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Today's Commentary: 02.17.06
Your Financial ABC's: A Look at Age, Balance, and Continuity
It is easy for me to say that everyone should contribute to their 401(k) plan or open an IRA and begin that retirement savings program. And maybe you have decided to take my advice and you have called your plan administrator or called one of the big mutual fund companies and asked them to send you some investing information. Maybe you have gone online and tried to search for the best place to put your money.
In many cases, this is where the employee or investor stops cold. This would explain the low enrollment numbers at small companies, the less than stellar participation among large companies, and the scary fact that far too many people, once they enroll, do little to add to their accounts or worse, default to the money market fund in their employers plan.
The choices are amazing and are actually only part of the problem. The information that one needs to consider is often confusing and require a great deal of soul searching, a healthy dose of self examination about who you are, and more than just a little guessing about where you are going, how soon you want to get there, and the ultimate question: how long will you live.
Iıve simplified the process for first time investors and more experienced ones who may not have achieved the kind of success with their retirement plans they had hoped or planned. It is called the Financial ABCs.
The Financial ABCs represent: Age, Balance, and Continuity
Age: Although many of us start our plans later than we would have liked to, age becomes one of the most important factors to consider.
Experienced investors know that investments need time to grow. The markets will go up and the markets will go down. Successful investors know that time - the longer the better - is needed to ride out the slower periods to create real wealth.
While it is ideal to start young, far too many of us do not have the savvy to realize that 25 is the best time to start. Starting in our youth requires the least amount of investment dollars to achieve the greatest amount of wealth. But our youthfulness finds us buying cars and clothes and any of the other toys that post college paycheck will afford. Along with the looming costs of repaying college loans often stops the "perfect age" scenario right in its tracks.
Then along comes a family, a house, and life in general. About midway through, we wake up to the fact that we might live well beyond our working years and begin to wonder how are going to finance those golden years.
With defined benefit plans or pensions coming under increased pressure of late, even financially solvent companies are looking at ways to stop funding their employees with their post-work lives. Instead, they are throwing the ball back into our court more and more with the encouragement of the current administration - and that creates a major problem for many workers who suddenly realize that their retirement is now their problem.
Ideally, you need at least twenty years to create a retirement nest egg. Even better, you need 30 years to ride out those market cycles I mentioned earlier. That means that if you are forty-five years old, working until you are 75 would give you the best return for your efforts and provide you with the best returns.
We always seem to use a million dollars as the target for the perfect retirement. Getting there is often not as easy as it sounds. Even if you start at age 25 and get a 6% return for your investment dollar, you will need to contribute about $500 a month, every month until age 65 to get to that seven figure goal.
Start at age 45 with the same lofty goals and the same retirement age and you will need an annual contribution of $27,184. What a difference twenty years makes!
Starting at age 45, working until 75 with a $500,000 nest egg target that is not counting your home or any other assets, which for many make up the lion's share of their wealth the investor would need to start saving $500 a month and work another 30 years.
Balance: Faced with those age considerations, folks often think that they need to be more aggressive, seeking out riskier investments that have higher returns. No advisor worth their weight would ever suggest that someone starting late seek the highest risk for the best results. Even if it seems the most logical conclusion, adding risk while in a short time horizon is just asking for trouble.
Because you have a shorter investment horizon, balance is absolutely necessary. Unfortunately, balance often means accepting a more conservative approach. One of the greatest investors of all time, Benjamin Graham has a steadfast rule for investors. His 75/25 rule offers the best balance available if you are investing in stocks.
Younger investors aged 25 years or so would have 75% of their holdings in the stock market and 25% in fixed income investments such as bonds. Mid-life investors would, according to his sage advice, hold an even distribution of 50-50, stocks and bonds. Close to retirement investors should be 25% in stocks and 75% in bonds.
Unfortunately, the hardest target to hit is when you will retire, which leads to the question of when is mid-life. Mr. Grahamıs ideas are classic and some may say antiquated but they hold some basic truths no matter how old they are.
The first is risk. The markets haven't changed since he wrote his last installment of his book "The Intelligent Investor". Investors still need to avoid risk and achieve balance. Risk adds the gamble that the upside will be there when you need it the most and the downside will be minimal. It doesn't work that way. Stocks can only defy financial gravity for so long before they tumble back to reality.
To achieve balance, investors in 401(k) and in IRAs will find it relatively easy. Many mutual fund companies now offer asset allocation funds or lifestyle funds as part of their portfolio choices. Recent studies have revealed that these
types of funds have actually done slightly better than funds that were actively managed by the investor. In other words, these funds automatically revisit their accounts and rebalance them for you keeping your investments age appropriate. They tend to match where you are age-wise and risk-wise without any effort on your part. While they might not always beat the market, they have proven to be steady gainers for those invested.
Continuity: Dollar Cost Averaging, the method of investing regularly and consistently remains the only way to achieve wealth and the only formula that has worked for investors. By default, it creates discipline and allows the investor to take advantage of the down markets by buying cheap psychologically, investors usually try to sell during these periods - and avoid rushing into the up markets another curious fault investors exihibit.
One more note and another letter in the financial alphabet:D stands for death. If you could easily target exactly when you will die, you could do a better job at figuring exactly how much you would need to survive until that point.
Some key points to remember:
Take care of your health - it will prove an extremely costly problem for retirees who are not healthy and act as a tax against your savings efforts.
Start investing now - donıt worry about what age you are starting your savings but do take advantage of lifestyle funds that adjust to your age and risk.
Be consistent - it is okay to tweak your payroll deduction now and again, but never contribute less than 5% and if you can, increase that number with each raise you receive.
