FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 1.5: Planning for the Future
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
Much of what we’ve already discussed leads us to a pretty simple conclusion: If you want to get rich, you’ve got to have a plan. Buying lottery tickets, going to the casino, and praying a lot for a financial miracle are not the solutions to financial woes. You’ve got to plan, and you have to plan in stages. Perhaps the most important thing to plan for is your retirement. If you don’t plan, you are likely to spend your golden years in misery, praying that death will hurry up and take you away from the cold, cruel world. The great thing about planning for retirement is that time is your biggest ally in the wealth building game. If you are young, you’ve got up to 50 years to set aside enough money to ensure a bountiful retirement that you can truly enjoy.
We will deal with some of the details of budgeting, saving, and investing in later sections. At this point, we’re trying to get a view from 38,000 feet. My primary goal with this section is to get you to understand the importance of planning, and the basics of how to put a plan together. A big part of the planning process is working up a budget. This is a limited view, however, because budgets are things that change a lot over time. Doing a single budget and then ignoring it for 50 years does not constitute a financial plan. A big first step is to draw up an even bigger plan for yourself. What do you want to be doing in 5 years? 15 years? 30 years? 50 years? Some of us don’t have the luxury of planning what we’ll be doing in 50 years–we’ll likely be dead. If you are young, you have an amazing gift of time. Don’t be the stereotype that makes us old guys say “youth is wasted on the young!”
When I was an undergraduate, my advisor told me something that I found shocking: He said that I needed to plan on having two careers. His explanation cleared up my confusion. I was studying policing at the time, and my advisor explained that law enforcement is a young person’s game. You can’t go running through back alleys at 3:00 AM chasing bad guys when you are in the physical decline that claims us all with advancing age. Twenty to twenty-five years is the average law enforcement career. Even if you have a good balance in your retirement account, the IRS makes it very painful to try and retire before you are 60 years old.
What are you going to do the rest of those working years? Even though I went into higher education instead of law enforcement, I worked as a volunteer “reserve officer” for many years. At about 40, I started to realize the wisdom of what my advisor had told me all those years ago–it was too physically demanding to stay up all night and chase bad guys. Had I gone into law enforcement full time, I would be about ready to look into a career change. Leadership in law enforcement was one option, but a second, different career path is another that few think about in advance.
Since I’ve worked in higher education, I have served on many “search committees.” Search committees are groups of professors that are responsible for finding potential new professors, reviewing their application materials, and ultimately interviewing the ones that make the shortlist. Many of these potential teachers had careers in the field doing the work that they now want to train others to do. One of the common threads I saw in both criminal justice and social work is burnout. Helping others is an honorable profession–even a calling–but there are limits to how much the mind can take. When the helping professions are called in, people are in genuine need of serious help. You are exposed to the best and worst that humanity has to offer. There is death and human suffering aplenty in these fields. Even if you can stay in the same job for an entire career and retire from it, you will most likely not want to do so.
Your ability to stay nimble in the job market depends a lot on your decisions while you are young. If you think you may ever want to teach, it is probably best to think about graduate school while you are young and haven’t yet taken on the responsibilities of mid-career professionals. If I had to go back and redo the work leading up to my doctorate degree, I would not do it. The thought of all those sleepless nights and stress of studying for exams and defending dissertation proposals is just too much for the older me.
Another aspect of far future career planning is your mobility. Are you willing to move off? Maybe you want to do so. I’ve always liked the idea of living in Alaska for a while, taking in the rugged beauty every day. If I were to do that, I’d have to think about what to do with my house. I’d have to think about what to do with my retirement account. I’d have to think about starting a new job as the “new guy.” There is a lot of work moving to a new place and starting a new job. It is very hard to say whether or not you will want to do this twenty years before decision time. My advice is to plan to make a late career move as easy as possible.
The biggest issues will be your home and your retirement account. With homes, you have two basic options. You can keep it as a second home, and in that case, you can potentially rent it out and use the extra cash as a passive income stream. Another option is to sell and buy a new property in the new location with the proceeds. From a financial perspective, this is simply moving your money from one investment to another. Done carefully, there is little risk to your investment.
