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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.

Using The Money Management Tool: Setting a Budget

Recently we introduced The Money Management Tool to help clients better organize their financial lives. The tool has lots of features and we will occasional explain how some of the features are being used by our clients (or should be used) to help them reach their financial goals.

This post will deal with prospective client who needed some help staying on budget.

Situation: A young couple with two children asked us for guidance on getting a handle on their debts. They had multiple credit card balances with obscene interest rates, a result of unexpected bills. They were spending more and more of their income to make debt payments instead of saving for retirement. They were slowly realizing that they would not be digging themselves out of debt anytime soon and needed a plan to get back on track to save for retirement.

Problem: During the initial meeting, we discovered a significant amount of their take-home pay was going toward non-essential expenses, such as the most premium cable package available and eating out for lunch every single day.

Solution: Directing savings originally intended for retirement to pay down credit card debt is an acceptable strategy in some cases. But when there is a lot of non-essential spending occurring, a tightening of the belt should be the first strategy. In this case, the client could connect their credit card account to The Money Management Tool and analyze their spending habits to see just how much is spent on restaurants and entertainment. They could then develop a budget to help them stay on track.

budgeta

If you or someone you know needs help getting their financial house in order, this tool can help.

Contact us today to get started.

How to Invest in Yourself

To reach financial goals, many investors focus on their rate of return. But more important than the portfolio’s rate of return is the amount contributed by the investor.  If an investor can save and invest more, it takes the pressure off the portfolio to do the work.  That means, the portfolio can take less risk to reach the investor’s goal.

If an investor has extra savings, perhaps they should consider taking a class, developing a skill, getting certified, hiring a career coach, or going back to school.  It may make more sense to invest in themselves.  And the employer may even chip in to offset the costs.

Need ideas on how to invest in yourself

Most Valuable Career Skills You Need

Money Magazine’s recent article on career skills shows that an entirely new breed of skills are needed to remain competitive in today’s markets.  The top four skills all deal with data – data mining, data modeling, search engine marketing and statistical analysis.  Just about every skill mentioned involves technology from computer aided design to IT to technical sales.  And there are a few staples that we all would expect to see – new business development, strategic planning, and financial analysis.

The full article can be found here

 

 

Emergency Funds should be Replaced with an Emergency Strategy

Here is the old way of looking at Emergency Funds:

  • Keep 3 months of take home pay set aside if you are single, a renter and have a steady paycheck.
  • Keep 6 months of take home pay set aside if you are married, have kids, and have a mortgage
  • Keep 9-12 months of take home pay set aside if you are married, have kids, have a mortgage AND have variable compensations (such as anyone in sales).

The rules of thumb may work well for many investors, but in a lot of cases the Emergency Fund concept needs to be updated.

Let’s stop thinking about it as an Emergency Fund and start referring to as an Emergency Strategy.  Not all emergencies are the same so the tools and approaches must be crafted with more care. Below is a better, more holistic approach to consider. It breaks the Emergency Fund into 3 categories, each with a separate approach:

1)      Short Term Emergency Fund:

  • 1-2 months of discretionary expenses set aside in a bank account.  This is designed to cover smaller, unplanned expenses quickly and easily.

2)      Long Term Unplanned Expenses:

  • Insurance is the backbone for these expenses.  Funds and savings are used as a supplement.
  • Ensure that the HSA account is funded or could be funded up to the deductible limit in case of a health event that’s expensive to treat.
  • In case of layoff or disability, the investor should know how much they would receive from unemployment or disability insurance and their non-discretionary expenses.  That difference, if any, needs to be funded anywhere from 3-6 months depending on the investors situation.  Certain careers are harder to come by than others and may warrant more funding.
  • The amount determined should be invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market.  Instead of sitting in cash earning nothing, it continues to grow and be productive.

3)      Long Term Planned Expenses:

  • Budgeting is the backbone for these expenses. The key to this will be taking stock of the investors current physical assets and determining how much and when each should be replaced.  An investor with an aging roof and old car should have more saved than someone with a new roof and new car.
  • The goal is to determine an ongoing amount that must be saved each month so that when something breaks down, the funds to replace it have already been saved.
  • The funds are invested in conservative investments to minimize the fluctuations associated with the volatility in the stock market.  Instead of sitting in cash earning nothing, it continues to grow and be productive.
  • In conjunction with the funds invested, it may be cheaper to establish a line of credit. And use the equity in the house to one’s advantage.

Too complicated?  Here is a simplified approach:

Follow the rules of thumb outlined above to find how much should be in the Emergency Fund.  Any amount over $50,000 could be invested in a specially designed conservative portfolio of low volatility stocks and/or target date maturity bond funds.  It remains readily available, but continues to grow and be a productive asset.