August 17, 2010
LISTEN: Whole Life Insurance: Complex, Ingenious (mp3audio) (11:47 min)
What is whole life insurance? A simple answer, one you might find on a financial information website, might describe whole life insurance as a combination of life insurance and cash value. But once you get past this basic definition, the details and workings of a whole life policy can be quite sophisticated, maybe even confusing. Writing in the January 11, 2009 Palm Beach Daily News, life insurance expert R. Marshall Jones said that:
“Until recently, permanent life insurance was arguably the financial industry’s most complex instrument…”
As with many other complex financial products, whole life insurance is the result of the integration of several basic financial ideas. The starting point for whole life is an understanding of some of the shortcomings with a simple financial instrument, term insurance.
Here’s the big issue with term insurance: As you get older, it gets more expensive. Because statistics show older people are more likely to die than younger people, insurance companies price the coverage accordingly. To illustrate, here are 50 years of scheduled premiums from a reputable life insurer for a healthy 35 year-old male non-smoker to secure $500,000 of life insurance on a yearly renewable basis.
This pricing, while accurately representing the risks assumed by insurance companies as people get older, creates a dilemma for consumers. As they live longer, and pay increasingly expensive premiums, the cost of insurance becomes prohibitive. Thus, when they are most likely to die, they may not be able to afford the insurance. From a financial perspective, the only way to “win” in this transaction is to die “young,” before the insurance gets too expensive. Given the aversion most of us have to dying, the most likely outcome of yearly term insurance is paying premiums for a period of time, then lapsing the coverage. Even though the consumer may have a real need to provide the financial protection of life insurance, the yearly renewable premium schedule creates a financial incentive to drop the protection as soon as possible – or simply forgo life insurance altogether. This is a lose-lose proposition, for the consumer and the insurance company.
Integrated Solution, Step One
One response to increasing yearly renewable premiums is leveling the premium. Instead of increasing the cost every year, the insurer determines a flat rate for a specified number of years, i.e., for a term. A typical term may be 10, 15, 20 or 30 years. The level term arrangement results in a policyowner overpaying (relative to the true annual cost of insurance) during the early years of the term, then underpaying at the end. For the 35-year-old in the above example, the 30-year level term premium is $490/yr. Compared to yearly renewable term, the level premium is more expensive for the first 10 years, then less expensive for the next 20.
To accurately price level term insurance, the insurance company must make some assumptions about the time value of money, because the “additional” premiums they collect in the first 10 years will be invested to subsidize the cost of insurance for the following two decades.
A level term premium schedule significantly resolves the problem of the cost of insurance becoming progressively more expensive in later years – at least during the term. But when the term expires, the problem returns. In our example, the cost to renew $500,000 of life insurance at age 65 is $5,025/yr. – providing the individual can prove excellent health by passing a new physical examination. Even if he is healthy, the new term is limited to 20 years (age 85). And what happens if this man lives to age 86? The scheduled renewal premium is now $207, 990! For one year!
While level term premiums help consumers afford life insurance longer, the same end-of-life problem remains: Just when you are most likely to collect on the life insurance, you may not be able to pay for it. Level term insurance is certainly a win for the insurance company because policyholders pay more premiums longer, but the financial outcome is less clear for most consumers using term insurance – they still are not likely to have an insurance benefit in force at death.
Integrated Solution, Step Two
A lifetime term policy with level premiums would solve the problem. But fairly pricing term for one’s entire lifespan creates a new problem: As illustrated by the yearly renewable table, the cost of insurance rises steeply after age 60. So even with a long time to “overpay” at the beginning, a policy guaranteed to be in-force at age 100 requires a sizable annual premium. In the case of our healthy 35-year-old non-smoker, the lifetime annual premium is $6,165/yr., more than 12 times the annual premium for the 30-year term policy. Unless the consumer has money to burn, the idea of overpaying $5,600 each year (the difference between the whole life and level term premium) for the next 30 years just to keep the premiums affordable in old age probably won’t set well. There’s just too much overpayment for too long to convince most consumers to set aside that much money for an event that may be 50 years in the future.
Enter the concept of cash value. The overpayment of premium in a whole life policy represents reserve capital the insurance company will use to cover the cost of insurance as the policyholder ages. In the meantime, this reserve capital will be invested to generate more capital. A portion of this excess cash value, and the earnings from it, is credited to a cash account tied directly to the policy. While the policy is in-force, the policyowner has the right to access this cash value, through a variety of transactions (loans, partial surrenders, dividends, etc.).
In a typical whole life policy, this cash value can eventually exceed the total premiums paid, i.e, the policyholder not only owns the insurance benefit, but has received a positive return on the premiums.
This blending of cash value and life insurance is a brilliant example of integrated thinking. A whole life policy with a level premium provides economic certainty for consumers – they know how much insurance they will have, they know how much it will cost, and (as long as premiums are paid) they know the insurance will be in-force at the end of their lives. At the same time, the larger premiums give the insurance company greater financial stability. It has greater resources to meet its contractual obligations. And during the lifetime of the policy, the owner also has access to this stable source of cash value (and its growth) as well.
Complexity begets more complexity – and more opportunities
Besides turning the life insurance benefit into an asset instead of an expense, the cash value component opens the door to other possibilities. Dividends* can be received as income, or used to pay premiums. Additional paid-up insurance may be purchased. Depending on the performance of the cash value account, additional premium requirements may change or be eliminated.
