Your Choice- $1 Million or $5,000 per Month for Life?

Most of our readers will likely have to make that type of decision someday.  From our perspective, it’s a pretty easy answer.  As Cuba Gooding, Jr. famously told Tom Cruise in “Jerry Maguire”:  “Show me the money!!”

Yet, an article in the WSJ on Monday tried to make the decision sound really tough, with losers on both sides.  It would have you believe that many will suffer from either an “illusion of poverty” or an “illusion of wealth” and are likely going to experience a disappointing retirement.  Really?

Researcher Daniel Goodwin at Microsoft Research asked people how adequate they would feel if they have $1 million at the time they retired.  He used a seven-point system with one being “totally inadequate” and seven being “totally adequate.”  Then, he asked them to rate instead an income each month in retirement of $5,000.

In theory, the choices are similar based on pricing of annuities. If a 65 year old paid $1 million for a “single premium immediate annuity” they could receive payments of $5,000 each month for their life.  Actuarially, a 65 year-old is expected to live 18-20 years.  So, 19 years of monthly payments of $5,000 would be $1,140,000 and represent a 1.4% annual return on the investment.

Yet, believe it or not, many people, feel that $5,000 per month is more adequate than the $1 million lump sum.  Mr. Goldstein says that this group suffers from the “illusion of poverty.”  Apparently, these folks are “inclined to think about wealth in terms of monthly income” and don’t want the “burden” of a lump sum which could run out someday.  Hence, they dial down their expenses, eliminate any wants or wishes and make do on their $5,000 per month.

Mr. Goldstein then suggests that I and most people may suffer from the “illusion of wealth.”  He thinks that those selecting the lump sum, through a false sense of security, may spend too much and run out of money. In fact, the larger the lump sum, the more likely the “extra millions will lose their meaning.”  Really?  Do we all suffer from illusions, as Mr. Goldstein suggests?  Are we all on the road to an unsuccessful retirement regardless of our choices?  It certainly doesn’t have to be that way.

Perhaps I should contact Mr. Goldstein and invite him (and his wife) to go through the DWM Boot Camp.  First, we’d sit down and help them with their goal setting. We’d help them identify their needs, wants and wishes.  We’d look at their assets, health care costs, income taxes, expected inflation and investment returns, and insurance and estate matters.  Ultimately, we’d help them design a financial plan.

If Mr. Goldstein was under an “illusion of poverty,” we’d show him that his $5,000 per month program is a poor choice.  To begin with, his $5,000 per month would lose its purchasing power each month due to inflation.  With 3% inflation, after 15 years of retirement, his $5,000 would only buy $3,200 worth of goods in today’s dollars.  Second, if he did a “personal annuity” by simply taking the lump sum, investing it, earning 6%, e.g., and withdrawing the $5,000 per month, his family would still have the $1 million in principal when he passed away.  No need for an illusion of poverty here.

On the other hand, if Mr. Goldstein was under an “illusion of wealth”, the plan would help him identify his needs, wants and wishes and would have helped evaluate whether those potential expenses were affordable based upon his assets, expected investment returns and the other metrics.  We would have created numerous scenarios to ultimately result in a plan that was successful.  The plan would be stress tested for items that could negatively impact that plan and monitored and modified over time.  In short, the plan would not suffer from an illusion of poverty nor of wealth.

We’re glad contributors Shlomo Benartzi and Hal Hershfield ran the article Monday focusing on Mr. Goldstein’s findings. Retirement/financial independence planning is extremely important.   However, we don’t agree that it has to be a dire situation with poor choices, lots of suffering and disappointments.   It’s simple: take the lump sum and put together your realistic plan with a fee-only adviser like DWM and then have us help you monitor it for the changes that will undoubtedly occur in the future. You’ve worked hard for your money, the time will come to enjoy it. As Ginny’s blog http://www.dwmgmt.com/blogs/82-2017-02-07-23-30-00.html pointed out a few weeks ago, retirement/financial independence should be a time for “jubilation” not illusions or disappointments.  Proper planning with the right team can make that happen.

