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On Finance: Core Assets

In discussing how people weather financial difficulties I mentioned that core assets provided the foundation for financial stability. In addition these also provide the basis for meeting many people’s future goals. Money, more than anything else, is a tool which enable an individual to accomplish various things in one’s life. For many those goals include retirement, travel, providing a child’s college eductions, and/or the ability to help others. Most people’s goals are more easily approached with secure financial base than without. Let’s explore how to build that base.

Retirement Accounts:

The first core asset many people start building is a retirement account — usually through a 401k or similar payroll program. These are excellent programs from a saving, investing, and tax perspective. At a minimum one should contribute the maximum amount matched by an employer as you’ll unlikely encounter a better initial investment return.

The largest problem is that most consider the matching amount as the top-end of their retirement contribution needs instead of the floor. Most assume that with that and social security they’ll be set for life. That may well be correct thinking, but most likely you’ll be set to work for life. Few have taken a look at what is really required to retire in the lifestyle they desire.

The suggestions I like to make is that at least 10% of your GROSS income (before withholdings and deductions) should be placed in retirement accounts — and more if you start the accounts later in life. However, a MUCH better way to determine this is to work through a lifetime financial plan to determine how much YOU need based on YOUR desired retirement lifestyle. I usually suggest counting very little on Social Security, keep your retirement within YOUR control and use any government provided funds, if any, as a bonus.

Tapping your retirement plan for anything other than retirement is trading off your future security. Do so only in the most dire situations.

Home Equity:

The second major asset people tend to start building is equity in a house. In our grandparent’s day the equity in their house represented a critical component of their retirement.

One of the most frequently complains about living today is that today’s economy requires two incomes just to afford a house. People usually say this with a longing for our parent’s time when only one income was needed. To a certain extent economic theory probably guarantees that when you have a majority of households with two incomes, the cost of living will adjust upward to match the average household income. But the major problem with the two-income-required mantra is that we are comparing apples to oranges.

The big disconnect with our grandparents generation is that their “starter home” was about a thousand square feet. They tended to have one car, one television one stereo, etc.. They typically lived in the same small house, raised a family of four to six people, and paid off the 30 year fixed rate mortgage in 30 years. After paying off the mortgage they greatly reduced their daily living expenses by not having a mortgage or rent payment — or they sold the house and moved to a lower cost housing arrangement and used the excess equity for living expenses.

Today, in comparison, we move into a “modest” starter home of two to four thousand square feet, move into something larger when the family expands to three or four, and live with a large compliment of connivence items and convenience activities. We refinance to new adjustable rate 30 year mortgages on a regular bases to finance most of the luxuries of our lifestyles — and all the while failing to build the same financial foundation they did.

The problem of requiring two incomes isn’t the increased requirements of the economy today, but rather the increased requirements of our personal economies as dictated by the culture we choose to live in. I’m sorry if that’s harsh, but that is the reality of much of the past ten to fifteen years of this country’s most affluent middle class. Frankly, the primary problem with our country’s economy is that the bill has finally come due — and we don’t have the economic foundation to make the payment.

I’m sorry, let’s get back to our task of building core assets: hidden in thr last few paragraph are the keys to securing equity in a house. The critical financial foundation strategy our parents or grandparents knew but we seem to have missed; move into a small single family house, get a 30 year fixed mortgage, and pay it off in 30 years without refinancing. If relocations to new digs are required, finance the new house for the remaining time left on the original 30 year mortgage.

Tapping into home equity is never a good thing to do. I can’t say this enough: tapping into home equity is never a good thing to do. As a nation we made a major mistake when we changed the tax laws to encourage people to borrow against their home equity to pay off consumer debt or make consumer purchases. While I’ll explore this in more detail while talking about debt, using home equity generally means paying for things for twenty years after you stop using them. This is digging a hold through the middle of what should a critical foundation of your financial security. Tapping into home equity is never a good thing to do.

Cash Reserves:

If our retirement and home equity is the foundation for a long-term future, our savings and investments are the key to managing cash flow problem created by various inevitable events in our lives. Unexpected things happen; we loose a job, we have an accident that lays us up, a car needs to be repaired or replaced, an extended family member didn’t plan ahead, or one of a thousand other things comes along and impacts our financial life. Other things we can foresee, such as a child’s college tuition. The first place we SHOULD be able to turn to is are our cash savings, and if the need requires, our short-term investments.

Savings should be split into short, medium, and long term investments. That means putting money into different investment vehicles based on how soon you may need access to the money. Short term investment might be held in a money market savings account that you can use for handling big ticket items such as vacations, car repairs, and all the little things that happen in life. Medium terms might be CDs or low-risk stocks for things such as emergency medical needs, car replacement, moving expenses. Long term investments should probably be a diverse investment portfolio based on your age and position in life for things such as college tuition, early retirement, helping children buy their first house.

These cash reserves aren’t built up over night, it takes time to build up a healthy savings. Fortunately we typically have time to build up our reserves. For most people the unexpectedly events early in life tend to require far less cash than those which occur later. As a single person, living with their parents, the cost of loosing a job early in one’s career is minimal. Loosing a professional job at 40 with a family of four, a mortgage, and half a career behind you, can require far more money to manage. Starting early we typically have the time to build our reserves.

The key to building savings and investments is to do so consistently, over time. The best way to determine how much to put aside is to do a lifetime financial plan to determine what might be needed when. For an initial rule of thumb I’d like to suggest is a minimum of ten percent of your GROSS income (before withholdings and deductions) should be saved and invested.

I expect most people are a bit perplexed… Ten percent for retirements AND ten percent for savings? I’ll add another ten percent for tithing to your church — in addition to charitable giving. Ok, Ok…. sit down and stop screaming. Yes, I know that’s thirty percent of GROSS income and we haven’t even started paying all the bills yet. But there is a reason, a logic, AND A WAY.

First the reason and reason: I’ve mentioned before that building a solid financial future means caring more about the future than about the present. The easy answer is “no pain, no gain”… but it really isn’t that bad. What you are getting for a simpler, less expensive, lifestyle today is the greatly reduced pain and stress of financial chaos added to the major life crisis events that are ahead. I’m not talking about possible future event, you WILL experience a variety of crisis in your life. What I’m saying is that you can plan ahead and pay for them now while life is easy, or deal with the additional financial chaos while you’re also dealing with crisis even itself.

Now the way: Putting aside more than ten percent of your gross income is not nearly as difficult as it sounds when it is part of a solid financial plan. In our financial plan, or our rule-of-thumb, are the major purchases and expenses if your life. By saving a healthy amount we have essentially pre-paid for everything we’ll need, if not everything we want. We have virtually eliminated the need to incur consumer debt. No credit card debt — no credit card interest, no credit card monthly payments. Not only that but no car payments! No installment payments for the HDTV or jewelry. No carry over debt from our vacations. The lack of those payments makes plenty of room in most budgets to put the money aside in the first place when you start out with the plan at the beginning.

What happens when you don’t start off with the plan at the beginning? I admit that catching up isn’t going to be easy. The later you start the more difficult it is. Unfortunately there aren’t any rule of thumb to catch up as everyone’s situation is different. Each likely needs a unique plane. There are ways, but it takes a desire to change and may require a substantial shift in lifestyles and your approach to life. However, I can say that by starting to work on it today you will be reducing future pain and stress.

Posted by Paul Gernhardt on Monday, December 29, 2008