I recently read The Secret Shame of Middle-Class Americans by Neal Gabler. As someone who has worked for thirty years as a financial adviser, reading the article was both sobering and painful. It was sobering because it gets to the root of the angst in America so evident in this political year. It was painful because it showed how financial planners have failed in their responsibilities, how I have failed over thirty years in my responsibilities.
It didn’t have to be this way. I thought back to the first article I wrote on financial planning for The Ridge Review in 1986. I went back and read that article again and I stand by what I said. The article is copied below. Perhaps my grandchildren will read it when they are a little older. It’s never too early to start developing the right financial habits. That may be too late for those Gabler writes about, but it’s a beginning.
I would add or change a few things if I were to write a similar article today. I would strongly discourage the use of credit cards. I have never used them except for convenience in ordering online, and I always pay the bill in full each month. Misuse of credit cards is one of the largest reasons so many people are in financial straights today. I would also advise preparing for long term care needs, a subject not on the radar thirty years ago but very much on the radar today. Longer life expectancies increase the chances we will need some type of long term care. Finally, I would stress the importance of communication in all your financial affairs.
The advice I gave thirty years ago appears below with a few changes. I think it is still relevant today.
Steps to Security – First published in The Ridge Review, 1986
You know, Ernest, the rich are different from us.
—F. Scott Fitzgerald
Yes, I know. They have more money than we do.
Steps to Retirement
You probably expect to live longer than you will work. If you consistently save 10% of your income from age 30 through age 65, you will accumulate a sum you can live on for the rest of your expected lifetime. The basic rule of financial planning for retirement is no mystery: “Work hard, save, and you will be rewarded.” However, “twixt the cup and the lip there is many a slip.” To insure that your cup is full when you need it you might ask: “How hard must I work, how much must I save, and how well will I be rewarded?” If you manage to save only 5% of your income, you will come out short. Furthermore, if you choose your methods of saving poorly and if inflation is worse than you expect, even 10% savings will be too little. Confused? Don’t give up yet. Retirement planning is more complex than it may seem at first sight; but there are some remarkably simple ideas which, when understood and acted upon, can provide you with just what you are looking for: a financially secure retirement.
You’re On Your Own
No one cares how well fixed you are for retirement as much as you do. Your children will probably continue to need your support rather than be in a position to offer theirs. Social Security can help you meet your financial needs at retirement, but it will probably not be sufficient to provide you with the life style you expect. The lottery, a large inheritance, an unexpected windfall? Your security is your concern. Your most important assets are yourself and time. Start planning early for your retirement. Set realistic goals. Seek out good advice and be persistent. The steps below provide a basic outline of how you might proceed.
Check Your Insurance
Almost everyone spends either too much or too little on insurance. Almost no one knows what insurance is. Insurance is the substitution of a small certain cost (the premium) for the elimination of a large uncertain loss (the risk). Insuring risks that you can cover is a waste of your money. Failing to insure risks you cannot cover could impoverish you. Insurance is not an investment. Insurance is not a savings program. In most cases there are more economical and efficient ways to save and invest. Proper insurance is an important step in financial planning for retirement, but it is not the whole story.
There are essentially three financial bumps in the road that can cause your financial cup to slip: early death, disability, and a long life. In the happy event of a long life you need good financial planning for retirement. Keep reading! Term life insurance will provide a retirement sum for your family in the event of your early death. Disability insurance will replace some of your income if you are unable to work. Major medical insurance will protect your retirement savings from unforeseen major medical expenses. You should budget for these three types of insurance before you begin a savings program for retirement. Without basic insurance coverage hard won savings and wise investments could quickly disappear. You should also become informed about long term care costs and determine if long term care insurance is something to work into your budget.
Establish a Financial Reserve
Before you can plan for retirement, you need an income sufficient to keep body and soul together. That means you need a job, one that pays as well as possible. Next, before you consider investing, you need a cash reserve. Investing can be the most exciting part of planning for retirement; however, if you don’t have a few months’ income set aside in a safe and accessible place for a rainy day, the excitement can disappear quickly. Because of penalties or market constraints, retirement assets and other investments are often not very liquid (readily convertible to cash). You should establish a three-to-six month reserve held in a money-market account, a savings account, or some other short-term financial vehicle that is safe and liquid.