Because the benefit paid at death is now certain, life insurance can do more than provide income replacement protection in the event of a premature death. Among other things, the proceeds can be vital in estate and inheritance planning, serve as a supplement to long-term care, pay creditors and fund charities.
Some might argue that it is hypothetically possible to project similar or greater financial results by choosing to use term insurance alongside other accumulation vehicles. On paper, this is possible. But while two simple stand-alone financial products might appear to out-perform whole life in a narrow set of criteria (such as pre-tax accumulation in a 20-year period), they cannot equal the combination of benefits, guarantees and flexibility that result from using a whole life policy. The integration of level premiums and cash value, and the resulting opportunities make life insurance a win-win for all parties.
Just as whole life is a multi-faceted complex financial instrument, there are many ways to position whole life in one’s financial program. Contact us to find out how whole life might best fit your current circumstances.
*Dividends are not guaranteed, and are generally declared annually by the company’s Board of Directors.
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July 21, 2010
LISTEN: Should a Second Home Be The Only One You Own? (mp3audio) (10:24 min)
It’s too early to make a definitive statement, but the fallout from the real-estate bubble may result in some fundamental long-lasting changes in Americans’ perspectives on home ownership. Not only is there the chance that fewer Americans will be able to own a house, but even those who are prime candidates for home ownership may find other options more attractive and financially profitable.
A little background:
Before 1940, slightly less than half of all American households owned a home, a percentage that had remained unchanged for more than four decades. Following World War II, the Baby Boom, coupled with government tax breaks and subsidies, rapidly increased the percentage of Americans who owned their house1. By 1960, more than 60% of Americans were homeowners, and for a period in the late 1990s and early 2000s, the number approached 70%.2 Homeownership became a standard fixture in the American Dream.
However, the allure of homeownership has lost much of its luster in the recent financial melt-down, both for homeowners and the financial institutions who initiated the mortgages to make the purchases possible. Where once only a few financial commentators questioned the financial value of owning a home, a tide of commentary is asking if the US economy would be better off with fewer homeowners and more renters. But maybe the problem isn’t how many people own a home, but what type of home they own.
When the housing market was booming through the past two decades, it was assumed that almost every homeowner could expect to cash out with relative ease, either by selling the house or taking a home equity loan. Home equity was seen as a liquid real asset, one that could be accessed at almost any time.
However, as banks have tightened their lending standards to potential homeowners, the market of potential buyers has shrunk, driving prices down. At the same time, more homes are being liquidated at discount in foreclosures and short sales, further depressing the market. In the course of the past three years, current homeowners find their home equity has substantially diminished – and isn’t very liquid.
These changes in the real estate market increasingly make homeownership a much longer term proposition. A decision to buy a home today isn’t easily undone. For those who currently own a home, it may take awhile for values to rebound, and selling the home in the future is no longer a foregone conclusion, even at reduced prices. This fundamental change in perspective regarding homeownership should compel individuals to consider questions like:
- Is there a profitable exit strategy for this house, or should I plan to live here for the rest of my life?
- What happens if an employment change requires a relocation?
- What is the projected market for my property in the future?
- What is the legacy value of my home? Is this an asset my heirs will want to inherit?
In the past half-century, the largest increase in American residential housing has been in suburban communities, and the bulk of the middle-class homeowners own single-residence dwellings in subdivisions. If you are one of these suburban home-owners, how would you answer the questions above? Can you see yourself staying in this house for the next 20 or 30 years, or into retirement? Would someone else want to live in your subdivision? And if your children or other heirs inherit this property, will they see it as a valued asset or a financial albatross?
When you consider the changing demographics of an aging population, a post-Baby Boom contraction in housing demand for single-family homes, and fewer financially-qualified home buyers, it is reasonable to think the long-term prospects for suburban housing won’t be what they have been for the past 50 years. If this is true, a different approach to homeownership might have some appeal.
A different approach.
Instead of a single-family house as the default option for real estate, look at other options. For example, think about renting a primary residence and buying a “second home” – such as a cottage, a vacation or resort property, or a even an income property in a thriving community. Under the right conditions, this strategy could have several advantages.
First, many buyers of a “second home” property could still receive tax advantages that would closely approximate those that come from owning a primary residence. Second, income from rentals (seasonally on resort properties, or year-round in residential locales) may offset many of the costs of ownership. Third, resort and vacation properties can be enjoyed by owners and their families for their recreation and destination value, both now and in the future. Fourth, renting may offer greater flexibility in adjusting to fluctuating living conditions, such as changes in employment or children leaving the nest. Fifth, if it is desirable to make this property a home in retirement, the transition is simple; you stop renting and move into the house. Sixth, a profitable rental or desirable vacation home would likely have ongoing value for heirs; a sale would not be required for them to receive value from the inheritance.
