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Investing

Financial Freedom: Building the bankroll, part 2

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We’ve seen that a key part to underwriting Bumhood is living below your means and using the resulting extra cash from income to build savings.

The corollary to this important principle is that your money needs to work for you. That means it has to earn money instead of you having to go to work to earn a paycheck.

How to make this happen? Invest. Your strategy should not be excessively conservative, because truly safe, FDIC-insured instruments such as high-interest savings accounts and CDs don’t return enough to keep up with inflation. Although clearly some cash should reside in your bank or credit union, where it will be insulated from a major market crash such as the one we recently saw, to grow your money you have to take some risk. This means investing something in the stock market or (yes!) in real estate.

Investment plans that work to support bumhood are long-haul arrangements.* Savings should be invested for the long term in reasonably stable instruments such as fairly staid mutual funds and left there, even when the market slides. Low-overhead mutual funds are an excellent choice, because the various costs involved in maintaining them do not bite significantly into your gains. Vanguard and Fidelity funds lead the pack here.

Some mutual funds buy stocks; others buy bonds; still others are balanced funds with a variety of investments. Read the prospectus for each fund that interests you, and be sure your choices don’t duplicate each other. Most advisers suggest that equities investments be allocated about 60 percent to stocks and about 40 percent to bonds, because as a general rule when stock values fall bond values rise. (This is a huge oversimplification, as I’m sure we’ll hear from readers. Study up on investment products. Several “For Dummies” books on the subject have good to excellent reviews, and regular reading of the Wall Street Journal and the New York Times business section can be instructive.)

Stocks and bonds are not the only places to grow savings. Some people have done well investing in rental real estate. This also is a long-term hold: expect to keep the property for 10 to 20 years before it turns a profit. As we’ve seen, for investors real estate presents no less risk than the stock market, and so you  need to be prepared to watch values go up and down. A quick perusal of Amazon’s offerings on real estate investment will clue you to the amount of snake oil out there: be extremely careful, and do not operate without a trusted adviser who can prove his (or her) expertise. As with the stock market, it’s important to do your homework and know what you’re doing before investing. If real estate interests you but the prospect of dealing with renters does not, consider a real estate investment trust (REIT) or an REIT mutual fund. Sometimes limited partnerships invest in commercial real estate, although this tool is probably not for everyone.

Because money sitting in the bank does nothing for you—it just sits there—it’s crucial to put your savings to work by investing in a diversified set of financial instruments, ranging from the relatively safe (CDs, the money market) to relatively risky. The degree of risk depends on your age (i.e., how many years you have left to make up any losses) and your personality. To make money work for you, you’ll need to take some risk with some part of your savings. But as you draw closer to your projected escape from the day job, it makes sense to pull back from riskier investments and shift funds to more conservative tools.

One way or another, at any age your savings should be working for you, and some part of it should be in stocks or instruments that earn similar returns. Over the years, my savings have returned about 8 to 9 percent, on average. Of course, that faltered when the Bush economy crashed. While the artificially pumped-up economy was hot, some months I would earn $8,000 on a $250,000 investment. Although all that went away when the market collapsed, returns are now back up in the 8 percent range.

Thus if I draw down the widely recommended 4 percent—more than I need to live on, as a matter of fact—savings will continue to grow even without my adding any  new cash.

And voilà! Full-blown financial freedom: Return on passive investments that meets or exceeds the amount you need to support yourself. The less you spend on your lifestyle, the more you can save, the more you can invest, and the sooner you can get off the day-job treadmill. Living below your means, faithful, regular saving, and wise investments can spring you free sooner than you think.

The Financial Freedom Series

• An Overview
• Education
• Work
• Debt
• The Health Insurance Hurdle
• Own Your Roof
• Bankrolling Bumhood, Part 1

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* I am not an investment adviser! I am just a writer sitting in front of a computer. No part of this information should be taken as investment advice. For advice on financial planning, consult a tax professional and a certified financial planner. Always read all prospectuses and related information before investing in any stock, bond, or mutual fund.

Return-of-Premium Insurance: Is it a good idea?

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Over at Bargaineering, Jim recently discussed an relatively new insurance instrument called “Return of Premium Insurance.” This is a type of term life policy whose issuers promise to return your money after the policy expires.

In term insurance, you pay a specific monthly or annual premium so that the company will pay a benefit to your survivors should you die an untimely death. Unlike whole life insurance, which builds something like equity at a very low return, term does not pretend to be any sort of “investment.” It exists simply to protect a spouse or children from the loss of your income. A policy normally has a beginning and an end (typically ten to thirty years), after which it expires and, if you still need coverage, you have to buy a new one.

