A while back I blogged about the book, The Secret Currency of Love.  Now I am reading Financial Infidelity by Bonnie Eaker Weil.  There was an article on CNNMoney some time ago about the financial crimes committed in relationships and this book was referenced.  The contributors to The Secret Currency of Love, many of them high income earners,  were ashamed to admit that they wanted to be taken care of financially.  Dr. Weil reveals that at least a third of women desire to be taken care of financially regardless of their level of income.  This concerns me.  To be out of control and blissfully ignorant financially is to be a slave.  And I am of the belief that their are no benign slave masters even if that master is your domestic partner.  There is also a startling statistic:  either through divorce or death of a partner a woman will, at some point in her life, find that she has become head of household.  AARP data indicates that 48% of women over 75 will live alone.

Over the years I have worked with women whose spouses suddenly died or filed for divorce.  One of my friends told me of the humiliation that she felt when she realized that as as a result of her divorce, she was getting stuck with half of her husband’s credit card debts most of which were incurred while he entertained his mistress.  One of my colleagues experienced the sudden death of her husband only to find her grief turned to outrage and fear when she discovered that he had allowed his life insurance policy to lapse and he had amassed credit card debt that she knew nothing about.  She told me that for several months after her husband’s death opening the mail and packing his things revealed debt and expenses that she was simply unaware of.  She said that being at home was like waiting for bombs to go off as she discovered more and more about how her husband really ran their household.  I’ve worked with nurses who have had to endure personal bankruptcy because there were no marital assets to divide in divorce and the debt outstripped their income.  The converse is also true.  Women who are financially “in-the-know” can choose to leave unsavory relationships because they have the means to do so. A financially savvy nurse recently told me that she was happy she had the financial resources to leave her husband of 20 years after she learned that he was having an affair and refused to end it. As Carla Fried writes in her CBS MoneyWatch post:  “If women don’t see the value in being an active decision-maker in their financial security, then they bear plenty of responsibility for any future financial disadvantage.”  And therein lies the rub.  There is risk, not bliss, in ignorance.

Dr. Weil articulates that money is a stand in for many issues in relationships.  Issues that often began in childhood and were nurtured into adulthood.  She asserts that 33% of women will be be secretive in the area of money and, therefore, damage their relationship with their partner while 26% of men will.  A partner’s unwillingness to be open in the arena of money is a sure sign that the couple needs to go for counseling because deception or lack of openness in one area is a sign of deception in others.

I have simply seen too many women who refused to participate in their household finances find themselves left with relatively little after even decades of marriage failing to understand that the situations in which they were living were on some level simply unsustainable. Some of the wealthiest men I have come to know over the years have credited their wives with their success.  These men are business owners  with 30 to 50 years of marriage and I have found two traits they have come to value in their wives:  active involvement in the running of the family business(es) and frugality.

What can women do?  The road to becoming actively involved in family finances may be a rocky one and may require the aid of a counselor to navigate well.  These are strategies that I have found in the world of personal finance that women can use to become more actively involved:  1) review trusts and wills, regularly making adjustments as children age. 2) regularly review insurance especially life insurance.  Are the coverage amounts sufficient to replace at least 3-5 years of lost income?               3) review credit reports at least yearly. 4) review all bank accounts and the reasons for those accounts. 5) develop a household spending plan and stick to it.  6) regularly review retirement accounts.  7) know where all important documents are being kept.

These few strategies can help women remain in touch with their household’s relative wealth so that they can make responsible financial decisions regardless of their stage of life.

What are your thoughts? Please comment.

I don’t know why this happens but every tax season there are disturbing articles about how much one group of people pays versus how little another group of people pays.  This year did not disappoint.  Yahoo finance published the article, “Nearly half of US households escape fed income tax.”  What I learned when reading the article was that a family of 4 making $50,000 may pay no taxes and that tax credits intended to zero out taxes for low income families are actually refundable.  This is an extreme example but if you are low income and qualify for a $2000 tax credit and have $1000 in tax liability you will get $1000 back in federal income tax.

All this wouldn’t matter except living in America is not free and everyone drives on the roads, attends the schools benefits from the public services.  It is not reasonable that one segment of society should pay all while another segment pays nothing.

I do believe we should have an alternative minimum tax. A tax that is imposed on low income households if income tax burdens are zeroed out through tax credits.  The minimum tax could be say 1% of income.  For a person making $30,000 that would amount to $300 dollars but for a country in which half its residents pay no taxes that 1% would amount to tens of billions of dollars.