This strategy of buying a “leisure home,” while living in a rental is not a new idea. This pattern was typical of many wealthy individuals during the late 19th and early 20th century. They owned an “estate” in the country, and rented a workplace residence. American steel magnate and finance giant Andrew Carnegie (1835-1919) was one of the richest men in history, and he established his fortune quite early in life. When he was in his twenties, Carnegie erected a large estate home on property in Homewood, PA, near his hometown of Pittsburgh. Yet for much of the next 25 years, Carnegie resided in luxury hotels in New York City, returning to his estate during the summers or as a stop on his travels. At various times, other members of Carnegie’s family also lived at the estate, but it was never Carnegie’s exclusive residence. In later life, Carnegie established additional large estates in Massachusetts, Georgia and Scotland.
In several ways, the “titans of industry” during the Industrial Revolution mimic some of the work circumstances of people in the 21st century Information Age. Carnegie and other businesspeople of his era were establishing continent-spanning businesses that required them to be mobile. Even though some employers may offer telecommuting options, today’s workforce opportunities often require a high level of transience. Today’s worker expects to change jobs more often, and to change their places of residence as well. While any relocation is stressful, it could be argued that renting makes moving easier from a financial perspective – there is no home to sell, no monthly mortgage payment on an empty home, and there is no equity loss to worry about.
At the same time, buying an “estate property” offers several tangible and financial benefits, both now and in the future. A well-managed income property has the potential to add revenue to your financial program. A vacation home can be a welcome getaway and a gathering place for families as they grow up and expand. In both instances, the need to sell will be lessened, which allows more time for equity appreciation, and gives owners the upper hand in deciding when and if a sale should take place. If this property stays in the family for several generations, the long-term benefit of buying estate property could be incalculable.As the turmoil from the Great Recession recedes, the fallout is revealing changes in the financial landscape. Those changes may affect the role of homeownership in the American dream. While single-family residences may still occupy a prominent place in the financial lives of many Americans, it doesn’t hurt to consider (and prepare) for other options.
DO YOUR LONG TERM FINANCIAL PLANS INCLUDE “ESTATE PROPERTY?
IF YOU FOUND AN ESTATE PROPERTY OPPORTUNITY, HOW WOULD YOU EXECUTE THE TRANSACTION?
WOULD YOU LIKE TO EXPLORE THESE, OR OTHER IDEAS WITH US?
U.S. Census Bureau:
11989 report, Historical Statistics: Colonial Times to 1970.
2 US Census Report, Homeownership by Area (focusing on homeownership from 1960-2008)
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June 7, 2010
LISTEN Bugged by Gold (mp3audio) (10:32 min)
It’s baaaack!
The foundation of monetary systems for centuries, gold has been considered an anachronism in modern financial philosophy, something that computers and sophisticated monetary models had made irrelevant. With the exception of a few contrarian “goldbugs” who market a doomsday view of the financial future, gold is now seen as a precious industrial metal, and its value depends on how it is used – in jewelry, dentistry, electronics, glass-making, etc. But as the shake-outs continue from the global financial crisis that began two years ago, gold has resurfaced in the financial arena. Two news items during the same week in May highlighted a return to prominence for an ancient financial asset.
- Beginning May 13, 2010, CBS News and the Wall Street Journal were among several news outlets to report on an ATM in Abu Dhabi that dispenses gold in exchange for paper money. The ATM provides updates of gold prices every 10 minutes, and dispenses both coins and bars of gold in exchange for paper money.
- Later that week, on May 17, a high-profile television stock market guru (known for his loud and animated opinions) weighed in that now was the time for investors to consider gold as an investment. Citing “Six Reasons to Buy Gold Now,” this investment expert was enthusiastically recommending gold as a “buy.”
At the same time, there is a proliferation of commercials on radio and television urging consumers to exchange their “unwanted gold” (usually jewelry) for money. So…there’s a group that says “now is the time to buy gold”, and another that says “now is the time to sell”. What to think?
Because of its chameleon-like characteristics and long history, gold holds a unique place in the financial world. It is truly a one-of-a-kind financial asset. And there are numerous ways to view gold in a financial program.
Gold as Money
One of the most common uses for gold through history has been as money. In coins or bars, gold has been a preferred medium of exchange. Historically, several characteristics have made gold well-suited as money. First, gold itself, in any form, has an almost-universal appeal. It is attractive, durable, and malleable. This means gold can be converted from its function as money into another type of asset without an exchange taking place. A person with five gold coins can melt them and recast the metal into a bracelet, or gold thread or a crown for a tooth. Second, gold is a fungible commodity, i.e., one ounce of gold is considered interchangeable with another. Possessing these two traits, almost every society was more than willing to accept gold as payment for any type of transaction. The face or national symbol stamped on the coin might vary, as would the measures of weight, but for most of the past twenty-five centuries, gold has been the universal currency. (In the early years of the United States, all sorts of gold coins circulated as money, from Spanish doubloons to American double eagles.)
While other items (such as shells or animal pelts) have also served as money, the proponents of gold argue that no other item, including all types of paper currency, is a better medium for financial exchange. Because gold is relatively rare (it is hard to extract and hard to refine), and has real value besides serving as money, there’s not enough in circulation for governments, institutions, or individuals to manipulate its value. In contrast, governments and central banks can “re-price” their money in a variety of ways, typically by increasing or decreasing the amount of paper money in circulation.
