years.

But compounding isn’t always your friend. It also comes into play with debt, as you incur interest not only on the original sum borrowed, but also on interest from earlier periods that wasn’t repaid. This is the trap that many credit-card borrowers fall into, as their minimum payments barely offset the financing charges they incur.

Just as my students add together investment gains, they also make the mistake of adding together gains and losses. For instance, if a hypothetical investor loses 50% this year but makes 50% next year, many of my students think our investor is back to even. But in fact, the cumulative result is a 25% loss. The grim reality: To recoup a 50% loss, you need a 100% gain. This highlights the danger of betting heavily on a few stocks, buying investments with margin debt and purchasing leveraged exchange-traded index funds.

Struggling with the notion of investment compounding? You might try playing around with a simple investment calculator, such as the one offered on Dave Ramsey’s website. Unfortunately, the calculator doesn’t allow you to assume a negative rate of return. But it does show how your money can balloon, given enough time, good savings habits and even a modest rate of return.

Eight Signs You're a Seasoned Investor

AS THE STOCK MARKET YO-YOS up and down, I figured it was worth taking a step back and talking about how investors should behave. Below is an excerpt from the Jonathan Clements Money Guide. What does it mean to be a seasoned investor? Here are eight signposts:

You have mixed feelings about rising markets. Yes, it’s great that your portfolio has grown fatter. But it also means future returns will be lower. By contrast, tumbling markets excite you, because you could get the chance to scoop up investments at bargain prices.You select stock and bond funds that you would be happy to hold for a decade or longer—and you do indeed hold them for that long.When you make investment decisions, you think not only about the potential return, but also about risk, investment costs, taxes, why you’re investing and your broader financial picture.You can succinctly explain why you own the portfolio that you do, including the reasons behind each investment.When your investments lose value, you’re never surprised, because you have a good handle on the likely risk and reward for every investment you own.You can coolly decide whether to buy or sell, without getting fixated on what’s happened in the market recently or what price you paid for a particular investment.You’re mentally prepared for parts of your stock portfolio to have wretched results over five and even 10 years, you have the patience and tenacity to stick with these sectors—and your financial goals wouldn’t be at risk if stock returns were truly awful.You realize that markets are unpredictable and that it’s extremely difficult to earn market-beating returns, so you always have some money in bonds and some money in stocks, and you avoid overly large bets on individual investments and narrow market sectors.

Beating Janet to the Punch

IT'S ONE OF THOSE INDELIBLE teenage memories: visiting the Bank of Baltimore in suburban Washington, DC, in the late 1970s.  I would hand over my babysitting or lawn-mowing money to the bank clerk, who would slide my green bank book into some magic typewriter. After a joyous clatter of keys, my bank book would be returned, and there would be recorded not just my deposit, but also the latest quarterly interest payment.

My children and stepchildren—ages 10 to 27—all have bank accounts. But there’s no joyous clatter of keys and, more important, there’s little or no interest to be had. As it happens, they are better off today than I was then. In 1978, we earned around 5% in pretax interest—but inflation was 9%. Today, my kids earn nothing—but annual inflation is running at just 0.2%. It’s hardly the stuff of playground or barroom boasts, but they are losing money far more slowly.

Still, I suspect I was more motivated to save. I may have been the victim of a money illusion—imagining I was making money when I was actually losing ground—but I had the pleasure of watching my account grow both because of the money I socked away and because of the interest I earned. By contrast, my children and stepchildren’s accounts are firing on just one cylinder, the raw dollars they deposit.

How can you making saving money more exciting for your kids? You could beat Federal Reserve Chair Janet Yellen to the punch and raise interest rates for your kids. Every three months, you might pay 5% interest, adding an extra $5 to their bank accounts for every $100 they have saved at that juncture. Depending on how good your kids get at saving money, this could become an expensive proposition.  But that, of course, will be the sign that you’ve succeeded.

Is Tax-Loss Harvesting Overrated?

AFTER A TURBULENT FEW MONTHS for stock prices and with 2015 winding down, talk will soon turn to tax-loss harvesting. The notion: You sell losing stocks in your taxable account, and then use the realized capital losses to offset realized capital gains and up to $3,000 in ordinary income, thus trimming your 2015 tax bill.

Sound like a smart strategy? If you trade individual stocks actively or you’re a really bad investor, tax-loss harvesting might make sense. What about the rest of us, who sit quietly with a handful of mutual funds and exchange-traded index funds, and perhaps also own a few long-term individual stock holdings? Most of the time, there won’t be any losses to harvest.