Adjust your taxes deductions - giving the government more in taxes in the hopes of receiving a large refund is still counterproductive and keeps you from achieving a chance at a good retirement.
Today's Commentary: 02.13.06
Waking Up Screaming: How the American Dream is about to Change
The second half of the twentieth century belonged to the middle class. No one was pointing fingers at the growing disparity of incomes. No one was suggesting that the top 2% of the nation was further distancing themselves from our existence. No one in this class, which contained both blue and white-collar workers, was complaining much about the state of their finances beyond the backyard barbeque. In other words, life in these United States was good.
Unfortunately, the American Dream was only reached through hard work, proof of income and 20% down. No more. Interest rates were falling and hitting new historic lows. Markets around the country began to heat up with local housing prices inching up in some places or taking off in others.
Banks understood the marketplace better than we did. With less interest on the money they loaned, volume was the only the answer to lending. Now, those bankers are about to reap the rewards of that creative period.
During a time when housing became expensive as demand outpaced good sense, a time when the cost of a house outpaced the average income, and a time when the old rules simply would not allow the average American to qualify for the home of their dreams, bankers had an answer. At a time when it seemed as if everyoneıs home was an ATM with equity used to pay down high credit bills, finance remodels, or otherwise, just to pull mad money from their properties for whatever consumer whim they had, bankers threw out their standards a loaned to folks who had no business borrowing money in the quantities needed to get into a house.
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Undeterred by soaring prices, potential homebuyers became investors, albeit of the speculative variety. No longer was it about the right place to raise the kids. It was now about appreciation and the potential value of the home. Amenitites would follow these home buyers wherever they went.
In days gone by, the search for a new home often began with the question: "how much can we afford?" Realizing this and with a nod to the "American Dream" more and more lenders began their conversation with potential buyers, many of whom had a house already in mind with, "What can we do to get you into a house?" without adding, "you could not otherwise afford?"
It is difficult to predict the outcome of these types of lending practices, but the worry that many of these sub-prime loans, over $600 billion worth will change the American Dream into a modern day nightmare.
Here is an example of the kinds of loans they created to service the demand:
Hybrid ARMs which are adjustable rate mortgages with introductory teaser rates that allow the borrower to pay a lesser rate initially often in the first three to five years.
IO mortgages are interest only loans in which the borrower pays only the interest while the principal remains the same and often require no repayment of that amount.
No Doc Loans or as they are sometimes referred to as "Stated Income" loans involve only the word of the borrower when proof of income is required.
Option ARMs are loans with smaller monthly payments with the difference owed being plowed back into the principal owed.
Piggyback mortgage, by far the most popular are loans in which the borrower borrows 100% of the money needed, 80% to the first mortgage at a higher than market interest rate paid by good quality borrowers and the remaining 20% borrowed on a line of credit with an adjustable rate tied to the prime rate plus.
These mortgages didn't just go to those who were looking to purchase homes for the first time. Many were initiated to tap the growing "paper" wealth in occupied homes.
If you are a sub-prime borrower, you may be faced with some difficult times in the near future. A previously unknown phenomenon is about to take place. Known as equity resets, many sub-prime borrowers could be facing an interest rate jump of 50% or more.
In many of these loans, the reset will be based on the LIBOR, a six-month money market benchmark set by the London Interbank (current rates can be found at Bankrate.com). As of this writing, the rate is 4.93% and headed up.
If families have any equity left in their homes, the reset might mean that they can refinance their home with similar type adjustable rate mortgages. Unfortunately, those "teaser" rates are now 7.25% and are also heading higher.
Risk layering will come back to haunt far too many households. Borrowers who used risk layering, a method of amortizing the principal for two years and paying only the interest will find that not only will they suddenly be obligated to pay not only the principal but at a new higher interest rate.
This economic double whammy could have devastating results to an economy that grew so strongly on the backs of these borrowers. All, however, is not lost.
If housing prices in your area remain the same, your current loan could be converted to a fixed rate. Be prepared however to take a 40 year loan and if you are a sub-prime borrower and expect to pay upwards of 9.25% interest on the money. A homeowner would then adjust their monthly outlays to meet what would be a much higher fixed monthly payment.
Another possible break could come with the lowering of short term interest rates set by the Federal Reserve Bank. While these rates are not tied to home loans, when they rise, banks tend to follow their lead and do likewise. The new Fed chief Ben Bernanke has made it known that he is an inflation hawk and should prices rise nationwide housing prices are optimistically predicted to increase by 5% - he might change the direction of the Central Bank and begin lowering rates.
The next best situation involves an income increase that would allow you to pay those additional costs and weather the storm. While economists are optimistic about jobs and the wages workers receive, it is unrealistic to assume that wage increases will keep pace with these newer loan rates
Typically, overheated markets will fair the worst. In many locales, homeowners will see an average price decline of 15%. National City, a top ten mortgage originator recently conducted a survey and found that 38% of the housing market is currently at "extreme" price levels.
While most of us are unsure how this will play itself out, wishing for the best of all possible scenarios to occur - interest rates fall, prices stabilize or rise, and your income increases - is unrealistic.
You can be assured of one thing though, the lending practices of the previous years have changed. Sub-prime borrowers will face a more difficult qualifying landscape with higher rates, higher qualifying income levels and less optimistic appraisals of houses. Changes in how future purchases are determined will decrease the loan to value ratio, widening the gap between the potential house and the buyer.
If you own a loan similar to the ones described above, don't wait to tighten your belt. Explore your possibilities now, discuss it with your family (if they are old enough to understand the buying power of a dollar, they should be included in the conversation things will change for them as well), and adjust your sights lower.
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