Currency manipulation is a primary cause of inflation. In the past, countries and banks have so drastically manipulated either their currency or notes of credit that they became worthless. In the 20th century Germany, Argentina and several African countries experienced periods of hyper-inflation such that their paper money systems collapsed. Instead of serving as units of value, the “money” was nothing more than small pieces of printed paper. Because of the possible dangers of paper money, some economists advocate that all paper money be backed by gold, i.e., you can always exchange a paper note for a corresponding amount of gold. Today, no countries operate on this gold standard, but in times of financial unease, gold may become “money” for people who don’t feel secure making transactions with the paper currency of a particular nation.
Gold as an Investment
Since gold has a long history as real money, it is possible to use gold as a gauge of the value of other forms of money, and to make bets as to which forms of money may fluctuate in value. For example, the market price of an ounce of gold in US dollars on May 21, 2005 was $416.27. Five years later, on May 21, 2010, the price was $1,187.80. An individual who bought 100 ounces of gold five years ago for $41,657 and sold it on May 21, would have realized a gain – in US dollars – of $76,889, which equates to an annual rate of return of slightly more than 23.3%. That sounds like a pretty good investment decision. However… If you bought 100 ounces of gold 15 years ago, in May 1995, the price was just under $400/ounce. During the 10-year period, from May 1995 to May 2005, the rate of return on a gold investment – in US dollars – was close to 0 percent. From an even longer perspective, the price of gold compared to US dollars dropped from a high of $850/ounce in January, 1980 to $481.50 two months later, then stayed in a range between $500 and $300/ounce for the next 15 years. This isn’t the type of long-term performance that most investors are seeking.
From an investor’s perspective, gold usually delivers returns when the bet is against the economy. As the TV stock guru put it, gold is for “when the mentality toward the market becomes negative.” But the trend of a nation’s economy, and human activity in general, is not downward. Down cycles are corrections, followed by new growth. This makes investing in gold primarily a timing strategy. You have to believe you know when to get in, and when to get out.
Statistically, most of us, even the experts, are poor market timers, whether the investment is gold or something else. A cynical observation is that the only people who consistently profit from market timing are those who market the idea.
A “Classic” Idea: Gold as “Insurance”
Besides the use of gold as money and as a speculative investment, there is a long financial tradition of gold as a small, permanent fixture in a financial portfolio. In the form of jewelry, coins and other physical forms from works of art to bars, gold has been viewed as another real asset, like real estate, equipment or art. These gold items were not intended to be bought and sold – they were purchased for collections, for artistic and personal reasons, and were intended to be passed on as family heirlooms.
But just in case…there was always the security in knowing that as a last resort, these items could be liquidated in the event of an extreme financial emergency. This was not an investment strategy, like a collector who buys in order to sell later. This was financial “insurance”, because regardless of whatever might happen to the collectible value of coins or jewelry or other gold objects, there was the assurance that the gold gave it some underlying value. In this context, many individuals would routinely acquire some gold or similar precious metals, primarily as things to enjoy, but with a perception of “financial security.”
Ultimately, gold is a real asset. While it is fungible and accepted by almost everyone as being valuable, its value depends on all sorts of other variables. While it can function as money, and be used to speculate on the relative value of other types of money, a case can be made that the classical perspective on gold – small amounts purchased for enjoyment, inheritance and rare financial emergencies – is one that can be most applicable to everyone.
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May 11, 2010
LISTEN (mp3audio) (5:45 min)
Right before the 2010 Super Bowl, a page 1 article in the February 5, 2010 Wall Street Journal opened with this sentence:
“Investors are sometimes accused of treating the stock market like a casino. Now, one Wall Street firm wants to treat casinos like the stock market.”
The article details the decision of a Wall Street bond-trading company to take over the management of sports betting at a new Las Vegas casino. Lee Amaitis, the company executive who runs the betting operation, says the firm got into sports gambling because “we wanted to turn gamblers into traders.” Using sophisticated financial-markets software, bettors can not only bet on the final outcome, but also make wagers on events during the game, such as whether the next pass might be completed, or who kicks next field goal.
On several occasions, the article noted similarities between investing and gambling. The article even featured a bond trader-turned-professional gambler who said “Wall Street is just a form of legalized gambling.”
Is investing just a form of gambling? For many investors, the answer may be “yes.” But it doesn’t have to be. And it probably shouldn’t be.
In July 2000, Tom Murkco, the CEO of Investor-Guide.com, published an essay titled “What is the difference between gambling and investing?” While Murkco noted that many aspects of gambling and investing might appear similar, there were several distinct and easily defined differences.
For either investing or gambling, the beginning of Murkco’s definition is the same: An activity in which money is put at risk for the purpose of making a profit.
But while the purpose of gambling and investing is identical, the methods by which the purposes are achieved are drastically different.
Here are Murkco’s distinctions:
When someone invests…
- sufficient research has been conducted;
- the odds are favorable;
- the behavior is risk-averse;
- a systematic approach is being taken;
- emotions such as greed and fear play no role;
- the activity is ongoing and done as part of a
- long-term plan;
- the activity is not motivated solely by entertainment or compulsion;
- ownership of something tangible is involved;
- a net positive economic effect results.”
When someone gambles…
- little or no research has been conducted;
- the odds are unfavorable;
- the behavior is risk-seeking;
- an unsystematic approach is being taken;
- emotions such as greed and fear play a role;
- the activity is a discrete event or series of discrete events not done as part of a long-term plan;
- the activity is significantly motivated by entertainment or compulsion;
- ownership of something tangible is not involved;
- no net economic effect results.