Return of premium (ROP) insurance offers to return your premiums after the policy expires. In other words, if you paid a total of, say, $15,000 over the term of the policy, at the end of the term you get the 15 grand back. Thus you appear to be getting something for nothing: the insurance coverage works like any term policy, but the amount you pay for it is returned to you if you outlive the policy.

This, we’re told, amounts to a kind of “investment,” and oh, joy, the money you get after 30 years is tax-free! (It’s really not income: it’s a refund.) This strategy supposedly has the advantage, in addition to providing “free” insurance coverage, of forcing you to save over a long period.

Let’s think about that.

ROP insurance costs significantly more than ordinary term insurance, and the costs are going up in 2010 because regulatory agencies now require companies to return a significant portion of your premiums should you cancel the policy before the end of the term. These policies can cost as much as 50% more than a plain term policy. If you can afford to pay that much for life insurance premiums, it stands to reason that you can afford to pay the cheaper amount for the same coverage with a term policy and put the difference away in a mutual fund.

A few insurance premium calculators that don’t make you a target for insurance salesmen reside on the Web. According to this one, an ordinary 30-year term policy for a 30-year-old man ranges from about $620 to $825 a year. A middling premium for term insurance, then, would be about $720. A similar calculator for ROP shows him paying $2,270.50 a year for a 30-year ROP policy.

The difference between $2,271 and $720 is $1,551 a year, or $129.25 a month.

At the end of his 30-year policy, our ROP buyer, who by then is 60 years old and contemplating retirement, gets $68,130 back. At that time, an average 4 percent inflation rate  has reduced the buying power of this amount to $21,005.75, in 2010 dollars.

What happens if our consumer buys the old-fashioned, plain-vanilla term policy and stashes the extra $129 a month in savings?

Let’s say he starts with nothing but invests the $129, faithfully, month after month, in a mutual fund returning a fairly typical 6 percent. In 30 years his fund is worth $129,582.44. The corrosive effect of inflation erodes the purchasing power of this amount, over 30 years, to $39,952.69. But even this pallid value is almost twice as much as he would have had were his premiums simply refunded to him.

Meanwhile, however, the insurance company is not hiding our consumer’s premiums under a mattress. It also is investing the money, but instead of a mere $129, the company has his entire ROP premium to invest: $189.25 a month. In 30 years at 6 percent, the policy earns $190,104.47 for the insurance company. After the company returns $68,130 to the customer, it sees a profit of $121,975.

That’s assuming the company stays in business for 30 years. We’ve seen what “too big to fail” means…who would have thought, just five years ago, that major banks would go down in the dust? An insurance company is just another financial institution, no more nor less vulnerable to the vagaries of future recessions than any other corporation. If the company folds before the 30-year policy expires, our consumer could very well lose all of his “investment,” since a bankrupt company is unlikely to honor a contract to return money it doesn’t have.

Pretty clearly ROP life insurance is a great idea…for the insurance companies!

😀

Assets reviving

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Well, even though unemployment doesn’t seem to get any better, the economy is said to be recovering. And as a matter of fact, my savings are starting to come back. Last March, investments hit a low point of $420,565, having lost just under $160,000 in ten months. This month, the balance is at $480,753, a $60,188 gain in 8½ months. Not bad, considering that after we were told our office would be closed and our entire staff canned, I used $25,000 of my savings to pay off the second mortgage on my house and that I pay my $800 share of the mortgage on the downtown house with proceeds from those investments.

My financial advisers hope I can refrain from drawing down anything, including the mortgage payments, during 2010. I’m cashing in part of a whole life policy to cover that bill—it will pay the entire year’s worth. They think that if I can leave the money alone for a year, it will recover its former glory. With a $60,000 increase in less than a year, that almost sounds believable.

I’d be happy if it would come back up to $500,000—just another 20 grand—and stay there. A four percent drawdown from that, plus Social Security plus part-time teaching, would yield a net income just slightly less than GDU pays me. And that would cover the bills reasonably well, even though Medicare will drive my monthly costs significantly higher in retirement.

If I’d left the $25,000 in savings instead of using it to pay off the loan, of course, the total would be back at $500,000. But consider: the loan cost $169 a month. Four percent of $25,000 prorated monthly is less than half of that. And if anything happened so that I couldn’t make those payments, I could have lost my home. Now it’s very unlikely that anybody is going to take my house away from me. Not even if the market crashes so spectacularly that I lose every penny.

Let us watch and wait.

Image: ScooterSES, Tokens from the U.S. Deluxe Edition Monopoly.
Public Domain. Wikipedia Commons

How does your (financial) garden grow?

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Over at A Gai Shan Life, Revanche has been contemplating the degree to which her investments have recovered from the late, great economic crash. In comparison to the pickle we were in just a few months ago, even “not great” returns look good!

