Personal Finance

Goals are a “destination”.  A Financial Plan is a “roadmap”.  Creating a roadmap requires you to identify your starting point as well as your ending point.

Many business coaches and books tell the story of a famous study of 1979 Harvard graduates (or 1953 Yale graduates).  Ten years after graduation, the 3% who had written goals were earning ten times the average income of their peers who had no goals.  The story is an urban myth, but verifiable research at Dominican University has confirmed the power of putting your goals into writing.  Develop a Financial Plan, have SMART Goals in writing (SMART stands for Specific Measurable Achievable Results in Time) and join the fabled 3%.

This is a critical step.  The difference between dreams and goals is a written plan.  Look at the four walls around you.  The building first existed as an idea in someone’s mind.  The blueprint was a key step for converting the dream into the solid structure you can see and touch.  There’s an old saying that people don’t plan to fail, they just fail to plan.

After creating the blueprint, the next step for turning dreams into reality is massive action.  Are you ready to act on your plan?

Your beliefs determine your behavior.  Therefore it is extremely important that you believe your plan is achievable.  Achievable is the “A” in SMART goals.  What you achieve is primarily mental.  “Whether you think you can or can’t, you’re right.”(Henry Ford).  Only human beings have the ability to create the future in their minds first.  Remember the building illustration.  Every human accomplishment, from the invention of the plow to smashing the atom and putting a man on the moon, was first a thought in the human brain before it became a reality.

Every one of us has this amazing ability.  We just don’t use it.  If you can plan a vacation, build a home or plan your day, you can plan and achieve financial independence.  It’s 99% mental.

The final step of the financial planning process is to monitor the plan.  Monitor how your net worth grows by recording your income, savings, portfolio, real estate, and amortization over time.

Unemployed will have specific list of actionable steps for:

1. Short term damage control
2. Regaining long term employment
3. Overcoming dysfunctional emotions of guilt, depression and procrastination

 What Causes Unemployment? 

Technology causes unemployment.  150 years before the Great Depression over 90% of all Americans worked on small farms, ranches or large plantations.  Today less than 3% of Americans work in agriculture.  Engine power replaced manpower and horsepower.  During the Great Depression we experienced 25% unemployment as technology destroyed old jobs faster than new ones were being created.  The Great Depression marks the transition of the United States from the Agricultural Age to the Industrial Age.

Today we are experiencing the highest unemployment since the Great Depression as the forces of creative destruction accelerate their work.  From May 2008 to October 2009, technology destroyed a net 250,000 jobs per month faster than it created new ones.  The Great Recession made the transition of the US from the Industrial Age into the new Age of Information & Communication.

What Should Do To Limit the Economic Damage of Unemployment?

Implement the following check list for the unemployed

• Create a cash flow projection or budget for the next 12 months and always keep it up to date.
• Increase liquidity.
• Apply for unemployment insurance.
• Review insurance needs and use COBRA to keep your existing health insurance until the new Obama health care legislation takes effect.
• Pay off debts.
• Rollover your Qualified Retirement Plan (e.g., 401k) to an IRA.
• Create a tax plan and verify any opportunities for tax free Roth Conversion during low income years.
• Plan for worst case scenario.

What Should You Do To Regain Employment in the New Information-Communication Age? 

Invest in yourself.  To find and keep employment in the new age requires more thinking than in the past.  In the Information Age it is your ability to think that will bring wealth and job security.  Unless you have unique physical skills that cannot be automated (plumber, waitress, professional athlete, etc.) the muscle in your head is the key to job security.  Only your brain can process and manipulate information to create wealth.  You begin that process now with your search for employment.

• Understand the job market.  In the United States there are three automobiles for every household while in China there are 30 households for one automobile.  What does this information tell you about searching for work in the manufacturing or construction industries?  Many manufacturing and construction jobs have gone the way of the blacksmith and farmer.
  • The same technology that destroys old jobs also creates new ones.  What are the new jobs that are being created?  Will clean energy replace the automobile industry?  Do you think there might be a growing demand for career counselors and other people who gather, analyze, manage and provide information about the job market?
  • The US Department of Labor project job growth for every industry and career in the county.
  • The internet is another source of information about the job market.
• Could you qualify for the new jobs created by technology?  Are some of your skills transferable?  Farmers who used their hands to repair equipment, learned how to assemble or repair automobiles.  Blacksmiths became tool and die makers.  You have skills and values that are marketable and may require minimal training to apply in a different field.  Do an inventory of your skills.  Read books like What Color Is Your Parachute? by William Bolles.  Use the internet and Google to find other resources.
• Contact a nearby College, University, technical or community college.  All offer classes on Career Planning and Development.