The issue of your retirement account is a little more complex, depending on what type of account you have. The best kind of mobility is an Individual Retirement Account. This is money that you own and manage; the IRS just won’t let you use any of it until you retire. It’s not tied to a job, so you can just take it with you when you go. The next best thing is a 401K type of retirement account (or 403B if you work for a nonprofit). These accounts are usually sponsored by your employer and have a lot of rules based on your employer’s contract with the investment firm.
The money is yours (usually) but there is usually a lot of red tape and rules on how it is managed. You will want to read and understand those rules carefully when you first hire on. Most of us fill out the hire forms and forget about them for a decade before we worry about retirement again. With these types of accounts, you want to know how long it takes for the money to really be yours (become “vested”). Some jobs have the retirement plans set up so the money is yours right away, and some require that you be with the job a certain amount of time. You’ll also want to understand the rules for doing a “rollover.” A rollover is where you take your money out of one retirement account and put it in another with your new job.
The worst kind of retirement plan for mobility is a pension. A pension is a retirement plan where you are guaranteed an income in your retirement years that is provided by the company/agency that you work for. The rules for these can vary widely from agency to agency (or company to company), so you want to be sure what you can and cannot do with your retirement money if you change careers. The upside of pensions is that while you won’t have very much money in retirement, you’ll have a certain amount no matter what happens to the economy.
You may have to eat Alpo, but at least you’ll have that. Because pension managers have to make ridiculously safe investments with retirement money, they rarely keep up with inflation. This means that they are very expensive for agencies and companies to operate. The trend has been to move toward 401K type retirement plans where you are in charge of making sure you have enough money to retire.
Many young people pay no attention to retirement because it seems impossibly far into the future. Another reason that people don’t pay enough attention to retirement is that they know that Social Security is out there, and they can retire on that after all. The bottom line is that Social Security is in real trouble as people are living longer and staying retired much longer than in previous generations. The only way that Social Security can stay solvent, in the long run, is to cut the level of benefits.
This translates into a situation where you cannot maintain any decent standard of living on Social Security alone (I argue that you cannot now). Unless you have a crystal ball, I suggest planning on Social Security not being around when you are old enough to get any benefit from it. I actually think it will be there in some form, but the amount of the benefit will be very low and so will your quality of life if you plan on living on it.
This section, by necessity, sounds very vague. That’s because it is vague. It is impossible to be very specific as to what you’ll be doing or want to do forty or fifty years from now. For now, the best you can do is give some thought to what is likely. If, for example, you are the heir to a family farm that has been in your family for eight generations, then you will not likely want to ever sell. Therefore, it doesn’t make sense to do projects that will add to the real estate value of the old farmhouse. Contrast this with someone who has a retirement destination in mind and has no plans to stay where their job is. In that case, it doesn’t make sense to not keep an eye on the real estate value of the home. You want to maximize your profits when you do get ready to sell, and home improvements are an expensive business best done over time (and with sweat equity if possible).
Another sage piece of advice is to do what I call “staying nimble.” By this I mean when you have an option that keeps your options open, take that option. If you get the chance to move to a slightly different version of your career, do it. That experience makes you more valuable to employers and makes you more financially secure in a bad economy. Get all the free training and continuing education you can. Training may not be fun, but it’s an investment in your future and someone else is paying for it!
The Secret of Real Dollars
When you think about the “value of a dollar,” the idea doesn’t even make much sense. A dollar, after all, is worth a dollar. We view the numbers as fixed, and the value as unchanging. The dollar is the benchmark. This is absolutely wrong! To understand this, consider why we value money in the first place. If you had a million dollars in cash and you were on a desert island with no food or water, I bet you’d leave all that money behind in exchange for a Value Meal within the space of a month. We really don’t want money per se, we want the goods and services that money can buy us. Put another way, the real value of money lies in its buying power, not little green pieces of paper.