Coincidentally, just a few days ago I happened to take a look at my own funds’ performance over the past year or so…the first time I’ve had the heart to do so in a long time.

My big IRA, which is professionally managed, has been doing a lot better the past couple of months. Between mid-September and mid-October, it increased by a healthy $4,288. The taxable Vanguard funds increased $1,623 over the same period.

The high point reached by all my scattered investment holdings (not counting real estate) occurred in April of 2008. As of about three days ago, the value of all my non-realty investments had dropped by $110,470 off that high. However, I used about $20,000 to pay off a small second mortgage on my home, and so the real difference in value is about –$90,470.

The low point occurred in March 2009. The most recent figures show a gain of about $49,145 from the low point. Again, we need to remember that I made that $20,000 withdrawal in May 2009, and that some of the gain consisted of contributions to the 403(b).

The total package of investments, then, has a ways to go before my illusory riches come back. I certainly don’t expect to regain the remaining $90,470 of the retirement savings that evaporated in the economic meltdown anytime during 2010, even if I succeed in leaving the funds untouched. Really, I’m pleased just to recover that $49,000.

What a ride we’ve had, eh? How are your investments doing? Are you seeing any sign of life yet?

How much was that dollar worth? Interesting money tool

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In a history article for a client journal, one of our authors mentioned Measuring Worth, a nifty tool that allows you to compare a variety of money-related values over periods stretching back to 1774.  Among other things, it will calculate the relative worth of the dollar. Enter a specific sum and a year, and then ask what it would have been worth in a later  year. The engine disgorges the equivalent according to six different indicators: the consumer price index (CPI), the gross domestic product (GDP) deflator, the consumer bundle, the unskilled wage rate, the GDP per capita, and the GDP.

The first two are ways of measuring average prices. The third (consumer bundle) shows the average value of a household’s annual expenditures; the unskilled wage rate provides a way to compare wages over time. The GDP per capita is another way to compare income over time, and the GDP itself, the market value of all goods a country produces in a year, shows “how much money in the comparable year would be the same percent of all output.”

More on this feature in a minute.

First, though, let’s look at a feature of special interest to personal finance enthusiasts: Measuring Worth also has a tool that shows how much savings would have grown over time. Enter a value and a date, and then ask how much that value would be worth at another date (up to this year), and it will tell you the return on a short-term investment, a long-term investment, and a stock market investment.

So…let’s say your child is 19 years old now, and you’d like to send her to college. When she was born, in 1990, your parents gave you $1,000 to invest toward her education. If you’d put the money in an excruciatingly safe short-term asset, today it would be worth $2,060. Invested in a long-term asset with a term of 20 years, it would have yielded $4,973. And had you put it in a Dow Jones Average portfolio, you would have $4,196, a middling performance.

Well, what if your own parents gave you $1,000—say, when you were born—and now you’re about to retire? If you were 65 today, the gift would have come in 1944 (and it would have been a lot of moola in those days!). Assuming you kept that investment separate and didn’t add more cash other than reinvesting proceeds, how far would it go today toward supporting you in your old age?

• Short-term investment: $16,457.53
• Long-term investment, 30-year term: $32,816.67
• DJA portfolio: $78,449.64

Whoa! Over a really long term, the stock market beats the other two investment modes, hands-down.

I wonder how our college girl would’ve been doing before the Bushies screwed up the economy. How much would her stock portfolio have been worth a couple of years ago, when she was 17?

Ah hah! $4,918. In the stock market, her savings would have fallen off $722 over the the year between 2007 and 2008. In a long-term investment instrument, it would’ve been worth $4,549 in 2007, $424 less than the most recent value. It appears that given competent national leadership that recognized the importance of regulating financial markets and was capable of an intelligent response to 9/11, she might have been better off in stocks and bonds.

Entertaining, isn’t it?

Now for the money story:

At the time my father was born, in 1909, his mother had about $100,000. She’d inherited this small fortune from her father, who had made it freighting buffalo hides out of Oklahoma into Texas. Also at about the time my father arrived, her husband ran off. He eventually was found dead by the side of a rural Texas highway. This left her alone with an infant, a change-of-life baby. My father had two elder brothers, the youngest of whom was 18 years older than he was. By the time he was born, both men were out of the house with families of their own.

She became involved with a Christian church on the fringes of mainline Protestantism, and she also became interested in spiritualism. She donated copious amounts to both causes. By the time my father was about ten years old, these worthies had sheared her of every penny that she had. She was left destitute.

