I believe in the concept of capital preservation first, then capital growth second. I also believe that liquidity is very valuable, financially and emotionally. Text book financial theory will tell you that cash is a drag on returns in your portfolio. The argument is, over time, stocks, bond, real estate, etc should appreciate at a higher rate, therefore, being fully invested at all times is the prudent decision. That reminds me of the old saying, “In theory, there is no difference between theory and practice. But, in practice, there is.” Investments go up until they don’t. National real estates could never drop until they did. Cash will always underperform is a rising market, but cash is a great place to be in down markets. Holding cash can also allow you to act when prices drop while others are suffering large losses. Most importantly, cash gives you the freedom to handle a job loss, a reduction in pay, an illness, etc.

When people start talking about investing cash savings, it really shows how short memories are. The S&P 500 declined over 60% from peak to trough between 2007-2009. While the market has recovered and gone on to new all-time highs, how many people sold around the trough and suffered the losses, without all the subsequent recovery?

If you need the money in the next few years or are over 50, then the value of cash can’t be overstated. You don’t have time to recover from a large loss in the stock or real estate market. The best way to accumulate wealth over time is to 1) do everything you can to maximize income, 2) spend 10-20% less than your take-home pay and 3) take a prudent, long-term view of investing. In my mind, #3 includes holding a sizable cash position to provide financial flexibility and peace of mind.

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Here’s how I put together my own plan:

1. Get a clear picture of where you currently stand. This will include your retirement accounts, non-retirement investments, bank accounts, house and any other assets. This is called your Net Worth. Here’s a post I did previously on calculating your Net Worth.

2. Analyze your income and savings patterns. How much are you saving every year in absolute dollars and as a percentage of your total income. Most people recommend saving 10-20% of your income. This would be your total savings – retirement contributions, other investments and cash savings. I always include employer contributions into the equation. If your employer is putting 5% of your income, count that towards your savings plan. Ideally that will only serve to increase your total savings, but either way, that is actual money being contributed to your savings plan.

3. Determine how you want to save. I am a believer is using tax-advantaged accounts such as 401k and IRAs, but I also believe in the value of after-tax, easily accessible savings. Read this for more on non-retirement investments.

4. Use a relatively simply Excel model to make projections. Here is a spreadsheet I created for two accounts, but you can easily adjust to your situation (Retirement Projections). An even easier way would be to group all your tax-advantaged accounts into one group and all your taxable investments into the other – then make your projections like that.

5. After you complete Step 4 you are able to see if you need/want to make changes to your savings plan to accomplish your goals. I think it’s safe to withdraw 3-6% a year from your accounts when you’re in retirement, so look at your future balance and determine if that amount will be sufficient for you. Inflation is always a concern, but overtime investments should keep up with inflation. I use lower returns, to capture the annualized real return, meaning, the return over inflation in a given year. Using return figures in the 3-8% annually I think is fair. This is allow you to look at the future balance and future annual income in approximately today’s terms.

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First, investing in municipal bonds carries real risk. People are lead to believe that muni bonds carry similar risk to US Treasuries, but recent history suggests that is not true. Bankruptcies in Detroit, various California cities, Jefferson County, Alabama, etc have shown that muni investors often get pennies on the dollar when a bankruptcy is filed. While it is true that some muni bonds are insured against a loss, many are not. If you are invested in munis, or considering investing in munis, make sure you are buying insured bonds or be prepared for much higher levels of risk than the yield would imply. Even with insurance, you are counting on the credit quality and financial capability of the insurer to make you whole. We saw several bond insurers on the verge of collapse during the 2008/2009 credit collapse, so their solvency is not guaranteed.

Second, as a citizen and a taxpayer, you need to start paying more attention to your state/city finances. Large pension contributions are beginning to eat up significant chucks of municipal operating budgets. What this means is either services have to be cut, government worker and retiree benefits have to be cut or taxes have to be raised. No one wants to see police/fire services reduced and government employee unions aggressively fight to prevent pension cuts. That means, raising taxes is often the first, and easiest measure. In essence, many governments are deciding that hard working, middle class Americans need to pay more in property, income or sales tax to keep funding generous pensions fore retirees. As a citizen you need to be informed about what is happening with the finances of your locality.

This problem is likely to get a lot worse before it gets better. Promises were made to employees by politicians that had no hope of being kept. In many cases, the politicians didn’t care, assuming they would be out of office before the problems arose. The time has arrived though, or is beginning to arrive around the country. As an individual working to secure your own retirement, this issue needs to remain on your radar.

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There is no evidence that front-end load funds perform better than lower fee funds. In fact, logic would tell you that smaller, less successful funds employ front-end loads because they have been unsuccessful attracting assets in other ways, implying their performance could be worse. Additionally, when you see your personalized performance it won’t be based off your $10k investment, it will be based off the amount you invested AFTER paying the sales commission. Performance numbers are always inflated because they don’t account for that fact you started down 5.75% from day 1 due to the front-end load. If you invest the same $10k, your statement will show $9,425 as your cost basis. Meaning, if the value rises to $9,700, your advisor will tell you are up 3%, when in reality, you are still $300 in the whole from the $10k you invested.