As a general rule of thumb, you need a portfolio that is 10-15x your unfunded living expenses in order to stop working.  Factors that impact the ratio are: your life expectancy at retirement, your income replacement ratio from non-portfolio sources and your tax bracket.  The younger you are when you retire, the longer the time the portfolio must support you and the larger it must be. 

Assume for a moment that your living expenses are the same as your income.  If your pre-retirement income was $20,000/year, you can expect Social Security to replace 69% of your income, so you may need a portfolio of $62,000 to $93,000. 

If your pre-retirement income was $90,000/year you can expect Social Security to replace only 36% of your income, so you may need a portfolio of $576,000 to $864,000. 

That’s a significant difference.  The difference in income is 4.5X.  The difference in required retirement portfolio is almost 10X.  To compound the challenge, the higher your required retirement income, the larger your portfolio must be to pay the additional taxes.

There are two sources of personal financial wealth.

1)      Existing wealth is either transferred to us, or

2)      We create and accumulate new wealth that never existed before.

Existing wealth is transferred to us by gifts, inheritance, government programs, marriage, etc.  We create or produce new wealth with our bodies (physical labor) and/or our minds (ideas, innovation, etc.).

Human capital is a measure of an individual’s potential for creating new wealth by calculating the net present value of their lifetime earnings.  Assuming your current earnings of $22,000 and a working life of 40 years, the value of your human capital can be estimated as $509,000.

You may have heard that the United States is leaving the Industrial Age and entering the Information Age.  As we transition from a manufacturing to a knowledge economy, those who create more wealth with their mind (knowledge) will have a significant advantage over those who create wealth with their body (physical labor), unless they have a specialty such as professional athlete or washing the windows of skyscrapers.  By investing in your health to prolong your working life, and investing in your mind to increase your earning power, you increase your individual human capital.

Gross Domestic Product (GDP) is a measure of a nation’s produced or created wealth.  In 2008 the US economy produced $14.4 trillion dollars of wealth or Gross Domestic Product (GDP).  Our GDP per person or per capita was $47,440.  Our GDP per household was $129,540.  In other words, even after the market crash in 2008, the average US household created $129,540 in new wealth.

After 40 years of working (age 25 to 65), the average US household will create $5,181,600 in new wealth.  We are the largest economy in the world and the US worker is the sixth most productive in the world.  Yet, in an aging America 80% of all households have a net worth LESS than $250,000!  How can so many produce so much and have so little to show for it?

We propose two simple answers:

1)      BEHAVIOR – Individually, we are CONSUMING more wealth than we CREATE.

2)      BELIEFS – Most likely we have beliefs which

1. trigger consumption instead of investing
2. block the unlimited human capital in our minds

A Financial Plan addresses both issues and accelerates the journey to Financial Independence. 

When you use credit cards to buy things you can’t afford you are borrowing from your future to pay for your now.  If you cannot pay off credit cards monthly, by definition you are living beyond your means.  For example, paying interest of $700 – $1,000/year on a credit card balance of $6,000 equals to spending x% of your income.  As the goods or services you purchased with the credit card decline in value, the purchase price increases because of the interest.  After 5 years at 15% you paid twice the original sticker price.  Borrowing from your future to pay for your now is devastating to financial independence and peace of mind.

There’s an old saying that you can’t manage what you don’t measure.  The first step to controlling spending is to count it.  There’s an amazing benefit.  Forcing yourself to record every expenditure will automatically reduce your spending.  Use the Spending Plan / Cash Flow tool on our website to develop a budget for the next 6-months.

There is growing evidence that the primitive part of our brain called the amygdala triggers the impulse to consume now.  The urge to consume as much as possible probably helped us survive in a prehistoric world of scarcity.  But in modern times that survival mechanism may be just as harmful as the related mechanism that stores fat.  Today the urge to consume as much as possible harms financial, as well as physical health.

To override the urges of our primitive brain we must use our frontal cortex which gives us the unique ability to plan.  We can set ourselves up so that we become automatic savers instead of automatic spenders.  Many middle income millionaires achieved the status automatically.  Here’s how they did it:

a)      Set up automatic savings by having 10% (or more) of your paycheck automatically deposited into your 401(k) or IRA.

b)      Set up automatic bill paying from one checking account or credit card.

c)      Set up automatic tracking or accounting.  The monthly statement from the single account becomes your record of expenses.  To get a bigger and more detailed picture of your finances sign up for one of the FREE online automatic accounting services.  The most comprehensive is Yodlee MoneyCenter at www.yodlee.com.  The most user firendly and fastest growing is Mint at www.mint.com.  A relatively new service is Quizzle at www.quizzle.com.

d)      Finally, stop impulsive spending by cutting up all the credit cards except one.