Yes, if you’re a long-term investor, you might get the chance to realize losses in the first few years that you own a fund or an individual stock. But soon enough, your investments will likely be above your cost basis, and the chance to benefit from tax losses is probably gone forever. Instead, you’ll face an entirely different problem: How do you rebalance your holdings without getting whacked with big capital-gains tax bills?

The upshot: If you’re a sensible investor, I wouldn’t spend too much time worrying about tax losses, and instead focus your efforts on two far more important tax-minimization strategies. First, make sure you keep tax-inefficient investments in your retirement account. That list would include taxable bonds, actively managed mutual funds, stocks you plan to trade and real estate investment trusts.

Second, aim to hold tax-efficient investments in your taxable account, including stock index funds, tax-managed stock funds and individual company stocks you plan to hold for the long haul. These investments might generate dividends each year, but you shouldn’t pay much in capital-gains taxes, unless you opt to sell. You might also hold tax-free municipal bonds in your taxable account, though—as I’ve argued elsewhere—you’ll probably fare better by favoring taxable bonds in your retirement account, while reserving your taxable account for tax-efficient stock holdings.

Less Is More

"SOMETIMES, YOU HAVE TO GO BACKWARD to go forward." That's my advice to financial advisors in my latest article for Financial Planning. The advice is equally applicable to the typical investor. To get the most out of your money, occasionally you may want to take steps that trim your portfolio's value in the short-term.

Examples? It often makes sense to live entirely off savings in your early retirement years, while delaying Social Security benefits to get a larger monthly check. It might also make sense to sell certificates of deposit, money-market funds and high-quality bonds, and use the proceeds to pay off debt. Your debts are likely costing you more in interest than you're earning on these conservative investments, so you'll be ahead financially, even if your investment portfolio is a tad smaller. Got a year with relatively little taxable income? You might seize the opportunity to convert part of your traditional IRA to a Roth IRA. That may trigger a big tax bill--and hence take a slice out of your savings--but you will enjoy tax-free growth thereafter.

31 Rules of the Road

SOMETHING HAD TO GO. The final chapter of the Jonathan Clements Money Guide 2015 was devoted to 31 rules for the financial road ahead. For the Money Guide 2016, I'm replacing that chapter with a new final chapter, which details how to create your own financial plan in 18 easy steps.

But even as I axed the 31 rules from the manuscript, I figured they deserved a permanent home. Every year, we see changes in tax thresholds, financial products, market performance, economic numbers and what worries investors. But while the financial world changes constantly, sensible financial advice doesn't--and that, I like to think, is what's captured by the Money Guide 2015's 31 rules of the road.

A Distinction Without Merit

IF WE WORK LIKE DOGS for 40 years, we’ll get our reward, which is the chance to sit around and do nothing for 20 or 30 years. That’s the definition of a successful life, according to conventional financial wisdom. But it doesn’t sound like a whole lot of fun, does it?

My contention: It’s time to rethink the crazy distinction between work and retirement and, in the process, redefine what counts as a successful life. Most of us get a lot of satisfaction from doing work that we’re passionate about and that we think is important, and our goal should be to spend our days engaged in these sorts of activities, whether we’re age 30 or age 70. That brings us to two key questions: How much income will this work generate—and how much income do we need?

Early in our careers, we may not be able to do the work we love, because it doesn’t pay enough to allow us to service our student loans, buy a house and sock away money for retirement. But as we pay down debt and amass some savings, we buy ourselves more and more financial freedom. We might use this freedom to focus on work that may not be as lucrative, but which we might find more fulfilling. Think about the investment banker who becomes a math teacher or the corporate executive who quits to join a nonprofit organization. These folks traded dollar income for psychic income.

As I see it, retirement represents this tradeoff taken one step further. By our 60s, we should have a heap of savings, which means we have a heap of financial freedom—and we might use this freedom to do work we’re passionate about, but which doesn’t pay us any income. That might mean coaching a children’s sports team, volunteering, pursuing artistic endeavors, devoting ourselves to hobbies or getting more involved with our church. Don’t get me wrong: If we can get paid to do what we love, that’s all the better. Indeed, earning even a modest income in retirement can greatly ease the financial strain felt by many retirees.

The bottom line: We need to collapse the distinction between work and retirement—and instead view our financial lives as the pursuit of ever greater financial freedom. That financial freedom, in turn, can allow us to do work we find fulfilling, with less and less worry about the paycheck that comes with it.

September Newsletter

THIS MORNING, I hit send on my inaugural newsletter. What's next for the markets? How can you get your kids started as investors? How can you get a little extra yield without getting whacked by tumbling bond prices? Those are some of the  topics I cover. My next newsletter will go out in early December. If you want to be on the distribution list for that issue, shoot me an email.