Save Some Money
Your income is derived from three sources: your job, your investments, and charity. Your expenses are derived from one source: you and your family. You are responsible for every dollar that you spend. There is a simple rule in economics: if your expenses exceed your income, you will kill the goose that lays the golden eggs. If you inherit a million dollars at age 40, invest it at 10%, retire and spend $150,000 a year, you will be broke before age 50. Simple economics. But if you save $100 a month starting at age 20, you could be a millionaire at age 65. Even if you put away only $10 a month, you could end up with $100,000 in retirement. Good financial planning means first that you are able to take control of your budget. You must increase your income and decrease your expenses until you can achieve a surplus. How much of a surplus? That depends on your personal goals and objectives; however, 10% of your income would be a good target. Always pay your full credit card balance each month. Better yet, don’t use credit cards. The interest costs of money borrowed on credit cards can seriously undermine your financial health. Equally important, discuss all your financial decisions with your spouse and family. Lack of communication on financial matters can be a major cause of financial distress.
Start an IRA
Now that you are ready to invest, start an IRA. This is simply a retirement plan for individuals. Almost everyone with earned income can have an IRA. The advantages of an IRA are: (1) You don’t pay taxes on the money you contribute until you take it out of the plan (Note: Roth IRAs work differently); (2) The money in your IRA compounds tax deferred; (3) You are in control of how much you contribute and how your money is invested. This is a good way to start saving for retirement.
You should concentrate on investments that produce dependable income and are not speculative. If you are safety conscious, consider Certificates of Deposit at your local bank. With a little more risk you can probably obtain a greater return using TIP bonds that are adjusted for inflation. Most mutual fund companies allow you to move money in your IRA between their various funds for a minimal charge. You can invest in bonds, stocks, money-market accounts or any combination. These investments are not insured and you may experience losses, but over the long term stocks and bonds have the potential to provide better returns. Banks, mutual-fund companies, and brokerage houses all have simple applications to establish an IRA. If you are unsatisfied with the service or the return, you can move your funds to another custodian through a transfer or an IRA rollover. A self-directed IRA, which can be established with a special custodian, will broaden your choice of investments to individual stocks and some alternative investments that may be appropriate as your account grows. It is important to diversify, to follow the rules, and not to speculate. Over the long run the fluctuation in most diversified investments evens out even if some investments perform better than others over shorter time periods.
Use Employer Pension Plans
Employer pension plans including 401(k)s and SIMPLE Plans allow the employee to defer a percentage of income which can compound tax free until it is withdrawn from the plan. In many cases employers can contribute to the plans in the form of a match that is a tax-deferred bonus to the employee. Always try to invest enough to qualify for the full employer match. Employer plans work much like an individual IRA. The contributions can be larger but the investment choices might be limited. These plans can provide substantial retirement income if they are well constructed and if the monies are invested wisely.
Buy A House
The question of whether to buy or rent depends upon a number of personal, economic, and political variables. The comparative rates of return on other investments will be an important factor as will the tax advantages of investing in your own home. Your personal housing needs, the rental market, the personal satisfaction you expect to derive from home ownership, and your ability and desire to maintain a home are also important considerations.
With lower inflation and changing tax laws, investing in your home may not be as good an investment as it was in the past. There is also the risk of investing a large part of your capital in one particular asset—your house. For most people, however, investing in a home proves to be a good investment simply because people tend to take care of their homes, thereby maintaining and increasing the home’s value. Most people take better care of their homes than they do of their money! If you are this kind of person, you should probably own a home. If you are not, perhaps you should rent and invest the difference.
Understand Investment Risks
There are four kinds of risk in investing. No investment eliminates all four. The risks are: inflation risk, business risk, market risk, and interest rate risk. Inflation risk simply means that a dollar ten years from now will not buy what it will buy today because prices will be higher. To guard against inflation risk, you must earn interest on your money sufficient to keep up with inflation. Leaving your money under the mattress or in your checking account is not likely to protect you from inflation risk. Interest-rate risk results from the fact that changes in interest rates affect the market value of income investments. If interest rates rise, the market value of bonds issued at lower rates and other fixed income investments may fall. If interest rates rise, you could be sorry that you didn’t wait and invest at the higher rates. Business risk is the possibility that the particular business in which you invest may lose money or completely fail. Market risk occurs when all investments in a particular asset class (stocks, real estate, etc) decline in tandem.