The fact is that our society is is free society but it is not a FREE society.  Living here comes with rights and responsibilities and just as in any civilized society costs money.

In order to claw ourselves out of the current mess taxes are going to have to rise for all.  I finally finished reading the Big Short.  The whole world, literally, went crazy.  Wall Street bankers simply tapped into the increasingly prevalent desire in our country to buy now and pay later, if at all.  Something for nothing, a home for a song.  Am I excusing the bankers?  Uh-uh.   I have some choice words for the bankers, but without us, they would not have been able to do what they did.

An article in the Times spelled it out.  We want to be mad at Wall Street otherwise we’d have to be mad at ourselves, our sisters our brothers, our parents and grand parents for buying homes and taking out loans they could in no way afford to repay.  A home isn’t free, society is not free and everyone must pay.

We are all in the same boat and living in a civil society requires sacrifice that is why everyone must pay.

Please comment.

I am working on a post, “Why Medicare Sucks.”  I am having difficulty writing it.  Not because Medicare is perfect.  It isn’t.  But because so many users of Medicare believe it is a great program.  Great insurance.  It isn’t.  I have written about the perils of the stock market and home ownership as wealth-creation vehicles.  Both are lousy wealth-creation vehicles, but most of the people who were told to invest in the markets for retirement or that a home was an investment have learned the bitter truth.  The same with Medicare.  As I put the post together, I will take you from my cousin’s practice in Atlanta, to a conversation that I and 2 other doctors had almost a decade ago on the beach in Santa Monica, to a conversation I had with a retired doc who told me that the happiest day in his practice was the day he closed his doors to both Medicare and Medicaid.  The post is coming.  Watch out for it.

Now for a rather abrupt change of topic.  Something rather interesting happened the other day that I just have to share.  As I mentioned before, when I was getting my financial life together, I read beaucoup books on personal finance.  Still do.  But I came across some advice from Suze that I should manage my property tax and insurance payments myself.  At the time I was paying a certain amount each month to my mortgage company so that they could escrow the funds for me and make the property tax and insurance payments on my behalf.  Millions of American homeowners do this:  pay additional money to the bank each month that the bank then sets aside, so I was not special in this regard.  You can understand why the bank might want to do this.  When a bank loans money for a home, they actually own the home and they just let the mortgagee live in it.  The insurance is there to protect the bank’s collateral, the home.  Property taxes actually trump a mortgage.  A home owner or mortgagee can fall so far behind in property tax payments that a county can order a home sold for the unpaid taxes leaving the mortgage company stuck with a loss on the mortgage.  It is in the mortgage company’s best interest to collect the property tax payments from the mortgagee and pay the taxes.

The reason I don’t escrow is simple I want to control my cashflow and banks are allowed to keep a cushion in the account as stipulated by the mortgage contract.  As an example, that cushion may be equal to 90 days of property taxes and 60 days of insurance premiums.  The bank is not required to pay interest on that cushion.  So for a home with a $720 dollar insurance premium and a $2400 dollar tax bill the monthly escrow amount would be $720+$120+$2400+$600 = $3840/12 = $380.  The balance in the escrow account must never drop below 60 days of insurance premiums plus 90 days of property taxes or, in this case, $720 dollars.  If it does, the mortgage company will increase the mortgagee’s payments to escrow to make sure they can make the property tax and insurance disbursements and maintain their target cushion.  If you are a home owner, you know that that cushion represents a new washer, dryer, water heater and it is just silly having that money literally locked in a bank just to make the bank feel better about lending you the money in the first place.

But what happens if the bank doesn’t actually do with the money what they were supposed to.  What if they don’t make the payments or make them on the right property. This is a rare occurrence, but something that happened yesterday put me right in the middle of such an event.  I made property tax payments on the properties that I hold before I went on vacation.  When I returned, I ran the checks to make sure they had cleared.  Two of the properties I hold are right next door to each other.  I placed the property tax checks for those properties with coupons in the same envelope and sent it in.  When I ran the checks I realized that the county treasurer had only cashed one of the two checks I placed in the envelope.  When I called the county treasurer they told me that they had received so many property tax checks they were behind in data entry, the fact that they hadn’t cashed my check didn’t mean they had lost the check and asked me to check back with them in a week.  They ran the account for the property and pronounced that the tax account had a surplus on it and that Chase Financial had been making payments as well as lil’ole me.  That’s all well and good except that Chase wasn’t the lien holder on the property.  B of A was.  In other words Chase was mistakenly making tax payments on a property they had NO financial interest in.  How could this happen?  I asked and a mistake of this type can happen pretty easily.  See a financial institution like Chase sends over a portfolio of parcel numbers to county tax assessors across the country.  These parcel numbers are data entered in to a company like Chase’s system a simple key error could produce an incorrect parcel number. The parcel numbers are not sent with a corresponding property address which would allow crosschecking to occur at the county tax assessor’s office.  The tax assessor sends the bill to Chase or any other requesting financial institution and the institution pays the bill. No questions asked.

