Personal Finance

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.

Off course you can!  Most people underestimate their ability to grow both their income and their wealth.  Most people do not create a written plan to increase their income and wealth.  Do you believe you can double your net worth in five years?

The four primary areas of increase where average people build their net worth are:

1. Savings
2. Portfolio return
3. Real estate (home) appreciation
4. Debt reduction/amortization

There are five major inputs or “levers” by which you can control the four sources of increase.  These include:

1. The growth rate of your income
2. Your savings rate
3. The rate of return on your investment portfolio
4. The rate of appreciation on your home
5. The rate at which you pay off debt

You have the most control over your income, your savings rate and your debt reduction rate.  You influence your portfolio rate of return with your asset allocation.  You have the least influence over the rate of your real estate appreciation.  However you influence the return on your investment or equity in real estate through leverage or the size of your mortgage debt and the rate at which you pay it off.

Start now!  For the next 30 days, when you get up in the morning and before going to bed at night, ask yourself the question: “How can we increase our income?”

It is extremely important that you believe your plan is achievable.  90% of achieving financial goals is mental, not financial.  “Whether you think you can or can’t, you’re right.”(Henry Ford).  Belief determines behavior.

For example, you can reject your Financial Plan because it does not fit your belief systems.  Or you can change the Financial Plan until it fits your belief systems.  Or you can work on changing your belief systems.  Helping people change their belief systems is the work of therapists, psychologists, ministers, educators and financial planners.  The purpose of all human communication is to change belief systems.

There are many ways to change your belief systems which are beyond the scope of the work of a Financial Advisor.  I believe the primary way to influence your belief system is through education.

Tip #1:  The best way to save for college 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.

Tip #2:  The best way to pay for college is to take the money from the most effective source with the least impact on your wealth.  That may mean using government subsidized loans and tax credits, paying out of current income or pulling equity out of your home.

sn86cf4ekq

Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals.  Research shows (Brinson, Hood & Beebower, 1986) that over 90% of investment portfolio performance over time is explained by the asset allocation decision. Thus asset allocation is so important, way more than security selection.

Do not believe the myth that diversification can be achieved with 10-30 individual stocks.  Academic research indicates that it takes at least 60 randomly selected individual stocks to eliminate 88% of diversifiable (uncompensated) risk.  Build a $250,000 core portfolio with low cost index funds or at least 60 individual stocks from different industries and countries.

For this core portfolio, adopt a financial asset allocation target of equity mutual funds and interest earning vehicles.  The split between these groups is based on your risk profile.  As you build wealth with this proven strategy, you create the solid foundation which increases your risk capacity. Your asset allocation will also change to match your increased risk capacity as your overall financial position on the Financial Life Cycle improves.

Use Morningstar’s fund screener to find mutual funds under these categories.  We recommend passively managed or index funds with low expense ratios.

There are many strategies for changing your financial asset allocation to more closely proximate the model of middle income millionaires.  All the strategies accomplish the same goal, but differ in terms of:

• Transaction costs
• Tax consequences
• Complexity
• Time to implement
• Financial benefits ($$$) to you
• Your emotional resistance

These strategies include:

• Liquidating portfolio equity assets and reinvesting in interest earning assets
• Invest 100% of your new IRA contributions/salary deferrals into interest earning assets until you achieve the target.
• Purchasing  US Savings bonds with after-tax dollars
• Some combination of the above

The National Association of Personal Financial Advisors (NAPFA) wants you to become more knowledgeable about personal financial issues, like basic money management, investments, kids and money, and much more. That’s why they’re launching a series of FREE online seminars (webinars) over the next year. The Consumer Webinar Series is for everyone – no matter how in tune you are with personal financial issues.

Each session is led by a NAPFA-Registered Financial Advisor who commits to the highest of standards in the financial planning industry. Many of the instructors are authors, educators and leaders in the industry.

The Consumer Webinar Series is a year-long initiative beginning August 7 (2009) that will provide an opportunity for anyone in the country to learn about a wide range of financial issues.  Each month a new session will be conducted live online. Consumers can attend the live session after registering for free, or listen to an audio file after the program.

The series will include 12, one-hour sessions delivered via the internet.  The individual sessions will be conducted from 11:00am – 12:00 noon Colorado time and will include:

• August 7, 2009:  Money 101: Knowing the Basics
• September 4, 2009: Kids & Money
• October 2, 2009:  What is Financial Planning?
• November 6, 2009:  Protecting What You Have
• December 4, 2009:  Investments: The Basics
• January 8, 2010:  Investments: Advanced Concepts
• February 5, 2010:  Managing Your 401(k)
• March 5, 2010:  Leaving a Legacy
• April 2, 2010:  Women and Money
• May 6, 2010:  Financial Planning and Small Business Owners
• June 4, 2010: Your Retirement
• July 1, 2010:  Financial Windfalls

Learn more about the Consumer Webinar Series by visiting the webinar page on the NAPFA website.

Asset Allocation is the process of dividing investments among different kinds of asset classes (such as stocks, bonds, cash, real estate, commodities, etc.) to try to meet specific financial goals.  Brinson, Hood & Beebower research of 1986 proved that asset allocation is the single most important decision that an investor makes.  Over 90% of portfolio performance is explained by the asset allocation decision.

 Traditional asset allocation models do not work for real people because their portfolios are much different from institutional portfolios.  Over 80% of all American households have a net worth that is less than $250,000 which includes the value of their home. Some of the big differences between institutional portfolios and those of most individuals include single vs. multiple goals, single vs. multiple time horizons, simple vs. complex tax treatment, professional vs. amateur investment management.

These differences led the founder of the Cambridge system to create a Functional Asset Allocation (FAA) model for individuals.  FAA illustrates how individuals build wealth as measured by Net Worth.

1)      Functional Asset Allocation – all your assets, including your home and personal belongings.

2)      Traditional (institutional) Asset Allocation – only financial assets, including checking accounts, savings, emergency funds, etc.

Using Functional Asset Allocation, your assets should be distributed across three asset categories: Interest Earning, Equities, and Real Estate. Generally, you want to have 1/3 (range of 25-40%) of your net worth in each of the three major asset classes.  Each of the major asset classes serves practical functions in wealth accumulation and risk management.

Read more in our INFO CENTER