 You can also use financial planning software such as Quicken or Microsoft Money.

The best way to save for future college expenses is to put money in the most effective place to build wealth the fastest.  That often means maximizing our contributions to our 401(k) or IRA.  Money saved in a 401(k) or IRA can be used to pay for college and under current law does not reduce eligibility for financial aid.  The best way to pay for current college expenses is to take money from the most advantaged source that still allows your wealth to grow the fastest.  That may mean using government subsidized loans and tax credits, paying out of current income or pulling equity out of your home. 

In real life no one knows what methods for paying for college will be available years from now.  We have only to look at the recent changes to understand the challenges of financial planning for college in the future.  Twenty years ago Education IRA’s and state-run Section 529 plans did not exist.  Twenty years ago there were no provisions to borrow from your 401(k) plan or to make penalty free withdrawals from your IRA to pay for children’s college.  There were no education tax credits.  The concept of using home equity to pay for college was not an accepted practice.  Liquidation rules for US Savings bonds did not allow an exemption from federal and state taxes if the bonds were used for qualified college expenses.  Many of the federally subsidized loan programs were not available twenty years ago.  The reality is we do not know the best way to pay for college education even five years from now.  We do not even know for sure if our child will attend college.  Planning for college is an example of what we call “planning under extreme uncertainty”. 

Most of us should not be setting aside money for children’s college until we have adequately funded our own retirement.  The government and financial institutions will lend you money for education just as they will lend you money to buy a home.  But no one will lend you money to pay for your retirement. 

Paying for your children’s college is a great act of love.  But building your wealth so you can pay for long term care in your old age may be an even greater act of love.  The “sandwich generation” refers to the growing number of families who find themselves financially impacted by the need to care for children and aging parents at the same time.

The table below illustrates one more reason it is usually better to keep assets in parents’ name until the child receives an invoice for college expenses. 

Investors face many kinds of risks:

Exogneous Risks – Risks that are external and common to all investors
1. Market risk – Risk which is common to an entire class of assets
2. Interest rate risk – Risk that value will change due to a change in interest rates
3. Reinvestment risk – Risk that future proceeds will have to be reinvested at a lower interest rate
4. Business risk – Risk associated with the unique circumstances of a particular company
5. Liquidity risk – Risk that security cannot be sold quickly
6. Default risk – Risk that company or individual will not be able to meet contractual obligations.
7. Industry risk – Risk which is common to a specific industry
8. Deflation risk – Risk of contracting (vs inflating) volume of money and credit relative to available goods. Considered the most dangerous risk to an economy because consumers stop spending and hoard cash. This triggers a vicious cycle of increasing unemployment and declining economic activity which is difficult to reverse.
9. Inflation risk – Risk of expanding (vs. deflating) volume of money and credit relative to available goods. Also called “purchasing power risk”.
10. Uncompensated risk – Risk for which the investor receives little or no reward because the risk can be diversified away.

Endogenous Risks – Risks that are internal and specific to the individual investor
1. Longevity risk – Risk of outliving your money
2. Unemployment risk – Risk of no income
3. Morbidity risk – Risk of disability or need for long term care
4. Mortality risk – Risk of premature death
5. Cash flow risk – Risk of insufficient cash to meet living expenses
6. Default risk – Risk of not being able to meet contracted financial obligations
7. Decision making risk – risk of suboptimal decisions triggered by emotions, lack of knowledge, bad information or bad advice from media or incompetent advisors. Evidence suggests this is the greatest risk faced by investors.
8. Fraud risk – Risk of being defrauded by criminal activity of advisor (Madoff, etc.)

The three Commandments for Successful Investing
1. Thou shall not take any risk that thee dost not need to take
2. Thou shall not take any risk for which there is not commensurate reward
3. Thou shall not risk any money thee cannot afford to lose.

The primary purpose of life insurance is to protect against the loss of income caused by the premature death the person who earns the income that supports dependents. If you do not have dependents, you probably do not need life insurance.  Life insurance provides the “instant portfolio” that the bread winner did not have time to build due to his or her premature death. 

Level premium term insurance that fits the time period needed to build the portfolio or estate is the best fit for this need.  Twenty year level term purchased after the birth of a child is often a good fit for a young family starting out in life.