When defined this way, it’s easy to see the differences between investing and gambling. It’s also easy to see that because of the methods some people use to invest, their behavior may more closely resemble gambling.
For example, industry studies have repeatedly shown that the behavior of mutual fund investors often accounts for poor investment performance. Because they don’t approach investing systematically, emotions like greed and fear may cause people to make impulsive decisions, with little or no research. Not surprisingly, the results from these methods more often resemble the returns from lottery tickets.
Not Gambling with Your Investments: Easier said than done?
In his book, Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes With Your Money, author David Adler says it’s the psychological component of investing that is the most difficult to manage. Adler contends that behavioral research shows many individuals have an almost over-whelming set of hard-wired dispositions to take gambles rather than make investments. Adler quotes Andrew Lo, an MIT professor of finance:
“The same neural circuitry that responds to cocaine, food, and sex has been shown to be activated by monetary gain as well.”
For some people, the thrill of investing/gambling can be addictive. But when the stakes are one’s financial future or retirement, or your children’s college education, the need for a thrill shouldn’t come by jeopardizing one’s investments.
This imperative to not compromise investing by gambling highlights one of the greatest benefits of working with a team of financial professionals: Besides receiving informed advice, a financial professional can often serve as a protection against gambling with your investments, by encouraging you to make sound decisions based on good research that have a high likelihood of success.
Take a moment to consider the last few major financial decisions you’ve made in the past year. Then look at the list above. Did you make an investment or take a gamble?
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February 28, 2010
LISTEN: mp3 audio (9:44 min)
“Perhaps the most valuable result of all education is the ability to make yourself do the thing you have to do, when it ought to be done, whether you like it or not; it is the first lesson that ought to be learned; and however early a man’s training begins, it is probably the last lesson that he learns thoroughly.” — Thomas H. Huxley, English biologist (1825 – 1895)
Often the biggest challenges most people face in reaching their objectives, financial or otherwise, are not external, but internal. For reasons we can’t entirely comprehend, great plans and good intentions are undone by our poor behavior.
We may blame it on a lack of willpower, a character flaw, or even a psychological condition; regardless the explanation, we find we are our own worst enemy. And even the best among us feel the frustration. Paul the Apostle once wrote:
“For what I am doing, I do not understand; for I am not practicing what I would like to do, but I am doing the very thing I hate.”
At one time or another, we’ve all been there. So if some of the biggest obstacles are internal and psychological, what can be done to fix them?
Hey, this isn’t a Dr. Phil column. There are a bunch of ways to resolve your issues, and a bunch of people to help you. But when it comes to achieving your financial objectives, there is one simple, practical thing anyone can do to improve their chances for success:
“GET IT IN WRITING.”
Seriously. Whether you use a pencil or a word processor, getting things out of your head and onto paper increases your chances of achieving your objectives. As Will Farrell would say in Anchorman, “It’s science.”
First, the physical act of preparing a paper document requires a greater level of engagement. Thoughts and words are vapors that can easily dissipate when new distractions emerge. But getting things in writing usually focuses thought and encourages clarity. And the physical act of writing (or, to a lesser degree, typing) engenders another level of reinforcement – your thoughts take on a visual aspect, and even acquire some “muscle memory.”
Second, getting it in writing leaves a trail, including one that is visible to others. Getting it in writing provides you with a definitive reference point, for the past and the future. You’re saying “on this day, here’s where I was, and there’s where I wanted to be.” And when you put it in writing before a spouse, partner, or advisor, that document becomes a common point of reference. It can be used by others to understand you, help you, remind you, and challenge you.
When it comes to my finances, what should I get in writing?
1. Write (or type) your present financial condition. Most people believe they have a general sense of their financial status. They can tell you if they’re current with their bills, if they’re saving money, and roughly how much they earn in a year. But move beyond the generalities, and you’ll find most people don’t have a good grip on what’s really going on – it’s all sort of fuzzy.
Consequently, it’s difficult to make new financial decisions with any degree of confidence. Are you sure you can afford a new car payment? What about re-financing? If you start a new life insurance program, will you be able to make the premium payments? When you’re not sure, you either make guesses or put off deciding, and neither of those options have a high success rate.
Imagine what could happen if you committed to preparing an accurate cash-flow statement every month. First, just attempting it would improve your financial organization. Checks would be written from the correct account, receipts would be kept – if nothing else, you would begin to have a paper trail.
For some, making an accurate monthly cash-flow statement might be a challenging task. It might take a lot of effort to set up the process and sort through your piles. If you find a cash flow statement requires too much work, start by picking one or two financial categories that need the most attention, like tracking your debt reduction progress, or monitoring the monthly accumulations in your savings and investments. Just collect some accurate information, and write it down.
2. Write (or type) your financial objectives. In general, everybody wants more money. But how much do you want, and for what purpose?
Everyone knows the job of sales and marketing departments is to convince consumers to buy their products. And most people understand that sales and marketing experts use a range of psychological ploys, both blunt and subtle, to compel people to buy. If you’re not clear on what you really want, you are much more susceptible to being sold something else.