Teach Your Children Well

As parents, we want what is best for our kids and want to prepare them to be independent and successful adults.  Two of my three children are in college now and, from my experience both as a parent and working at DWM, I have learned there are some gaps in the financial education and understanding of money in our young people, including my kids.  Money isn’t everything and certainly should be kept in perspective related to other pursuits in life.  That would be my first tip for the young adults in my life.  However, money is a means to an end and it is important for them to understand their own unique balance sheet and learn strategies to successfully manage all the variables that will affect their financial future.

1. Protect and Grow your Most Valuable Asset – YOU!

One of the most important things for college-age or young working adults to realize is that by far their most valuable asset is themselves!  For a young adult, the ability to generate income for the next 40 or so years is their most phenomenal asset.  Understanding the value of this asset can encourage them to look for ways to magnify that potential earning power and minimize the risks to it. Will additional education improve that income potential?  It is also smart for young people to realize that the future is uncertain.   We need to teach them to prepare for any risks, like economic downturns, that may reduce asset growth or increase their liabilities.  This can help them recognize that using resources to maintain adequate disability or life insurance can be as important as insuring your car or home.  Creating good habits in saving, tax-planning and budgeting are important to protect against unanticipated variables.

2. Diversify your Assets

When evaluating net worth, most people tend to think of some of the obvious current assets that you might include – a house or a car, for example.  Looking more deeply, though, will show some differences in those assets.  This is another area where younger people may need some education.  A car’s value, for example, should be considered against the taxes, maintenance, gas and depreciation that essentially makes it worth much less over time.  Same with a boat.  Real estate is usually considered a good asset to offer diversification, if it is appreciating at or above inflation.   An interesting article from the Wall Street Journal notes that as wealth increases, the percentage of net worth represented by a principal residence declines.  Young adults should understand that diversification is an important strategy and having a good mix of assets will make you financially stronger, especially over the long-term.

3. Spend Wisely

In general, a personal balance sheet should include the value of everything you have and everything you owe, even if some of those are intangible.  When you put the potential value of a career’s worth of income in real dollars in one column against the future costs of loans or other debts, it makes the impact more visible.   This strategy can help spotlight the real costs for student loans, houses, cars, trips, credit cards or luxury purchases.  An Investment News article recently quoted a study that found more than half of college bound students had failed to estimate their student loan costs adequately and regretted the decision to take out those loans, once their repayment programs had begun.  Certainly, when evaluating the merits of an educational program or even a business investment, it would be smart to consider potential income benefits against the costs for that investment.  Weighing the purchase of a new flat screen TV or expensive pair of shoes against the value of income needed to finance that goal might make anyone think twice!

4. Save and Invest Early

Finally, it is significant for young people to know that they can really maximize the potential on their balance sheet by saving and investing as early and as fully as possible.  Learning the value of compounding in real terms can be a wonderful eye-opener and understanding the effect of inflation on a dollar over time can be equally enlightening.  Not all saving is created equal.  A penny saved is worth more than a penny earned, when you factor in taxes and compound interest!  It is important to maximize retirement investments and practice the “pay yourself first” philosophy of saving and investing to create a good financial plan.

Also, young workers should be encouraged to immediately sign up for employer retirement plans, like 401(k)’s, and to maximize their contributions to take advantage of any match programs offered by their employer.  If their job doesn’t offer one, opening an IRA or Roth IRA might be a good solution.  Starting a Roth at a young age allows the investor to take advantage of making after-tax contributions while in a lower tax bracket and creating an account that can grow and offer tax free funds for use later in life.  As an example, a 25 year old who makes the maximum allowable annual contribution of $5,500 annually to an investment vehicle that averages a 5% return could have around $700,000 by the time they are ready to retire.

The biggest lesson that our kids and other young adults should be taught is that the most important key for success in wealth management, as in most things, is discipline.  We love to educate our clients and their families.  Please let us know if we can help teach your kids good financial habits.

Budgeting: Putting the Pieces Together

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Budgets are like a puzzle. You have a finite amount of money, regardless of how much you earn. You need to figure out where each piece of it is, and should be, allocated. It’s an honest look at your spending and saving rates. Many people have a negative attitude towards budgeting, thinking that it’s restrictive, time consuming, or unnecessary, but a budget is really something positive. It’s a tool to help you get where you want to be one day.