Most people should not be purchasing cash value life insurance unless they have special estate planning or business needs.  Cash value life insurance is very expensive compared to level term and often causes young families to be underinsured.  It’s illegal to sell life insurance as a retirement vehicle or savings plan.  Because of the high expenses and commissions to the agent, it’s usually a terrible investment.

Most people should not be putting money into cash value life insurance until they are maximizing their contributions to the Qualified Retirement Plans (e.g., 401k, 403b) and IRAs and are in a very high tax bracket.  Premiums paid into cash value life insurance are not tax deductible.  Investment money in cash value life insurance is not protected from creditors by ERISA.

What to do?

• Call your insurance company and ask for the “cost basis” of your cash value policies.  Cost basis is the total amount of after-tax money that you have paid into the policy and which you can pull out without having to pay any taxes.
• If the cost basis is significantly more or less than the surrender value, consider the benefits of doing a 1035 tax free exchange into a Vanguard variable annuity.
• Purchase low cost term insurance that will provide a lump sum large enough to replace lost income for the period of time needed by dependents.

Low cost term insurance can be purchased online at www.insure.com or www.vanguard.com or www.tiaa-cref.com.

People who practice good health habits are more likely to enjoy physical independence than those who smoke, eat junk food and don’t get enough sleep or exercise.  Clients who implement The Five Fundamentals of Fiscal Fitness© achieve financial independence and move successfully through the financial stages of life. 

 The 1^st Fundamental is to save 10% of your income.

 Why?

 a)      Saving 10% is the simplest and easiest of all budgets.  If you are saving 10% of your income, by definition you are living within your means.

b)      The secret to Financial Independence is to Fund your Future First.  No matter how much or how little you earn, you should always save 10% of your income as “permanent” savings.  Most people pay their bills first and save what’s left.  Financially independent people pay themselves first and spend what’s left.  The only money you really keep for yourself is what you save.

 c)      Saving 10% of your income is evidence of your ability to defer gratification.  According to psychologists the ability to defer gratification is an indicator of emotional intelligence and perhaps the most powerful predictor of success for young toddlers.

d)      Nobel Laureate, Robert William Fogel, has calculated that if the average couple with one spouse working part time, saved 14.7% of their income from the day both spouses entered the work force, the couple could retire at age 55 with a retirement income that placed them among the top 20% of all US households (William Fogel, The Fourth Great Awakening, p. 196.).

e)      Saving 10% of your income to build wealth reduces your dependency on Social Security.  Social Security was meant to be a social safety net, not a universal retirement plan.  When Social Security started there were 40 workers contributing for every one beneficiary.  Today the ratio of workers to beneficiaries is 3/1 and soon it will be 2/1.  There is no doubt that social security benefits will have to be reduced for the program to remain solvent.

f)       Saving 10% of your income provides a cash flow cushion which allows you to take more risk in your portfolio.  During an emergency, you can reduce your savings rate instead of tapping your investments.

g)      Saving 10% of your income even after you retire provides some inflation protection during the withdrawal years.  In practice this means that when you retire, your taxes and living expenses should be about 90% of your total income.

h)      Saving 10% of your income even during retirement reduces the impact of portfolio losses during the withdrawal years.  The key to retirement is managing spending.  By never spending more than 90% of your gross income, you continue to fund your future first and greatly reduce the odds that you will outlive your money.

The primary focus of a Financial Plan is to help you build and manage your wealth more effectively.  Achieving that goal requires you to choose one of three core financial strategies:

1. Accumulation
2. Conservation
3. Distribution

If you select the Accumulation strategy, your #1 priority is to build your wealth.  Accumulation may be the most suitable strategy if you do not have much wealth to protect or you do not have sufficient wealth for your life expectancy.  While you never want to lose money, adopting an accumulation strategy means that growth trumps safety.  A higher return is often more important than lower risk.

If you select the Conservation strategy, your #1 priority is to preserve your wealth.  Conservation may be the most suitable strategy when you have significant wealth to lose.  You may be near retirement or you may possess sufficient wealth to match your life expectancy.  In either case, not losing wealth becomes more important than gaining more.  Why risk going backwards if you have already arrived at your destination?  While you always want your money to work hard, during the conservation stages, safety trumps return.  Lower risk is more important than a higher return.

If you select the Distribution strategy, your highest priorities are enjoying the use of your wealth and planning for its final disposition.  Establishing and updating a values-based estate plan becomes very important.

You can leverage the Cambridge Financial Life Cycle© to determine the most suitable strategy for your situation.