Writing down what you want to accomplish makes it easier to resist the daily bombardment of sales pitches. You’ve embedded your own financial values, which allows you to see which items align with your objectives and which ones don’t. Clearly articulated objectives help you recognize that a flat-screen TV priced 50% off is a great deal – but only if you really want a flat-screen TV.
3. Write (or type) your plan of action. The default option for contemporary American culture is often the tyranny of the urgent; what’s immediately in front of us demands our attention. We deal with one momentary crisis after another, then either collapse in exhaustion or seek some recreational escape. And then we do it all over again the next day.
At some point we may notice the track we thought we were on is really a treadmill, but those moments of recognition are fleeting; there are new items hitting our in-box, and each one seems to be stamped “urgent.” Even if you decide to get off one treadmill – by changing careers, relocating, etc. – you may find yourself on another treadmill, running just as hard, yet still staying in the same place. Taking the time to write down a course of action in order to achieve your financial objectives gets you off the treadmill, first to reflect on, and then to redirect, your activities.
Does getting it in writing really work?
Intuitively, most people know getting it in writing would help them make progress. Of course, there are caveats. Making a direct cause-and-effect connection between writing it down and success is difficult because so many other factors are involved. You may have some financial issues that aren’t going to be resolved by simply writing them down (like back taxes to the IRS), but the very act of deciding to get your financial life in writing means you’re giving it a higher priority and a higher likelihood of success.
Thomas Stanley and William Danko are the co-authors of the Millionaire Next Door. Released in 1996, the book was a comprehensive study of the character traits and actions of American millionaires, particularly those the authors classified as PAWs – prodigious accumulators of wealth. Stanley and Danko found that the most successful millionaires spent a significantly higher percentage of their time reviewing their financial condition and planning their next financial action. Both activities required them to obtain accurate information, and develop clear plans of action – in some fashion, you could say they were “getting it in writing”.
You can find a lot of information about financial recording and goal-setting. Those details may help you, but the basic issue is this: When it comes to your finances, do you have it in writing? If you don’t, you have a simple question to answer: Are you going to get it in writing?
• HOW MUCH OF YOUR FINANCIAL LIFE IS IN WRITING?
• DO YOU HAVE A MONTHLY CASH FLOW STATEMENT?
• DO YOU HAVE A WRITTEN LIST OF FINANCIAL OBJECTIVES?
• DO THE FINANCIAL PROFESSIONALS YOU WORK WITH HAVE COPIES OF YOUR WRITTEN INFORMATION?
• OR… WOULD YOU LIKE TO HAVE A FINANCIAL PROFESSIONAL HELP YOU TO GET IT IN WRITING?
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February 16, 2010
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IDEAS THAT ENDURE
Ideas matter. The value of every statistic, every calculation, is determined by the ideas and philosophies to which the numbers are applied.
In the past several years, several trade publications have republished a short commentary on the essential elements of life insurance. Originally titled “Just a Life Insurance Policy,” this is a brief yet powerful statement of the timeless ideals that make life insurance a financially relevant product.
The article, probably written at least 50 years ago, was resurrected by Marvin Feldman, a prominent Ohio insurance agent and industry authority, in 2006. Feldman notes in an accompanying commentary that he was unable to identify the original author, and while the article can be found in a number of publications and websites, none of these sources cites an author either. Feldman also acknowledges he had to reword some of the article because the original syntax reflected a different era. Still, the financial and social concepts at the heart of life insurance remain relevant to the challenges and aspiration of today’s world.
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January 7, 2010
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Most of the factors regarding your debt are under your control. The terms and conditions of borrowing are typically well-defined, and with minimal effort, you can determine a payment strategy that matches your circumstances. Over time, a reduction in your indebtedness should free up more money for saving and investing.
By comparison, you may frequently find you have limited control over some of the factors affecting the performance of your invested assets. The broader market will determine the value of your equity holdings, whether in paper assets like stocks, or real assets such as rental property. And interest rates and dividend distributions are usually someone else’s decision, not yours.
With so many of the variables associated with asset management beyond your control, it’s worth asking the question:
Would you be better off devoting most of your energies to re-structuring debt to free up more money for saving, then using conservative, safe low-yield financial vehicles instead of trying to squeeze higher returns from riskier options?
Think of it this way: $100 earning 4% annually results in a larger amount than $75 earning 10%. If you can find the extra $25 through debt management, why take the risks associated with trying to earn 10% on a smaller amount?
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December 8, 2009
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In a very short time electronic communication, specifically the Internet, has effected a sea change in the way people conduct their basic financial transactions. Beginning with direct deposit and automatic withdrawals, then progressing to account transfers and online payments – for everything from utility bills to credit cards – much of our individual financial life is conducted instantly in a paperless environment. We don’t have to go to the bank, put the check in the mail, or wait for a monthly statement. Almost everything we want to know about our money, and want to do with it, can be accessed and executed with a computer keystroke.
Taking this blink-of-an-eye technology one step further, a number of businesses have developed online programs to aggregate, organize and update your financial information. Your bank accounts, credit cards, mortgages, investments, insurance policies – even your legal documents – can each be accessed on a unique, password-protected website. Constantly updated, this data can be formatted to provide all sorts of up-to-date consolidated financial information, such as personal financial statements, performance reports on investments, lists of assets for estate planning, etc.
