July 2019 Letter
Advice; for my 25-year-old self
How often do we look back at life’s experiences and think to ourselves, “I wish somebody would’ve told me that a long time ago.” Personal finance is a subject that many aren’t comfortable with or care to spend a lot of time thinking about. Yet, few decisions we make can have as long an impact on the quality of our lives as how we manage our finances. Whether you’re starting out on the road toward wealth accumulation, or you’ve reached the stage where wealth preservation is paramount, it’s critical to have a plan. In this letter, we talk about the start of the journey and discuss steps young people, in their wealth accumulation years, can take so they don’t find themselves falling behind financially later in life. By most financial health metrics, including those pictured below, Millennials find themselves behind the generation just ahead of them. So, we’ll look at optimizing both sides of the personal balance sheet. First, we’ll look at establishing sound savings practices (aided by the power of compounding) and utilizing tax-advantaged retirement accounts. Next, we’ll talk about establishing a sound credit profile, avoiding credit pitfalls, and managing student debt. Most of us have young adults in our lives, through family or friends, who could really benefit from knowing now what some of us wished we knew back then.
Personal Balance Sheet: Assets
Telling someone to save money is like telling them to exercise more; it sounds so obvious, but there’s always tomorrow. Adequate savings help satisfy two necessary objectives: establishing a rainy day fund to cushion life’s unexpected challenges and building assets toward a hoped for comfortable retirement. Surveys indicate that a majority of Americans today couldn’t handle a $1,000 emergency with cash on hand. The fallback, in most cases, would be expensive credit cards or other loans. So, how long would it take to build a $1,000 rainy day fund? Try skipping that $4 daily latte for a year and you’ll be there.
Young people have the most “tomorrows” ahead of them and seemingly can wait to start saving. After all, they do have more pressing needs, like starting families and buying homes. But, with the power of compounding, each “tomorrow” that a person lets pass without saving becomes more expensive later in life. On past occasions we’ve illustrated the mathematical power of building savings early in life, but with the message so strong it bears repeating from time to time. In the example we illustrate below, we take two 25-year olds starting out their careers, each earning $48,000 per year, and assume their pay increases 3% per year. Jessica decides to start saving right away, committing to saving 10% of her income. Luke has other priorities and decides to forgo saving at this stage of his life. After twelve years Jessica stops making monthly contributions and focuses on other needs. Meanwhile, at age 35 Luke realizes he’s ten years closer to retirement and commits 10% of his salary for each of the next 25 years.
Each invests in a portfolio producing an 8% average annual return. The graph illustrates how each strategy turned out. At age 36, Jessica had already accumulated over $90,000 when she decided to stop making monthly contributions and just let it grow. That head start allowed Jessica’s portfolio to reach the same level as Luke’s after 35 years, but with less than half the number of monthly contributions.
Admittedly, the example above is overly simplistic and doesn’t account for changes in savings rates, taxes, or inflation, but it’s main message is clear; establishing a saving/investing routine sooner in life is better than later. It should also be said that sticking with a saving/investing routine throughout your professional life is a must. If Jessica had maintained her monthly contribution rate of 10% over the entire 35 years, she would’ve accumulated nearly $1.2 million.
Importantly, saving for a house or a rainy day fund can be completely different from retirement saving. You’ll need to match investment time horizon with liquidity needs. If you want to buy a house in 3-5 years you’ll have to do the heavy lifting yourself (or lean on a generous friend or loved one). In that short of a time horizon you won’t get much help from the stock market, or your retirement accounts (can’t touch them without penalty for years). But if your objective is retirement, you’ll have an investment horizon of as much as 30-40 years, so a heavy allocation to stocks should do the job. Let’s take a closer outlook at the ways you can invest for retirement.
Individual Retirement Accounts (IRA)
Now that we’ve established the importance of saving and saving early, we want to describe how people starting out can take advantage of the tax deferred ways to invest for retirement. The two primary ways to invest for retirement using pretax earnings are through Individual Retirement Accounts (IRAs) and 401(k) plans offered by employers. IRAs are a good way to start but can be fairly limited, particularly if you are covered by an employer-sponsored plan. For 2019, the maximum IRA contribution for a single tax payer, not covered at work, is $6,000 ($500 per month). For savers covered by an employer plan, the allowable tax free contribution to an IRA begins to decline at certain income thresholds. IRA income taxes become due later in life when withdrawals can be made, at the beneficiary’s discretion, beginning without penalty at age 59½. Required minimum distributions (RMDs) begin after age 70½, although Congress has recently introduced the idea of raising the starting age of RMDs, stay tuned.