DWM works with clients to create custom financial plans. Why is that so important? The CFP website says it perfectly: “Creating a financial plan helps you see the big picture and set long and short-term life goals, a crucial step in mapping out your financial future. When you have a financial plan, it’s easier to make financial decisions and stay on track to meet your goals.” These plans help you define and quantify your goals. They’ll help you identify how much you will need to save to make these goals.

To create a realistic plan, one needs realistic numbers. One of the most important figures in all of this is the amount of money you spend, since the more you spend the less you have to save. Remember, you have a finite amount of money. Some people like to know exactly what they are spending, and we have clients that have created Excel budget spreadsheets that detail their spending down to the penny. On the other hand, some people don’t think about their spending (or live in denial about it) and have no clue. But burying your head in the sand doesn’t change reality. The money is still being spent whether you’re aware of how much you’re really spending on discretionary items vs saving for goals like retirement, or not. It’s better to face things now when you still have a chance to change your spending habits, and save to meet the goals that are important to you.

For DWM to provide you with a meaningful plan, we need solid numbers on your spending. So if you’re not currently tracking where your money goes, here is some advice to get you started:

  1. Take a look at your current spending. This is the part where many people stop before they get started because many budget worksheets contain 50+ categories. Trying to classify and tally everything into that many categories is daunting and time consuming. Instead, download a full year’s worth of transactions from your bank accounts’ and credit cards’ websites to an Excel spreadsheet, and sort by category or description to get an idea of where your money is really going. Label each category as Fixed, Goals, or Flexible according to the guidelines below in step two, and figure out what percentage of your take-home income each of the three composes. For some people there will be surprising or depressing revelations, but don’t be dismayed. You can take control of your spending habits. Now you’re ready for step two.
  1. Set goals and adjust your current spending accordingly. A good, easy to follow guideline is to divide your total take-home income 50/20/30:

–  Fixed expenses such as home, student, and car loans, utilities, insurance, memberships, and other expenses you are committed to and don’t vary much should make up 50% of your budget at the most.

–  Financial goals such as retirement, saving for college or a down payment on a vacation home, building an emergency fund, and paying off credit card debt should total at least 20%. (Note that you may be saving more towards retirement goals than reflected in this number because it only includes take-home income, and 401k contributions are deducted before your paycheck is deposited. For more on the ideal saving rate, see Brett’s recent blog.) For our clients, this is where a financial plan from DWM really helps you to know how much to allocate each month to meet your goals. Of course, we also review and offer our advice on fixed expenses and flexible spending as part of our comprehensive financial planning process.

–  Flexible spending makes up the other 30% (or less). This includes things that usually vary month to month like food (both grocery shopping and dining out), hobbies, medical costs, entertainment, shopping, gifts, etc. This portion may be spent on whatever you want or need, as long as you stay within budget.

This guideline is proportional (it uses a percentage of your income for each of the three categories), so it is scalable for all income levels.

We strongly suggest setting up automatic payments/contributions for the fixed expenses and financial goal categories. You will save time, avoid missed or late payments and contributions, and it can help keep your flexible spending portion in line. If 50/20/30 is a big change from your current spending and you are having a hard time cutting your fixed or flexible spending, start with adjusted percentages and continue to make small changes until your budget is in line with your goals. Monitor your actual-vs-budgeted spending monthly to see if your actual percentages are in line with your budget. Once you are consistently finding your percentages are where they should be, you can move on to step three.

  1. Re-evaluate as circumstances change. For example, if you receive a raise or bonus, your mortgage increases, decreases, or is paid off, you buy a new car or pay off an existing loan, when you are no longer saving or paying for college, etc. Otherwise, if you are making all your fixed expenses and financial goal payments/contributions without running up debt from flexible spending expenses, you know you’re doing fine and don’t have to track expenses each month.

So, look at how your income is being spent and be honest with yourself. With DWM on your team, you can develop a budget and make sound financial decisions that help you meet your short and long-term goals. Please contact us to update your plan or learn more about budgeting, saving, or our comprehensive financial planning process. Your future self will thank you.