By this point I had the supervisory treasurer on the phone and she gave me the contact for Chase Financial.  Her contact information was not valid and it took me several tries to get a live body on the phone which, at least for Chase, is virtually impossible if you don’t have a Chase account.  The rather stunned Chase property tax representative said, “Now, let me get this straight.  Chase is making property tax payments on a property we have no financial interest in?”  When I told her yes, she made a move to get off the phone to confer with her supervisor.  The problem with conferring with her supervisor was that she had no information, she was so flabbergasted that all she could do was think to confer with her supervisor.  I pointed out that she had no way of researching the property without a parcel number and situs address.  I provided both.  Now the information I provided was the correct information for MY property (okay the one I co-own with B of A), but the parcel number should allow Chase to back track and find an associated loan number and correct property address.  I also gave the Chase representative the name of the supervisor in the county treasurer’s office so that they could request their money back.

Why did I even bother to phone Chase?  I wasn’t worried about myself because I don’t have Chase’s money, the county treasurer’s office does. I phoned because somewhere out there a home owner or investor is paying into escrow believing that their lender is correctly making payments on their behalf.  At this point that home owner or investor is now one year behind in their property taxes and it is not their fault.

This odd situation is a reminder to me that the homeowner or investor is ultimately responsible for all expenses on their property even if they escrow and it behooves the homeowner or investor to follow up with their property tax office and insurance company to make sure those payments are made.  If your accounts are delinquent and you escrow, be sure to obtain documentation of your delinquency from the tax office then contact your lender’s property tax division.  Make sure they have the correct address and parcel number for your property.  If they don’t correcting the information will require you to provide that information to your lender in writing.

Please comment.

You start a new job with benefits.  One of those benefits is a 401K complete with a generous company match.  You feel lucky, your new employer is interested in your future, interested in helping you build a secure retirement.  But what if he isn’t?  What if you 401K is just a way for your employer to cut expenses?  Earlier this week, I ran across the CNN Money article: “Reality sinks in for 401K investors and providers” the article was pretty sobering.  That people are finding that they will have to work longer than planned because of the market turmoil of the past decade is really no surprise.  What I found surprising is the way employers view 401Ks, the coveted benefit that they offer employees.  The CNN Money article quotes a study by Wells Fargo that looks at employer attitudes toward the 401K.  The study found that:

1)Employers view retirement plans as a benefit rather than as the main way that employees will support themselves in retirement.  Half of employers say that they offer competitive benefits to attract and retain employees.

2)Fewer than 1/3 of employers believe that employees participate in 401K plans in order to have a comfortable retirement. Many employers believe employees are only after the match.

3) Only 1/3 of employers stated that their 2010 goal was to educate plan participants about retirement needs and  how much to save.

4) Only 20% of employers said that providing employees with the ability to retire was the greatest challenge their plan faced.

5) Only 10% said that they measured plan results against expected employee retirement needs.

In other words employers feel no obligation to assist employees in reaching retirement goals other than offering the 401K savings plan.  Most plan providers do not provide financial literacy education or education about the implications of investing in the markets.  When the markets were exploding during the heady 1990’s it seems that everyone became an investor, there was a millionaire born every minute, stock prices were destined to always rise and no one had to ask the important question: will the 401K really help people create the funds for a healthy retirement.

