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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.

Using The Money Management Tool: Connecting Accounts

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 a prospective client who has many accounts and struggles to keep track of where they are located.

Situation: A prospective client approached us looking for help managing his investments. He had about 10 different accounts – multiple checking and savings accounts and a several different retirement accounts from current and previous employers. These accounts were held with several different financial organizations.

Problem: He struggled to keep track of all the accounts. He was constantly forgetting passwords used to view his balances online. He was spending hours trying to stay organized and reading the statements. The inconvenience grew to the point where he just ignored his accounts.

Solution: The Money Management Tool could be used to connect all the accounts together. After establishing the connections between the tool and his accounts, he would be able to see daily account balances for all the accounts from a single account. No more trying to remember multiple passwords or trying to read different statements each month.

new account

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

Contact us today to get started.

The Relationship Between Happiness and Income Is Being Turned Upside Down

New research on the relationship between happiness and income is changing the rule of thumb. For years, it has been touted that an annual income of $75,000 is ideal and earning more than that results in a diminishing return of happiness.

Contrary to the old rule of thumb, there is a linear relationship between money and happiness, suggesting the more some makes, the happier they are in life.

So, maybe money can buy happiness after all?

You can read the study here

Is Retirement Savings Being Crowded Out by Student Debt?

A recent study conducted by HelloWallet suggests that a dollar of student loan debt is associated with a 35-cent decrease in retirement account balances! That means, investors with lots of student loans are unable to save as much for retirement.

This is a big problem on a large scale:

  1. 60% of college graduates take on some form of student loan.
  2. The average loan size has tripled over two decades form $9,400 to $27,300
  3. There is more student loan debt than credit card debt.

You can read the study here

I take issue with this study in several areas:

  1. The study assumes that people have a given number of dollars available and must split it between debt repayment and saving for retirement. In reality, I am seeing many people make significant sacrifices in their lifestyle in order to stay on top of their debts and retirement planning. People are living at home longer, avoiding more debt by not buying a house, or living a more modest lifestyle.
  2. People I see coming out of college with significant levels of debt are going through a crash course in personal finance much faster than those with no student loans. They are experiencing a wake-up call in their 20s and 30s as opposed to their 40’s or 50’s. Smart financial habits that they develop now could lead them to a more prosperous future.
  3. I’m working with many families on a more complicated dilemma. Not only do they need to weigh existing student loan debts and saving for retirement, but they also struggle to save for their own children’s education.

The final issue I take with this study is a line repeated multiple times: “There are few widely available tools to help individuals decide whether to prioritize student loan repayments or retirement savings.” In reality, there are lots of tools available to help people analyze that question, such as a Certified Financial Planner™ professional.