If you’ve made the choice to use mutual funds in your investment strategy, make sure your advisor knows that you do not want any front-end load funds. In fact, if your advisor is recommending front-end load funds, I think it’s time to find a new advisor. Many advisors have developed very effective methods to slip a few front-end funds into your account, convincing you of the relative value of said fund. In reality, there is no reason for an advisor to recommend a front-end fund other than wanting to earn the sales commission.

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Now, however, there is another way your advisor is getting paid by mutual fund companies. More reports are coming out about large mutual fund companies paying advisors commissions for putting client money into their funds. According to this report, one-third of Edward Jones’ earnings were generated from these commissions. According to this article, many advisors who advertise themselves as ‘objective’ are actually receiving payments from mutual fund companies to use their specific funds. This is NOT is your best interest. Make sure you understand who your advisor is really working for. Many advisors simply have a suitability standard when showing you an investment. Registered Investment Advisors (RIAs), which represent only ~7% of total advisors, have a fiduciary responsibility to clients, meaning they are legally required to put YOUR interests ahead of their own. This is important to remember as you consider your financial advisor options.

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The purpose of tax-advantage retirement accounts (401k, IRA, etc) is to encourage individuals to put away money for their future. We already have significant restrictions on contributions, income limits, withdrawals, etc, so to me this seems like a logical next step, although this specific proposal seems more about politics than actual revenue, since the President estimates it will raise only $9 billion over a 10-year period, hardly a significant number.

However, this is significant for average Americans even if you don’t believe you will ever hit $3 million in retirement savings. Many small business owners operate SEP-IRA programs for themselves and employees. The rules basically say, the business owner can contribute up to ~$50k a year into the account if the employees receive a 20% of salary contribution from the company. In these situations, if a business owner approaches the $3 million level in his/her own account, there is no incentive, in fact there might be a penalty for continuing the program. This ultimately hurts regular savers, even though the intent it limit upper-income earners from shielding too many assets from immediate taxation.

Read the full article here.

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Building a cash savings and making sure you get any company match in a 401-k is important, but today I want to write about the value of saving in taxable investment accounts. I think there are two key benefits to after-tax investments.

1. Liquidity – In a taxable brokerage account, you have access to the funds any time you need them. If you want to buy a house, need to pay a medical bill or simply like knowing you have access to funds if a need arises, money in a taxable account can provide flexibility and peace of mind. 401k and Traditional IRAs have tax consequences and steep penalties for withdrawals before you turn 59 ½. Some will argue that not having access to the funds will keep you from using the money frivolously before you need it. That is something to consider, but there is something to be said for access to cash and personal discipline.
2. No Future Tax Liability – Since you pay taxes on the money put into a taxable investment account and pay capital gains/dividend taxes annually, the money in a taxable account is 100% yours. You can withdraw money whenever you need, as much as you need and not generate taxable income. With a 401k or a Traditional IRA, every withdrawal creates taxable income, taxed at your marginal rate. That could be 25% or higher. For example, if you have $200k in a 401k plan, at a 25% marginal tax rate, you have a $50k future tax liability, so you really only have $150k.

I’m not suggesting people shouldn’t take advantage of the benefits of tax-deferred accounts. And if you are eligible for a Roth IRA, that is a great savings vehicle as well because you get the benefits of tax-deferred growth, don’t pay taxes on withdrawals and can always withdraw your contributions without penalty. However, there are income restrictions and you can only put $5k a year into a Roth. I’m suggesting after-tax investments should be part of your retirement savings plan.

The conventional wisdom says to maximize savings in tax-deferred investment accounts. I think there is a lot of value in that advice, but I also think the companies that provide 401k plans and IRAs benefit tremendously if you don’t have access to your funds. They are essentially guaranteed years of fee-income once you make a deposit, so their recommendation to focus your savings plan in those types of accounts might not always be in your best interest. You have to find the right balance for you personally, but hopefully I’ve helped you think about some of the benefits of after-tax investment savings.

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I probably go a little overboard in that I track my net worth on a weekly basis. I have stock prices automatically downloaded in a spreadsheet (Will talk about how to do this is a future column), update my savings accounts, mortgage balance, and any contributions or dividend reinvestments that occurred in my investment accounts over the prior week. I also graph all the data, so I can look at one graph and see my net worth and my investment portfolio balances over the past 3+ years. I started doing this at the end of 2009 and it’s amazing to see how we’ve performed in that time period. Amazing in the sense that investments have gone up, but also just in the sense that I can look at over three years of financial history in one place.