While there is no one investment that eliminates all types of investment risk, there is an approach based on common sense. Don’t put all your eggs in one basket. You can choose a proper combination of investments that will produce growth, income, capital preservation, and liquidity. The proper combination for you will depend on your age, your goals, your means, and your preferences toward risk. However, it is essential to diversify. No one can predict the future. If all your money is invested in CDs and bonds, your investments are not as “safe” as you may think. Inflation can evaporate savings just as effectively as unwise speculation. If all your money is in the stock market and you are feeling smug with the recent high returns, remember that the market can go down as well as up. Can you predict which will be the “best” investment in the future? Better to be diversified than sorry.
Unlocking Your Assets
In the end you can’t take it with you. If you are so lucky as to have accumulated more than you can comfortably spend, then you need to read an article on estate planning.
Of course, when you retire you will need some income from your investments. You can probably get by on 75% of what you’re used to because you won’t have work-related expenses, your income taxes will likely fall, and Social Security may still be around to supplement your retirement income. But many retirees say they spend more on travel, health care, and long-term care than they expected.
When funds from employer-sponsored pension and savings plans are distributed an employee generally has several choices: (1) take the money out and pay ordinary income tax on the distribution; (2) leave the funds in the existing employer plan if allowed; (3) rollover the funds into your new employer’s plan if allowed; (4) rollover the funds into an individual IRA. Keeping the funds in one or another pension plan generally avoids all taxes at the time of the distribution and allows your retirement funds to continue compounding tax deferred. Which method is best depends upon your age, income needs, tax bracket, and future plans. These will vary for each individual. If you don’t need the money all at once, a rollover can be a good choice. This is a complicated decision and you might benefit by seeking help from a professional.
You may withdraw funds from your IRA without penalty after age 59 ½. You must begin to withdraw funds by age 70 ½. Taxes must be paid on the monies withdrawn at the time of withdrawal.
If you have neither an employer sponsored pension plan nor an IRA, how can the income needs of your retirement years be met?
While savings of after-tax dollars is not as efficient as the tax-deferred compounding within an IRA, nevertheless many retiring today have managed to save considerable sums over the years realizing they would need this savings to provide financial security at retirement.
The main concern will be how to invest these funds. That will depend on the same factors mentioned above (Understanding Investment Risks). Emphasis will now be on preservation of capital and income rather than growth although inflation will still be a concern. Diversification is just as important at this time as it was in the past as a means to limit the various kinds of risk.
Your Home and Other Assets
Your home can be a source of retirement income in two ways. You can sell your home and invest the proceeds for income. There may be tax advantages for older homeowners. You will of course have to buy a smaller residence, rent, or live with relatives. Both the psychological and the financial effects must be considered. An alternative might be to rent a portion of your home. You may find that you don’t need as much space as you did in the past and you may enjoy the company. There are reverse mortgages that can provide retirement income but they are complicated and you should study the details carefully if you are thinking of one.
Most of us acquire a number of things over the years that we really don’t need. The value of these assets can add up to a tidy sum. Consider selling what you no longer need. Someone else could enjoy these assets while you enjoy the money resulting from their sale.
A Hobby or a Job?
“Don’t pity me, don’t pity me never.
I’m gonna do nothing forever and ever!”
–epitaph of an old Charwoman
There isn’t any time while you’re alive that everything simply stops. William Blake, the English poet, learned Italian at age 60 because he didn’t trust the existing translations of Dante. Perhaps you’ve come out short. Perhaps your cup has slipped. This can be an opportunity as well as a concern. Really, you are your own best asset. You have learned a lot over the years and you have developed many skills. Now is the time to put them to use in new ways. Even if you have sufficient funds you may find that working after retirement is financially and psychologically sustaining. As our population gets older many of us will likely choose to work longer. Even if you have no other assets you do have yourself. You’ve come this far. How far you can go depends on more than dollars. Loren Dunton, the “father” of financial planning, reminded us: “The most creative things are done by those who aren’t too busy making money.”