Category Archives: Retirement

Am I Saving Enough to Reach My Goals?

This is the second installment in our series on how individual investors can assess their financial health.

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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Economic Inequality

Income inequality is increasingly acknowledged as a key economic issue for the world.  The topic is a major theme at Davos this year.  Economic inequality is also an increasingly common topic in U.S. politics.

A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously.   The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult.  The numbers have not changed in three decades.

On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale.  The richest 1% of Americans now own 25% of all of the wealth in the U.S.  The share of national income accruing to the richest 1% has doubled since 1980.  In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.

Why is this happening?

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Estimating the Real Costs of Investing

One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio.  In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small.  Over long periods of time, however, the ups and downs of the market tend to average out.  The effect of those costs  however is persistent and continuous. 

There are a range of costs associated with investing in funds beyond the stated expense ratio.  In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds.  Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising.  He has written similar pieces in the past.  In this article, he provides updated numbers, backed up by a range of academic analysis.  His summary of costs is provided in Table 1 of his article:

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There are three types of expenses, in addition to the standard expense ratio.  First are transaction costs, which are simply a fund’s trading costs.  This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses.  Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds.  He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio.  The second source of additional cost for active funds is cash drag.  Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash.  To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance.  Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year.  The final additional cost that Mr. Bogle includes is sales charges / fees.  This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees.  Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate. 

When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year. 

The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference.  The ICI also reports that the most expensive funds can have much higher expense ratios.  They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%. 

Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year.  This number is highly uncertain.  The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%.  A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%.  Because of compounding, the long-term impact of these costs increases over time. 

The average costs from Mr. Bogle’s article are not unreasonable.  There are probably many investors paying this much or more.  On the other hand, there are plenty of investors in active funds paying considerably less. 

Where does all of this leave investors?  First and foremost, it should be clear that costs matter a great deal.  There will always be expenses associated with investing, but they vary widely.  Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings.  Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio. 

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60-Second Retirement Savings and Income Checkup

I think that the American public has largely tuned out the myriad studies showing that most households are woefully under-saving for retirement.  Even if we’d prefer not to think about this issue, however, it is crucial to regularly check on how we are doing.  There are two major questions.  First, during your working years, are you saving enough?  Second, during retirement, how much income can you sustainably plan to draw from your savings each year?  The good news is that there are some simple tools that you can use to do a fast estimate of how you are doing, how much you need to save to stay on track, or how to get on track. Continue reading

Financial Literacy: State of the Union in 2013

April is financial literacy month.  I believe that lack of financial knowledge is one of the most critical problems that our country faces. Continue reading