Some of these management programs are offered by banks and other financial institutions for their customers. Others are independent online ventures marketed to the general public. Depending on the features and/or your customer relationship, the institution offering the management service may or may not charge a fee. Even if you don’t pay a fee, understand that every management program has some profit incentives for the provider. In-house programs will attempt to find products that match your financial data (“We noticed you have $10,000 in your checking account. Have you considered our SuperSavers program?”), while most online programs for the general public are supported by affiliations with retailers and merchants (“Want to maximize your grocery savings at FoodWay? Why not use our in-store SuperSavers program?”).
In theory, these tools allow a person to take immediate, accurate financial snapshots of their financial condition at will, and help answer questions like, “Can you afford that big-ticket purchase? Are your investments due for a rebalancing? Did you have positive cash flow this month?” Questions that might take a few days to answer (or often get resolved with little more than a “guesstimate”) can be addressed with a high degree of certainty in the time it takes to log in, configure some report variables, and hit “Enter.” That’s powerful stuff.
Ah yes, but remember the previous paragraph begins with the words “In theory…” The bane of every computer program is user error, also known as “garbage in, garbage out.” These financial management programs deliver on their promises only if the information is correctly configured. And in spite of the best intentions of programmers to make their products idiot-proof, the biggest hurdle in making online financial management programs work their magic is getting them set up correctly.
And even the techno-geeks admit this can be a problem. Here are snippets of an online review-and-comment thread regarding a problem of a highly-recommended online financial management program, started by a computer science graduate working in the financial services industry. (Specific company and institutional names have been deleted.)
Reviewer: (The program) lets you put transactions in buckets – and naturally it will get a few wrong to start with – but you can set up rules to classify new transactions how you like.
Comment: I just tried (the program) and it’s not really simple to use.
Comment: I tried to setup an account at (the program site). I found out that (my bank) and (investment company) did not support the (program) site/ software. What to do, what to do?…. could someone suggest another software that is better?
Comment: (The program) does support (investment company), you just have to set it up after 8pm EST and before 8am EST, because (investment company) doesn’t want the access to slow down the site for others.
Keep in mind this is a program that receives overall positive reviews from the reviewer and many of those commenting. Still, user error is a definite possibility, even for computer- and financially-literate individuals. And the greatest likelihood of user error is right at the beginning; if you don’t set it up correctly, the program may not update correctly, and all you’ll get is bad information in an instant.
Getting Technical Assistance
People who really care about their automobiles have always known the value of a good mechanic. And as the personal computer has become a fixture in our lives, many of us have developed our own “tech support,” whether it’s a friend who works in IT, a local computer company, or even the service department of the big-box retailers. In the same way, the real value of an online financial management program might be the personal assistance that comes with it.
Financial Technical Assistance
One of the value-added aspects of working with financial professionals can be their assistance in helping you establish and operate an online financial management program. From formatting the accounts and the initial data entry to the generation of regular reports, the knowledgeable assistance and support from a financial specialist can make a big difference in the benefits you receive from online financial management.
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December 7, 2009
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A November 11, 2009 article in the Wall Street Journal titled “529 Plans – More Parents Are Becoming Dropouts” notes diminished participation in what “have been pitched as the ultimate college savings vehicle.”
In brief, 529 accounts allow investors to contribute after-tax dollars into an account that typically offers a range of mutual funds and other investments. Distributions and earnings from the account are tax-free as long as they’re used for higher education. 529 plans are sponsored by states, and their investment options and fees can vary widely.
Why the decline in participation? There are several external factors: Many individuals have experienced a decline in their ability to save, due to unemployment or underemployment; they just don’t have the money to save. In addition, the stock market collapse triggered some high-profile fund implosions, complete with accusations of mismanagement, exorbitant fees and lawsuits.
The nature of government programs
But the internal design factors of 529 plans may also account for the decline in participation. Like many other government-sponsored savings programs, 529s are singular, stand-alone vehicles that “don’t play well with others” from a financial standpoint. These government sponsored programs create a separate bucket with a new number or acronym – IRA, 401(k), HSA, 529, etc. – and once the money goes into the bucket, it is expected to leave the bucket under very specific circumstances, such as retirement income, medical expenses, or a college education. It is difficult to transfer funds from one bucket to another, and penalties are assessed for any alternative use of the funds. These restrictions can make it difficult to integrate a government-sponsored plan into the larger financial picture, especially when money is tight.
A tax benefit, but at what cost?
The principal incentive with government-sponsored savings plans is usually some form of tax break. But as the Journal article noted, “in today’s jittery investment environment, some consumers are forgoing the tax benefits of a 529 to retain the flexibility to use the money for whatever they wish.” Tax breaks are legitimate financial incentives, but especially in tight economies, many consumers are finding that financial flexibility and control hold a stronger attraction. As Michael Singer, a 49-year-old teacher who recently lost half of his value in a 529 account, told the Journal, “Any new money going to my kids’ college education is going into something that I manage myself.”
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November 30, 2009
LISTEN: mp3 audio (9:33 min)
“The wise man does at once what the fool does finally.” – Niccolo Machiavelli
“Sully” is Capt. Chesley Sullenberger, III, the pilot of US Airways flight 1549, who flawlessly executed an emergency landing of his Airbus A320 in the Hudson River on Jan. 15, 2009, preserving the lives of all 155 passengers on board. As a result of his heroic response, Sully became an instant celebrity.