Her home was taken away for taxes. She also lost a commercial property and another house she owned. The two older brothers, who knew nothing of this until they returned home and found her on the street, fell out over the fiasco. Tom, the eldest, was a ranch foreman who, of course, lived out in the sticks. He felt his middle brother, Ed, who lived in Fort Worth where their mother lived, should have been keeping an eye on her finances. The brothers were permanently alienated as a result of the bad feelings that arose in the wake of their mother’s impoverishment.

My father also was permanently affected. He developed a lifelong hatred of organized religion (his skepticism—shall we say—is the reason that to this day I will not donate to a church), and he also conceived a passion about money. He decided that, as his life’s goal, he would earn back the hundred thousand dollars.

And he did.

You understand, he was not a sophisticated man. He dropped out of high school in his junior year, lied about his age, and joined the Navy. He went to sea all his adult life, ultimately became a master mariner, and retired at the age of 53, when he achieved his goal of accruing $100,000 in savings. Details like the relative value of money were largely beyond his ken. Though he understood that a hundred grand didn’t make him a wealthy man in 1962, he had no way of anticipating the double-digit inflation of the 1970s. By the time that was over, the nest egg that would have kept him comfortable wasn’t worth enough to support him through his old age in a fashion other than basic poverty.

Luckily, he was a very frugal man by nature, and so it didn’t much matter: his lifestyle wouldn’t have changed, one way or the other.

I have always wondered what that $100,000 of 1909 would be worth in today’s dollars. Let’s enter it and the date of my father’s birth into the Measuring Worth relative value calculator. Current data, we’re told, are available only up to 2008. According to the various measures, today the dollar value of her inheritance would be…

• CPI: $2,441,007.10
• GDP Deflator: $1,777,507.10
• Value of consumer bundle: $5,009,823.18
• Unskilled wage: $10,307,228.92
• Nominal GDP per capita: $13,314,632.87
• Relative share of GDP: $44,808,290.00

In terms of purchasing power, my grandmother’s hundred grand would have been worth $2,441,077.10 in 2008. LOL! Think of the McMansion I could’ve bought with that as a down payment!

What if she had put her inheritance in the stock market, instead of diddling it away on her religious delusions? Invested in a nice, balanced portfolio, by the end of 2008 it would have been worth $16,595,085.85.

Well. Any way you look at it, if she been a little smarter about money and a little less inclined to woo-woo, today I wouldn’t be worrying about how I’m going to get by in retirement!

My father hugely underestimated the amount he would need to live comfortably into his mid-80s. Of course, without his mother’s crystal ball he couldn’t have anticipated the inflation that ate up his savings…but I think, given the way the government is spending money in the wake of the crash of the Bush economy, we can expect a similar inflationary period in the near future.

How much would I need in savings to have the equivalent of the $100,000 he had managed to earn back by 1962?

• CPI:  $711,510.24
• GDP Deflator: $569,106.07
• Value of consumer bundle: $879,310.34
• Unskilled wage: $809,366.13
• Nominal GDP per capita: $1,510,749.04
• Relative share of GDP: $2,465,665.02
• Purchasing power: $711,510.24

Hm. If the least of these—$569,106.07—is what I’ll need to survive in moderate comfort (or not!), then I’m in deep trouble. Eighteen months ago, my savings were close to that. But today they sure aren’t, thank you very much, George and friends!

Welp, too late now. There’s not a thing I can do about it, so there’s no point in fretting. Tra la!

Slow Money: Countercultural thinker may have something…or not

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I stumbled across Woody Tasch on NPR yesterday afternoon, when NPR’s All Things Considered ran a segment on his “slow money” concept, as it applies to a small organic dairy farm in upstate New York. It’s basically a variant onpeer-to-peer lending, or disintermediation, which cuts out the lending institutions with which we are presently feeling disgruntled.

The idea has a certain postmodern (or Depression-era?) charm. Like small-town bankers, we will all lend money to our friends and townspeople, here in the global village. Tasch’s take on it, however, is intriguing: that the speed with which financial transactions fly around the planet is a weakness in the global economy, because there are “structural limits to the power of industrial finance.”Speaking in favor of a simplified market, Tasch observes that “most recently, the subprime mortgage collapse signals the limits of ever accelerating, ever more complex, derivative-driven financial markets.”

He argues that the make-big-money-fast model, organized from “‘markets down’ rather than from the ‘ground up,'” works in favor of environmental degradation and, where food is concerned, brings us chemical-laden food, obesity, and hunger. Tasch focuses on socially responsible food production, suggesting that capital should be steered toward small, local, environmentally friendly farms and businesses.

It would be good to see organized support of farms that produce high-quality food all over the country. Wouldn’t it be awesome to have access to this kind of dairy product at a nearby market? Assuming, however, it came at a price one could afford…

Possibly if more financial support materializes for operations that produce organic foods, milk from grass-fed cows will become available at something less than $20 a gallon.
😉