Some friends of mine would say that it was never or should never have been an employer’s responsibility to provide for an employee’s retirement.  I am not sure I find the philosophical point relevant.  Employee benefits are expensive and any employer will have to do something about those expenses if they hope to compete globally but the shift from defined benefit to defined contribution plans as the primary mode of retirement planning occurred gradually and quietly.  Looking at where the DOW was in the 1980s before the proliferation of plans to where the DOW ended as 401K plans took hold, one cannot help but conclude that the proliferation of 401K plans created the market explosion of the 1990s by flooding the markets with new money, much the same way that creative financing and the securitization of those loans fueled the housing bubble. In short, the 401K plan fueled the very market boom that retirees were supposed to take advantage of.  This is what we are left with:  defined contribution plans are the primary vehicle of retirement planning, but the employer who provides the plan has no vested interest in making sure employees actually reach their retirement goals.  This is America, we fundamentally believe in freedom of choice including the right of individuals to make unsound financial choices therefore it is unlikely that we will ever mandate financial literacy and education.  I believe that the most that the American public can do is realize that Social Security is in trouble, that the 401K, maxing it out and getting a generous company match will not guaranty a comfortable retirement and that financial literacy is critical to building a sound retirement. Financial literacy is more than reading the jargon of the day, it means studying financial history, bubbles and true long term returns.  Going forward a comfortable retirement will likely be due to a combination of Social Security, the 401K, savings outside of a defined plan, and entrepreneurial activity designed to generate reliable cashflow.  One thing’s for sure the employee has never been more on his or her own to create a comfortable retirement.

Please comment.

It was the heady 1990’s and you really could not swing a dead cat without hitting a new personal finance book.  Just about all of them extolling the virtues of mutual funds and the stock market as the way to get wealthy.  The Robert Kiyosaki/Suze Orman smack down came down to just that: the viability of the stock market, mutual funds and 401Ks as retirement savings vehicles.

I was looking at a ranking of the world’s wealthiest people Warren Buffet is on that list, of course, but he has the distinction of being the only one who created his wealth as an investor and even Mr. Buffet doesn’t invest the way the average Joe is taught to invest.  Mr. Buffet doesn’t own mutual funds.  His company Berkshire Hathaway buys other companies like Wells Fargo, Sees Candies, the Pampered Chef, Geico and runs them.

Berkshire Hathaway has been around for decades.  Those who bought in the 1960s and held were the ones who created the  bulk of the wealth.  The truth is that the investment time horizon for the stock market is 30 years. In my post the Great 401K experiment, I quote author and financial strategist Charles Farrell who points out 68% of the wealth generated by market investors is generated in the years 21-30 of the investment.

One of the most interesting books I came across in the mid 2000’s was the Wealthy Barber.  Here was a small businessman, a barber, who mentored three young people about how to create wealth and wouldn’t you know it, his main vehicle was mutual funds.  He was a lover of term insurance and eschewed whole life.  Given the true historical returns of the market that I discovered while writing the Great 401K experiment, I am forced to conclude that that barber was a vampire pure and simple.

Before I go further I want to point out that mutual funds and 401Ks are not the same thing.  A mutual fund is a fund that invests in classes of assets from commodities to bonds to stocks to real estate.  You can go short. You can go long.  Yah, Yah, Yah.  The point is that you don’t have to have a 401K to invest in mutual funds.  A 401K is a tax-advantaged savings vehicle and it is a very common way that people invest in mutual funds.  I only care about 401Ks and mutual funds in so far as people use them to invest in the stock market.

Now back to vampires.  I truly believe that barber was a vampire.  From Twilight, to TV’s Moonlight, from Dracula, to TrueBlood all of our vampire subjects have become wealthy through the passage of time.  Time that exceeds the normal human life span.  Heck I just finished a cheesy vampire novel that has one of our vamp friends starting out poor in a one-room flat and, poof!, three hundred years later he is wealthy in a resplendent home.

All of this actually points out one true thing:  that wealth is actually created by taking right actions over time.  It is the American Dream that each generation will succeed and exceed the prior one.  We understand that wealth creation may take a generation or two or three.  There is simply no denying the impact of time on wealth creation and therein lies the rub.  In a pension-less society will parents become so focused on saving more, earlier in order to plan for retirement or will they simply accept a significantly lower standard of living in retirement while putting away for college and weddings for their children during their working years?

It is easier to spend money in the present when you know you have a pension in the future.  What about when you are dealing with an entity the long term behavior of which is unknown, like your 401K?  In some ways these are deep questions.  Those who begin saving early may have time to recover from the vagaries of the markets.  Those who begin saving late feel forced into the markets chasing returns in an effort to make up for the time they were not investing.  Something is afoot as more and more articles appear in the mainstream press about the shortcomings of the 401K and the perils of people being expected to provide for their own retirement.  Saving 10% with a company match will not be enough.  Perhaps we will conclude that saving 30-50% of our incomes will be.  Since most of us are human with but one life to live, I suspect that that will be the conclusion, a real bother since 70% of American households make $65,000 or less.

Ah, where is a good vampire when you need one?

Please comment.