Unlike many media-manufactured celebrities, the individual behind the deed turned out to be just as impressive. Speaking with genuine modesty, Sullenberger credited his training and vocational commitment as the elements that prepared him to perform coolly under pressure. The public’s positive response to Sullenberger’s action and his explanations created a demand for more information. This summer Sully collaborated with Wall Street Journal writer Jeff Zaslow to write Highest Duty: My Search for What Really Matters. The book, released October, 2009 not only recounts the details of the emergency landing, but devotes significant time detailing the upbringing and character-shaping events that equipped Sullenberger to handle the challenge of safely landing a plane on the water with both engines out.
For Sully, the ability to perform the unexpected under pressure was the result of a lifetime of preparation. In an October 14, 2009 WSJ column about writing the book, Zaslow discusses Sullenberger’s diligence in preparing for circumstances he might face as a pilot. This diligence was more than safety checks or reviewing accidents experienced by other pilots. Sully also believes one aspect of preparing well is having the right mindset. He tells Zaslow:
“In so many areas of life you need to be a long-term optimist, but a short-term realist.”
When you consider it, being a long-term optimist and short-term realist is a pretty solid financial philosophy as well. Things may happen, some of them bad, some of them good. Some issues may be hazardous, other benign. But on the whole, if the short-term items are handled appropriately, the long-term prognosis is over-whelmingly favorable.
This perspective usually resonates with people; at a gut level they know it is true. But quite often, other perspectives on personal finance subtly influence us to ignore or override this approach, particularly the short-term realist part of the equation.
Here’s an example: When asked, what do most Americans state as their primary financial objectives? The frequent answer: “Retirement.” This is certainly a worthy long-term objective. But applying Sully’s mind-set, what’s the best way to prepare for positive long-term success? By addressing the short-term issues realistically.
Realistically, one of the best ways to sustain a long-term saving plan is to first establish some cash savings, typically equal to three to six months of income. A financial cushion can absorb unexpected expenses without requiring either an end to long-term saving or expensive withdrawals from a retirement plan.
Realistically, one uninsured incidence of disability longer than 30 days could seriously delay or derail any retirement plans. Implementing a disability income replacement program solves this short-term challenge.
Realistically, the best time to buy life insurance is when you are young, healthy and most insurable. If circumstances deny you the time to build a retirement fund, life insurance steps in to replace your earning and saving potential.
Realistically, the longer debts remain outstanding the greater the long-term lost opportunity costs that compound against you. Planning (and acting) to become debt-free is a short-term action that will undoubtedly deliver long-term dividends.
Realistically, some of this might sound boring, and not very sophisticated. But when you consistently address your short-term economic realities, it makes you a long-term optimist.
DO YOU WANT TO GIVE YOUR LONG-TERM PROSPECTS THE BEST CHANCE TO SUCCEED?
BE DILIGENT ABOUT YOUR SHORT-TERM FINANCIAL REALITIES.
DOES PERSONAL FINANCE MEDIA “FLIP” SULLY’S PERSPECTIVE?
Just for fun, check the covers of the most popular personal finance magazines at your local bookstore rack. What do you see? How about these headlines, culled from current issues:
• “Put Off Retirement? No Way!”
• “The Best Time to Invest in a 401(k)? Now!”
• “How to Be a Better Investor”
A sizable chunk of words, column space and conversation in the personal finance media is devoted to long-term activities, like investing and retirement planning. Nowhere to be found in the headlines or as a lead story: debt, disability, life insurance, emergency savings. Even the things to do “now” (i.e., the supposed short-term things that require immediate action) are really long-term items. Why don’t the short-term realities get more ink?
Perhaps personal finance magazines figure most of their readers have already taken care of their short-term financial realities. But any quick study of Americans’ financial habits will find most of them underinsured, deficient in savings and carrying significant debt.
Another possibility is the feeling that long-term financial issues, like saving for retirement, must be addressed even if the short-term realities aren’t under control: better to start making deposits in a 401(k) at an early age and possibly have to borrow from the account than wait until the short-term issues, like debt and insurance, are resolved.
It’s not that the majority of the financial media is against savings accounts, insurance, or debt reduction. Probably the biggest reason the short-term financial issues receive less attention is because they aren’t attention-getting. There are no extraordinary gains, or tantalizing potential fortunes. The short-term issues are not often inspiring or heroic.
Interestingly, Sully acknowledges the ordinariness of his own situation, saying he is not comfortable with being called a hero for his actions. “A hero runs into a burning building,” he says. “Flight 1549 was different because it was thrust upon me and my crew…I don’t know that ‘heroic’ describes that. It’s more that we had a philosophy of life, and we applied it to the things we did that day.”
Sully received correspondence from people saying similar things. One that he found most touching said:
“It’s clear that many choices in your life prepared you for that moment when your engines failed.
“There are people among us who are ethical, responsible and diligent. I hope your story encourages those who toil in obscurity to know that their reward is simple – they will be ready when the test comes. I hope your story encourages others to imitation.”
Heroic incidents, including financial successes, are inspiring. It is good for us to know about them. But much of the success we see has a foundation of diligence and preparation. And it wouldn’t hurt if the process of laying a successful foundation received a little more press.
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