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Critiquing a Financial Plan

The following article examines five young people and their financial plan (more like their lack of planning).  They are then offered some preliminary advice about how to improve their situation.  Unfortunately, in every case I found the advice to be overly simplified.  Here’s the article

And here are some overarching strategies that apply to all the case studies:

1)      Emergency fund.  Start here first and make it a priority to build an emergency fund that can cover non-discretionary expenses for 3-6 months.

2)      Save more.  If you can’t save more now, earmark any future raise toward saving.  When asked about a rule of thumb for how much to save, I’ll often respond with “Save as much as you can”.  Young people and millennials are unlikely to have pensions and with the questionable future of Social Security, the burden to save is placed on their shoulders much more than previous generations.

3)      Automate.  Make sure any savings are set to occur automatically.  The mental anguish of writing a check every month or year to a retirement account can be surprisingly difficult.  Many times it is our own biases that create obstacles to reaching our own goal and simple processes like automating our savings can have a huge impact.

4)      Disability.  Life insurance is commonly discussed when a couple has children.  But disability insurance is rarely brought up.  What’s odd is that people are more likely to file a claim for disability insurance than life insurance.  And it doesn’t apply just to physical injuries, either.  We’ve had several clients and prospects tell us about their long term disability that affects their ability to do a desk job as a result of a bad car crash.

 

How To Save, When You Can’t Save Today

“ I want to save for retirement, but I can’t afford to do so right now.”

This is a common complaint we hear, especially with our younger clients. They are dealing with debts, saving for their children’s education, and even helping to take care of their aging parents. These younger clients want to save for retirement but just don’t know what to do.

So, what should they do?

Over the last few months I have written about this concept extensively:
Is a Creative Saving Strategy Right For Me?
The Most overlooked Saving Strategy: The Serial Payment
The Three Flaws With The Most Popular Saving Strategy

The strategy that I outline is to come up with a plan to consistently save more and more every year. Perhaps you save an extra 1% of your paycheck each year, or every year allocate a portion of your raise to retirement. This concept is also referred to as Saving For Tomorrow, Tomorrow and there is a great Ted Talk about it here.

If you’re on board with this concept, visit this New York Times calculator to see how this could work for you: One Percent More Calculator

Einstein is claimed to have said that “Compounding interest is the eighth wonder of the world”. And by combining the benefits of compounding interest and compounding savings into a retirement plan, it would make for a much, much more powerful strategy.

How To Retire in 4 Years

The story about a couple’s desire to retire in 4 year is compelling.

They have applied many of the important financial planning concepts:

1) The plan to live a very modest lifestyle in retirement – They plan to need 30,000 a year in retirement.
2) They have cut and reduced many of their expenses. They realized how freeing it is to not have a large mortgage.
3) They plan to work part time. Retirement is being redefined. Working part-time, doing a fun job, is becoming common.
4) They have a plan. While I have not checked their math, it’s appears they have thought through many of the common issues retirees face.
5) They are diversified. Between side jobs, investments, and real estate they will have multiple sources of income available for them.

Is a Creative Saving Strategy Right for Me?

Someone can reach an ambitious financial goal (such as saving for college education) despite having limited cash flow available to fund the goal.  The goal can be accomplished by using a creative saving strategy called a serial payment.

Many clients that I have worked with this year have expressed a strong desire to fund a majority of their children’s college education but currently have limited resources to commit to it today.  Instead, they have promising careers in which they expect decent raises in the future or expect their spouse to re-enter the workforce once the children are in school.  They have already tightened their belt and understand that a portion of future raises will be diverted to their future goals.  This strategy gives them a roadmap for the future.

For more details, read these other posts to learn about the process.

The Most Overlooked Saving Strategy: The Serial Payment

In a recent post, I argued that there is a flaw in the most common approach saving for a big goal like college education.

I argue that in some cases, saving for a goal should be done the way you would if you were to begin training for a road race. If you begin to exercise today and have a goal of running in a marathon twelve months from now, you won’t just start running 26.2 miles per day.  You’ll burn out or get injured.

Instead, you are more likely to come up with a plan where you gradually and systematically increase the difficulty of your exercise regimen over time.  By gradually increasing the workout,  you mentally condition yourself and can prepare for longer, harder, and more difficult exercise routines in preparation for the race.

While we mostly think about saving a set dollar amount per month, that may not be realistic or possible for many people who have limited cash flow. Saving for a goal could be done the same way by using a saving strategy referred to as the serial payment. Here is what makes this strategy different – the amount saved increases by a set percentage each and every year.  For example someone who saves $150 a month for one year, would increase it by a set percentage (we’ll say 4%) each and every year.  In year 2, they would be saving $156/mo ($150 * 1.04).  In year 3, they would be saving $162 ($156 * 1.04).

Let’s compare these two strategies.  Assume that John and Andrew each want to save $90,000 for college education in 18 years.  They plan to save a portion of their paycheck and will invest it in the market where they are expecting an 8% rate of return.  John plans to invest $2400 at the end of every year and will do so for 18 years.  Andrew will fund $1,825 at the end of the year but will increase the amount by 4% per year thereafter.

The result: they both reach their goal of $90,000 by the end of the 18th year.   Below is the breakdown of how much each of them has to save each year:

saving

Andrew is able to begin saving a lot less early on but will have to make up for it from the 9th year and on.  By then he will likely be in the peak earning years of his career and will have more cash available to fund the goal.

This strategy does have some drawbacks.  Making less contributions in the early years reduces the effectiveness of compounding interest which means that Andrew would have to save an extra $3500 more than John over the 18 years.  And that figure would be much larger if we adjusted for inflation.

If you are exploring ways to save for a goal, run the numbers assuming a flat/fixed amount first.  Saving more earlier is almost always preferable thanks to compounding interest.  But it may not be possible.  If you can’t afford that, try using a serial payment strategy.

The Three Flaws With The Most Popular Saving Strategy

The most common saving strategy is where the investor saves a specific and set amount of money on a regular basis. For example, $200 is automatically set aside (and possible invested) by a young family every single month to fund future college education expenses until their child turns 18.

Here’s the problem: Using a fixed dollar amount as described above is hardest in the early years which is when cash flow is already tight. There are three reasons why.

  1. Behavioral standpoint. The saver is just getting started and not conditioned to save such a large amount so quickly. While they have every intention of saving $200 a month, they crash and burn after only a few months.
  2. Cash flow limitation. A saver may decide they can’t afford to save $200/mo now and decide to begin saving at a later date after they have received a raise or two, abandoned the goal altogether or reduce the scope of their goal. All of which may be premature decisions.
  3. Economic standpoint. The purchasing power of $200 declines, slowly but surely, every year due to inflation. Think about what $200 could have bought 18 years ago? Now imagine that trend continuing 18 years into the future. When the saver factors in the effect of inflation, and future salary raises, the pain of saving $200 will decline substantially by the end of the 18 years. The saver would still be saving the same amount, but it will feel like a lot less 18 years from now.

Think of it this way: if you begin to exercise today and have a goal of running in a marathon twelve months from now, you won’t just start running 26.2 miles per day. You’ll burn out or get injured. The same can be said for how we save. Trying to develop a habit in which you save too much, too quickly, can easily fail.