For a more normal person, I think updating your net worth on a monthly or even quarterly basis makes plenty of sense. This requires only an hour or so every time you update, so the time commitment is minimal. I break my calculation down into several parts. First, I have my checking and savings accounts, then I track retirement investments, non-retirement investments (Read here for more on non-retirement investments) and estimated housing value less current mortgage amount. I don’t have any other debt other than the mortgage, but if you have student debt, credit card debt, auto loans, etc, you want to keep track of those as well.

To calculate your net worth you want to add up all your assets (house, checking/savings accounts, retirement accounts, other investments, other real estate, etc) and then subtract your liabilities (mortgage balance and any other kind of debt). It’s that simple. Here’s an example:

I left out the value of various household items such as furniture, appliances, etc., but those items do have value and could be included in this analysis if you want to. In fact, while I included a vehicle in my example, I actually don’t include my own vehicle in my calculations. I don’t have a car loan and I know the car is a depreciating asset that I would have to replace if I sold it, so I take a more conservative approach and don’t count it as an asset. However, since my example has a car loan, I thought it was fair to include the value of the car attached to the loan.

Tracking and understanding your net worth can be a very valuable and powerful tool in shaping and helping you achieve your financial goals. I built my own spreadsheet to track my net worth, but I have spent some time on a site called Net Worth IQ that seems like an interesting option. I don’t use it and can’t speak to its security, but at a minimum, it’s interesting to see and read about how people think about tracking their net worth. Happy tracking.

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1. Reaching for Yield – In today’s low interest rate environment, trying to get a higher yield through riskier bonds can carry significant risks. It’s also important to remember that low rates are creating a spike in the scam and ponzi market, so be wary of anyone promising you returns that seem too-good-to-be true.

2. Borrowing significant money for college debt – There are many ways kids can finance college, including working, going to a less expensive university, starting at a community college, etc. Don’t put your own financial future at risk to fund an lavish private university for your child.

3. Owning stock in your employer – I agree that you want to limit your exposure to the stock of the company you work for. You are already highly exposed to that company’s performance by virtue of receiving a paycheck from them. That said, if your company offers an attractive stock purchase plan, or you just really believe in the company, I think it’s prudent to limit your holdings to 10% of your total investment portfolio.

4. Taking Social Security too Early – Especially in today’s low interest rate world, delaying SS can be a great investment if you can afford it. SS payments increase 0.67% per month (8%/year) for every month you delay starting payments. 8% a year looks like a pretty attractive return in this market.

5. Buying Long-Term Bonds – with rates at historically low levels, locking in these yields for 10-30 years seems like a bad idea.

Here’s the link to the full article. 

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I like to think about insurance as a way to pay for necessary, large expenses in the unlikely event that you or your spouse dies. This could include paying off a mortgage, funding a child’s college costs and covering the costs of raising a child with only one parent.

If you have two working spouses, making about the same amount annually, your life insurance needs will be very different from a household with only one working spouse and different still from a single parent household.  So, it’s important to think through your specific situation and then apply the following principles.

Mortgage – Leaving a spouse and kids with a large mortgage they can’t afford is a tragic situation. Your life insurance should allow for the remaining family to stay in the same house for at least several years before a more long-term solution can be found. When thinking about how much coverage you need for this expense, you need to know what your current mortgage balance is and how many years are remaining before you pay it off. I recommend getting enough insurance to completely pay off the mortgage that lasts for at least the remaining term of the mortgage.

Family Living Expenses – You need to determine how much money it costs to support your current lifestyle on an annual basis. It’s important to remember that if you insuring the full value of your mortgage, you shouldn’t factor in your mortgage payment to your calculation, since that expense will be paid off. Then determine how long you want to fund that lifestyle. Remember that kids will leave the house at some point and costs will decrease.

I think covering expenses for at least 5 years or potentially more if you have young children is sufficient time to allow the remaining spouse to sell the house, adjust their lifestyle and get back into the workforce. Of course, if you want to provide a lifetime of benefits, you can insure up to 20-25 years of expenses. Remember that life insurance benefits are typically not taxed, so you will get the full amount of the policy and it’s a good rule of thumb that you can safely withdraw 3-5% of the principal every year without losing principal over time, assuming your adequately invested.

College Costs – To me, this is the least important of the three main drivers of life insurance needs. Kids have a variety of ways to finance college – going to a less expensive state university, starting out at community college, working through college or even borrowing, although I don’t recommend taking on much, if any, student debt. However, if you want to leave each child some funds to help pay for college, I think somewhere around $50-100k per child is sufficient. That would cover a 4-year state university in many places. This is an issue that you need to decide how much you want to pay and how much you want your children to finance their own college.

As an example, let’s say you work and your spouse stays home with the kids. You have a $150k mortgage with 20 years remaining, your annual expenses excluding the mortgage payment are $40k and you have two kids under 10 years old. In this scenario, you might want to consider getting a 20-year term life insurance policy for between $500k and $700k. That would be $150k for the mortgage, $300-400k for family living expenses and $100-200k for college costs.

Life insurance is a critical part of any sound financial plan and hopefully this article helps you think through your life insurance needs.

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