As you may have noticed, things seem to get more expensive every time that you go to the store. They don’t just seem to be getting more expensive; they really are getting more expensive, and the phenomenon is called inflation. The price of everything tends to go up around 2% to 3% per year. There have been really weird periods when things actually got cheaper, which is called deflation. These moments aren’t as good as they sound because they tend to come with terrible economies when nobody can afford to buy anything. The Federal Reserve tries to keep inflation at a steady rate of about 2% annually. They have the power to set interest rates and the power to print money, both of which are incredibly powerful tools. That this means for you (the consumer) is that something that cost you $1.00 this year will cost you $1.03 next year. You may not notice that price increase in a can of soda, but after a few years, you start to realize that your salary isn’t going as far as it once did. If your job doesn’t give you a raise that is the equivalent of inflation every year, you are losing buying power (getting poorer) every day that passes.
Economists recognize the problem with inflation, and they are also keenly aware that it takes some really, really big chunks out of your savings over time. From the personal finance perspective, you need to make sure that any money you have in savings is growing at least as fast as the inflation rate. This preserves your buying power at today’s level; it is not growth in any real sense. The number of dollars will seem bigger because the numbers are bigger, but the buying power remains constant. If you want your money to grow in buying power, you must beast all of the fees that it costs you to invest, and you must beat inflation. I successful retirement account must do this! You can’t save 10% of your salary for 40 years and have enough money to retire for 40 years unless that money grows substantially under the miracle of compounding interest.
The best idea we have about inflation is through a government statistic called the Consumer Price Index (CPI). When we say that the inflation rate is 2.43% this year, we are usually talking about the rise in the CPI. Economists are smarter than most of us (when it comes to money anyway), and they figured out that you can subtract the CPI number from an amount of money every year to get a price in real dollars. Real dollars are adjusted for inflation and are what you should always do your retirement planning and investment planning with. You may project that you will have $2,000,000 in your retirement account in 40 years. That sounds great, but what will 40 years do to your buying power? You will likely find that the projections indicate that you’ll have less than $900,000 in real dollars, which isn’t that much money when you split it up into 12 monthly payments for 40 years to live on when you are retired.
The takeaways from this critically important information about inflation and real dollars is that you always need to use inflation adjusted numbers when doing retirement planning and designing portfolios. It also means that bank accounts, CDs, money market accounts, and even U.S. Ten-year Treasures are terrible investments; the current rates of interest do not beat inflation, and there will be no growth unless you do beat inflation. What is worse, your money actually loses buying power sitting in the bank. You are much better off holding your money in markets that can beat inflation and provide you with an acceptable rate of return aimed at reaching your retirement goals. My final point about inflation is that you must get regular raises in your job if you are to keep your buying power level. If you go ten years without a raise, you are really working for about 70% of what you started at. Don’t let your boss tell you that you are getting a 2% “merit raise” when you aren’t even hedging inflation with that! If more Americans understood this simple concept, there would be much more collective action among workers across all spectrums of employment.
Types of Retirement Plans
As suggested above, there are several different types of retirement plans. The biggest differences depend largely on who you work for and how taxes are treated. We’ll delve deeper into the most common of these later. Right now, we just want to get an idea of what some different options are. These are critically important because they are the vehicle through which most Americans can save for retirement with sufficient returns to beat inflation and meet retirement goals. For many of the account types introduced below, you don’t have to pay taxes on the money that you contribute, and your employer will often contribute a specific amount that matches your contributions dollar for dollar up to a certain percentage of your salary. As you probably guessed, this money contributed by your employer is called a match. The tax advantage and the match make these retirement accounts among the best investments available. Not contributing enough of your salary to get the maximum match that your employer will pay is downright foolish. You are throwing away free money!
According to the IRS, “An individual retirement arrangement (IRA) is a tax-favored personal savings arrangement, which allows you to set aside money for retirement. There are several different types of IRAs, including traditional IRAs and Roth IRAs. You can set up an IRA with a bank, insurance company, or other financial institution.”
