Having a high income does not guarantee wealth

The recent debates over tax policy and the “fiscal cliff” have raised a pet peeve of mine.  My peeve is when people, use the word “wealthy” interchangeably with “high income”.  I do agree that there is a correlation between the two, but there are people with high incomes, with much lower wealth than people with significantly lower incomes.

I will draw a couple of examples based on a composite of my clients.

High Income/Lower Wealth

John and Mary Smith both age 42, work at high paying jobs and have a combined income of $400,000.  They have two children, ages 6 and 2.  They have high housing expenses, child care expenses, retirement savings, and college savings.  They also spend money on home improvements, eating out and vacations.  They have a net worth of $200,000 equal to a half a year of their income.

Lower Income/Higher Wealth

Doris and Boris Johnson, retired, are 67 and 65.  They both collect pensions and Social Security which total $90,000 which provide enough income for them to live the lifestyle they wish.  They spend time on volunteering, visiting friends and family, and some travel.  They have lower housing costs than the Smiths, even though they have a second home, and do not have to worry about saving for retirement or college for their children.  They have not spent any of their retirement nest egg of $1.8million, and plan to help their grandchildren with college expenses with some of it. Their total net worth is $2.3million or 25.5 times their annual income.

Factors that I have seen that are associated with a higher net worth besides income include.

  1. Age, the older you are the more time your investments have had a chance to grow.  In early retirement expenses may also be lower if you are in good health then they were if you were saving for retirement of college educations for children.
  2. A strong ability to delay gratification.  People who find it easy to delay gratification tend to spend a lot less.  They spend less both on shorter-term expenses (vacations, eating out, ‘stuff’), and longer-term expenses (housing, cars).  This is also manifested in a “pay yourself first” attitude when it comes to their income.
  3. Think about their future often and though generally optimistic, know that financial reversals do occur and want to prepare for them.

Personal Finance Magazines — Bad Advice?

I often read Personal Finance magazines because I know my clients do.  In a big picture way they give solid advice about investing — not timing the market, setting up a long-term asset allocation, etc.  At the same time many of their articles and columnists are advocating just the opposite.  The January 2013 cover story for Kiplinger’s title story is “Where to Invest Now” quoting Katerine Nixon of Northern Trust saying “It’s going to be a pretty good year for stocks.”  I have two issues with this cover.  First, it implies that market timing can be a successful strategy even when research implies that for most people it isn’t.  Second, what the heck does a “pretty good year for stocks mean?”

Opening the magazine we see that they feature a mutual fund manager in a red tie and socks (Cardinals Fan, were told — is that baseball or football?)  who only holds about 20 stocks.  Why don’t they feature the guy that bet on red at the casino and doubled his money in a few seconds.  Arguably a much better result that this guy achieved.  When a magazine features the mutual fund manager “winners” they imply that more than luck is involved in their winning ways, when in reality a long-term statistical analysis implies that it’s all luck.

There are two reasons why many people have a hard time buying this.

1. When it’s something we perceive as complicated and don’t fully understand how it works we give greater deference to those who seem to do well.  Since we do not understand how the stock market really works those who do well are perceived to have have special skills.   Such deference is usually not accorded to someone who flips heads 10 times in a row, a much rarer feat.

2. The mutual fund industry spends vast amounts of money to support this model. If you can make a lot of money convincing investors that you have a winning strategy for the long-term they will give you more money to invest.  If you do well in the short-term you can tout your performance to gather more assets and fees.  When you do poorly, blame it on the market or shut down that fund and start over again.

I understand that Kiplinger’s and the others have to sell magazines and web views but it would be great if they included a disclaimer by every article recommending individual stocks or actively managed mutual funds that “there is no empirical evidence that pursuing this strategy will be more effective than a buy/hold/re-balance asset allocation strategy using low-cost index funds.”

Are you on track for retirement?

Here is a ‘quick and dirty’ tool that I found in Money Magazine (Feb 2011), that gives you a quick assessment to see if your retirement savings are on track.

For each age there is a savings factor (e.g. at age 30 the savings factor is 0.3).  This means that if you want to retire at age 65 you need to have 30% of your salary saved by age 30.  If you earn $100,000 this means that you would need to have $30,000 saved for retirement.  At age 50 the factor is 4.5 which means that if you earn $100,000 you would need to have $450,000 in retirement savings.

Age        Savings Factor

30               0.3

35               1.1

40               2.0

45               3.2

50               4.5

55               6.2

60               8.2

65              10.6

This table is a better estimate for younger ages when retirement is far off and you want a quick reality check. As you get closer to retirement so many other specific factors could affect your number (e.g. will you have a mortgage, will you move, will your lifestyle change, etc.) that it may be worth doing a more specific sophisticated analysis, or even seeing a Fee-Only(tm) Financial Planner.

New 401k Plan Disclosure Fees – An Eye Opener for Small Business

May 21st, 2012

After many delays, 401k plan providers and advisers will finally have to begin disclosing their fees. Some of these fees may come as a shock to some employers who were told that their plans were “free.”

Providers will have to disclose what the administrative fees are for the plan even if they are bundled into the mutual fund expenses in the plan. Mutual fund fee will have to be disclosed to participants in terms of the annual cost per $1000 invested.

Many participants will be surprised to discover that they are paying 2-3% of their 401k plan balance in annual fees. High fee plans are often sold to small businesses that lack easy access to lower cost 401k plan solutions, and lack the expertise to decipher the hidden costs in a supposedly “free” plan.

Hopefully the new disclosures will serve as a wake up call for small business and get them to ask some tough questions to their plan providers. Read the article for more details.