The second way to invest with tax deferred earnings is through a 401(k) and finding an employer with a generous plan is a sure way to turbo charge your savings. For starters, the annual contribution limit to a 401(k) is much higher than an IRA, $19,000 for 2019. Then there is the employer match. Many companies will match an employee’s contribution dollar for dollar up to a certain percentage, but you have to make a contribution to get a match. For example, if your employer offers a 5% match, you would want to contribute at least 5% of your pay to get that match. On a salary of $50,000 per year, that 5% match would be an extra $2,500 in annual tax deferred savings that an employee gets just for participating in the plan, that’s “found” money. Encouragingly, employer-sponsored plans have resonated with Millennials as numerous surveys have shown high participation rates for this age cohort, helped in no small part by the growth of automatic enrollment plans. Additionally, government employees can enjoy many of these same benefits through 403(b) and 457(b) plans.
Roth Retirement Accounts
An alternative to the traditional IRA and 401(k) is a Roth IRA and Roth 401(k). In a Roth account, contributions are made with after tax earnings. Generally, Roth contributions can be withdrawn anytime without tax or penalty, but taxes and penalties may apply if earnings are withdrawn before age 59 ½ or if the account is less than five years old. Because Roths generally provide tax-free distributions during retirement years, they are not subject to mandatory minimum distributions beginning at age 70 ½. Roth accounts may be a useful consideration for young people starting out with relatively low earnings and tax rates. Retirement withdrawals will then escape taxation at what could be a much higher rate later in life. Even if a young person’s salary exceeds the level that allows for direct Roth IRA funding, contributions are still possible via a “back door” approach that allows them to make non-deductible contributions to a Traditional IRA and immediately convert the funds to a Roth IRA without tax consequences.
Personal Balance Sheet: Liabilities
As important as building savings for emergencies and retirement is, establishing good credit and avoiding credit mistakes that can erode savings is equally as important. The example to the right shows just how costly poor credit can be. This is from the myfico.com website and shows the change in interest costs for a 5-year, $35,000, and a new car loan. Just dropping from the top credit rating to the second tier results in nearly $1,300 more in interest costs over the life of the loan. Imagine the added costs to a mortgage that could be ten times a car loan. So the obvious question then is, how do I establish and maintain good credit?
There are several, fairly simple steps people can take to establish a credit history. First, apply for a credit card on your own, starting with a low limit, be responsible in how much you charge, and pay off your balances on time, every month. If you have a hard time getting credit, try a secured credit card backed by an upfront cash deposit. While there isn’t any credit involved, this does help establish behavioral trends. Another option is using a co-signer for a loan or a credit card. New borrowers can establish behavioral patterns with the co-signer on the hook for the balance, if you don’t pay. Finally, there are some services that will report bills, such as rent, to credit bureaus. Experian, for example, offers a service that allows the company to track household bills, including cell phones and utilities.
After establishing a credit history, maintaining it becomes a top priority. First, you’ll want to monitor your history and under federal law, you are entitled to a free report every twelve months from each of the three national credit reporting companies (https://www.ftc.gov/faq/consumer-protection/get-my-free-credit-report). Beyond that, keep card balances at a minimum (preferably zero) and limit the number of credit accounts you apply for. Frequent use of credit applications and installment plans, such as cell phone contracts can negatively affect your credit score.
Finally, when it comes to paying off multiple credit card balances there are two schools of thought: pay off the smallest balance first or pay off the highest interest rate first. While either approach is ultimately a personal decision, it may surprise some that a Northwestern University study showed that those who pay off smaller balances first are more likely to eliminate their overall debt, despite possibly paying higher interest costs.
The elephant in the room for young people today is education debt. If you’re not one of the 43 million Americans with student debt (averaging $33,000) then you’re already ahead of the game. But if you are one of those with outstanding student loans, you need to give special consideration to how you manage this debt so as to not inhibit you from accomplishing other life goals. One thing to consider may be consolidating multiple student loans into one account. Aside from streamlining the monthly chore of bill paying, it may be possible to lower your interest rate. There are two ways to go about a loan consolidation; with the Federal government or a private provider.
Most student loans outstanding were provided by the Federal government and the government offers a consolidation program for those loans only, not private loans. The most important thing to remember with a Federal Direct Consolidation Loan (FDCL) is that it won’t lower your interest rate, you’ll need to use a private consolidator for that. However, there is one exception to this. If your loans predate 2006 and have a variable rate, you can consolidate and lock into today’s low rates. To lower your interest rate through consolidation, you’ll need to consider a private lender, such as a major bank, but to achieve any real savings, you’ll need an excellent credit score and/or a co-signer.
It’s important to start taking your long-term financial health seriously, especially early in life. Having a sound personal balance sheet is a key foundational element to financial security. Yes, saving can be hard when just starting out, especially with student debt, but embedding a regular savings plan into your monthly household budget, as if it were a bill, will reap big rewards in the long term. Establishing and maintaining good credit can also be a challenge, particularly as life becomes more complicated. But, there are also advantages to being young. Early participation in tax advantaged retirement accounts (even at minimal levels) can compound and grow for decades, ensuring more retirement security. Establishing a clean credit history can lead to thousands of dollars in saved interest cost over the course of your lifetime. The financial habits developed early in life will go a long way in determining your future financial security. Don’t be this guy!