A Roth IRA is an IRA that, except as explained below, is subject to the rules that apply to a traditional IRA.
- You cannot deduct contributions to a Roth IRA from your federal taxes.
- If you satisfy the requirements, qualified distributions are tax-free.
- You can make contributions to your Roth IRA after you reach age 70 ½.
- You can leave amounts in your Roth IRA as long as you live.
- The account or annuity must be designated as a Roth IRA when it is set up.
A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. Elective salary deferrals are excluded from the employee’s taxable income.
A 403(b) plan, also known as a tax-sheltered annuity (TSA) plan, is a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers. Individual accounts in a 403(b) plan can be any of the following types.
- An annuity contract, which is a contract provided by an insurance company.
- A custodial account, which is an account invested in mutual funds.
- A retirement income account set up for church employees.
Generally, retirement income accounts can invest in either annuities or mutual funds.
SIMPLE IRA Plans
A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan. The employer is allowed a tax deduction for contributions made to the SIMPLE. The employer makes either matching or non-elective contributions to each eligible employee’s SIMPLE IRA and employees may make salary deferral contributions.
SEP Plans (Simplified Employee Pension)
A SEP plan allows employers to contribute to traditional IRAs (SEP-IRAs) set up for employees. A business of any size, even self-employed, can establish a SEP.
Payroll Deduction IRAs
Under a Payroll Deduction IRA, employees establish an IRA (either a Traditional or Roth IRA) with a financial institution and authorize a payroll deduction amount for it. A business of any size, even self-employed, can establish a Payroll Deduction IRA program.
A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires you to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions. Also, your business does not need profits to make contributions to a profit-sharing plan. If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.
One common method for determining each participant’s allocation in a profit-sharing plan is the “comp-to-comp” method. Under this method, the employer calculates the sum of all of its employees’ compensation (the total “comp”). To determine each employee’s allocation of the employer’s contribution, you divide the employee’s compensation (employee “comp”) by the total comp. You then multiply each employee’s fraction by the amount of the employer contribution. Using this method will get you each employee’s share of the employer contribution.
Defined Benefit Plans
A defined-benefit plan is a retirement plan that an employer sponsors and employee benefits are computed using a formula that considers various factors, such as length of employment and salary. The company administers portfolio management and investment risk for the plan. There are also restrictions on when and by what method an employee can withdraw funds without penalties. When you hear people talk about a “pension”, this is often the type of plan they are talking about. The plan is termed “defined” because the formula for calculating the employer’s contribution is known ahead of time.
Money Purchase Plans
A money purchase plan is a type of defined-contribution plan that is similar to a profit-sharing plan, except that the contribution amounts are fixed rather than variable. Thus, employers are required to make annual contributions to each employee’s account regardless of the company’s profitability for the year.
Employee Stock Ownership Plans (ESOPs)
An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees. The plan maintains an account for each employee participating in the plan. Shares of stock vest over time before an employee is entitled to them. With an ESOP, you never buy or hold the stock directly while still employed by the company. If an employee is terminated, retires, becomes disabled or dies, the plan will distribute the shares of stock in the employee’s account.
This type of plan should not be confused with employee stock options plans, which are not retirement plans. Instead, employee stock options plans give the employee the right to buy their company’s stock at a set price within a certain period of time.
Government Plans are retirement plans established and maintained for the employees of:
- The United States government
- a state or political subdivision (Cities, Counties)
- an Indian tribal government
Plans of deferred compensation described in IRC section 457 are available for certain state and local governments and non-governmental entities tax exempt under IRC Section 501. Plans eligible under 457(b) allow employees of sponsoring organizations to defer income taxation on retirement savings into future years.
409A Nonqualified Deferred Compensation Plans
Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation.
References and Further Reading
CNN Money’s Ultimate Guide to Retirement. This index contains loads of information about a wide variety of retirement-related topics. http://money.cnn.com/retirement/guide/