Let’s face it the famed childhood story is really about a home invasion.  It is a tale of theft and property destruction. Read the original fairy tale and you find something quite scary underneath.  The step sisters in the original Grimm’s tale of Cinderella actually cut off their toes to fit into the slipper.  Dig a little deeper and we find the truth about Goldilocks.  From Wikipedia:

“Each bear has his own porridge pot, chair, and bed. One day they take a walk in the woods while their porridge cools. An old hairy woman (who is described at various points in the story as impudent, bad, foul-mouthed, ugly, dirty and a vagrant deserving of a stint in the House of Correction) discovers the bears’ dwelling. After assuring herself no one is about, she enters the house. The old woman eats the Wee Bear’s porridge, then settles into his chair and breaks it. Prowling about, she finds the bear’s beds and falls asleep in Wee Bear’s bed. The climax of the tale is reached when the bears return. Wee Bear finds the old woman in his bed and cries, “Somebody has been lying in my bed,—and here she is!” The old woman starts up, jumps from the window, and is never seen again.”

And so we have it, a vagrant is made into a cute little girl too cute to allow us to see what has really happened in the story and Goldman Sachs became too gilded a financial player to allow many to appreciate the rot underneath.  A Goldman client structures a deal with investments he knows to be bad and then takes out insurance in the event those investments go bad.  He gets Goldman to find a 3rd party to certify the investments are good and Goldman sells the deal to investors who “go long”.  Goldman pockets a fee of $15 million, the client pockets tens of millions and the investors find their porridge eaten and their chairs broken to the tune of $1 billion dollars. The question remains whether or not Goldman will jump out the window or simply find a single employee who will.

Will Warren Buffett insist on a Goldman apology or will he simply vow that Berkshire Hathaway will never be a bear?  Financial writers are opining that Buffett has been used.  Is the $ 5 billion dollar investment and are the investment returns he has received are too high a price to pay for his reputation?  Goldman was aware that it would go trolling in someone else’s house for gain and wanted to keep Buffett around as a positive association.  Goldman could have bought out Buffett’s position at any time but it hasn’t.  I mean wouldn’t you want to pay off someone you owed $5 billion dollars to?  Instead Goldman is paying Berkshire Hathaway $100 to 200 million dollars a year in interest.    The problem, of course, now is that no one who invests with Goldman can ever be sure that Goldman will regard them as anything other than a dumb old bear.  On the bright side, we may finally see financial reform.  On the down side, how many pension funds are bears to the investment banks, ‘cause I don’t for a second think that Goldman Sachs is the only investment bank doing this.

Please comment

Okay, so like I am middle-aged and I have a high-stress job.  I am also a perpetual planner, so I have been sitting down, looking over the books and planning my exit strategy.

The traditional retirement plan that my company offered was a pension.  In the early 90’s my company did away with its traditional pension in favor of a hybrid, fractional pay pension coupled with a 401K.  I got in early enough though that I could have chosen the traditional all-or-none pension, which would have required at least 25 years of service.  There was a time when I couldn’t even imagine being 25 much less staying in the same place for 25 years. I opted for the hybrid system.

I finally sat down to figure out what my income will be at age 60 provided I don’t play with the money prior to that time.  Here is what I found:

1)   Continuing to contribute to my 401K after age 51 will only result in modest gains to my portfolio.  Why?  Because the bulk of gains occur with time, new contributions made after age 51 will not have had sufficient time to grow.

2)   Even if I hit my “number” and begin distributions at age 60, the monthly income result will be modest.  Remember this rule: Even if you manage to accumulate one million dollars in a 401K, that sum translates into roughly $4000 per month

3)   The pension component will be a larger contributor to my income at age 60 than my 401K!

Something has been bothering me.  Current retirement planning is based on planning for markedly reduced resources and reduced standards of living.  The rule of thumb is that people should set themselves up to live on 75-80% of their pre-retirement income.  That theory breaks down at the lower levels of income.  Should we tell a person making $30K that they should plan to live on $24K in retirement?  Current estimates are that it will take $250K to cover retirement costs alone in retirement.

In the Time Magazine article:  Why It’s Time to Retire the 401K, the author concludes that each of the people interviewed would have been better served by a pension plan.

Pensions cost the companies who run them a ton of money, but they are a great employee perk and from, where I sit today, they should be part of all retirement packages. I have already written about the perils of Social Security in an earlier post. Social Security is insolvent. Current payroll taxes intended to fund the program are being spent as part of general revenues.  Makes me wonder about the future of this social safety net.  Bottom line is pensions rock.  401Ks don’t.  The market boom of the 1990s that made so much 401K wealth possible is not likely to be repeated in our lifetimes.  The inflation-adjusted compound annual growth rate for stocks from January 1, 1989 to December 31, 2009 was 6.26%.  That assumes the investor was able to take full advantage of the 1990s market boom.  The inflation-adjusted return for the last decade? -3.42%.  It is hard for me to see how anyone with a family especially can hope to save enough to fund anything other than a meager retirement and after 30 years of working and “doing the right things”.  That truly sucks.

Please comment.

Why do we save? I mean really, why do we save? When I think of saving, I think of the coffee can that I used to put my money in when I was a kid. This was before passbook savings accounts. My baby brother used to put his quarters in a big green “piggy” bank. Someone broke into our house one day and stole it. I think that was when I started putting money in a coffee can. When I was a kid, I think I just liked having a can full of money. Heavens knows I never really felt free to spend it on anything. In my twenties, I discovered the easy money credit allowed and thought “why bother” with saving when I could just whip out a card. I remember telling a classmate friend of mine, who had been around the financial block once or twice, about this new thing I discovered, the credit card. I thought it was great that I could spend one hundred dollars and pay back forty. That I could spend two hundred dollars and pay back fifteen. Yippie, I thought I had found the money tree! My friend was not so sure. Now I am older and wiser. I save today to buy choices in the future. And here’s me thinking I am being older and wiser when I find in Wikepedia:

Within personal finance, the act of saving corresponds to nominal preservation of money for future use

Humm. And there we have it. Except, well, we don’t exactly save the way we used to.
Years ago we used to save by putting money into bonds and savings accounts, paying dependable interest guaranteeing the money would be there for future use. Today, savers have become investors. No longer content with saving money, we’ve become obsessed with the growth of money. The idea of diversification is simple: A portion of your savings goes into a safe investment earning dependable interest so you can have it for future use while another portion goes for investment understanding that you might not have it for future use. Once again from Wikepedia:

In terms of personal finance, saving specifies low-risk preservation of money, as in a deposit account, versus investment, wherein risk is higher.

What does all of this mean? Well there has been a fundamental shift in the way we save money and I am concerned that not all of that shift has been good. Millions of people did not recognize the inflationary spiral in the housing market and, believing the popular wisdom that housing prices always go up, paid too much for houses they could not afford. Millions of people, believing that the stock market will always go up, have chosen to place money intended for future use in a vehicle they have no control over: the stock market. Recently I read a blog post in which the author hailed the 401K as the great equalizer allowing the average Joe to participate in the stock market like the big boys. If the stock market actually translated into “free money” I might agree.

The financial world is changing, affecting how we think about something as basic as saving money. I am afraid that if we don’t stop and consider what we are doing, the money we save won’t be our own.

Please comment. What are your thoughts?

I’m tired of reading in the financial press that my 401K is recovering. I have only to look my the statement to know the lie of it. But then maybe if I apply the New Math it really has recovered and is on its way up.

New Math was conceptual mathematics popularized in the United States after the Soviet launch of Sputnik. After a decade, it was widely considered a failure. Teachers were afraid to teach it and parents were afraid they wouldn’t be able to help their children with their homework.

A humorous illustration of New Math can be found at
http://www.straightdope.com/columns/read/1529/what-exactly-was-the-new-math

The following examples may help to clarify the difference between the new and old math.
1960: A logger sells a truckload of lumber for $100. His cost of production is 4/5 of this price. What is his profit?

1970 (Traditional math): A logger sells a truckload of lumber for $100. His cost of production is $80. What is his profit?

1975 (New Math): A logger exchanges a set L of lumber for a set M of money. The cardinality of set M is 100 and each element is worth $1.

(a) make 100 dots representing the elements of the set M

(b) The set C representing costs of production contains 20 fewer points than set M. Represent the set C as a subset of the set M.

(c) What is the cardinality of the set P of profits?

1990 (Dumbed-down math): A logger sells a truckload of lumber for $100. His cost of production is $80 and his profit is $20. Underline the number 20.

1997 (Whole Math): By cutting down a forest full of beautiful trees, a logger makes $20.

(a) What do you think of this way of making money?

(b) How did the forest birds and squirrels feel?

(c) Draw a picture of the forest as you’d like it to look.

Popular financial wisdom tells us that because the Dow is up 67% as of today from its 2009 nadir that we should cheer up, our finances are on the mend and the 401K is still a great long term financial strategy. But I keep remembering a troublesome concept taught by William O’Neil, entrepreneur, owner of Investor’s Business Daily and author of How to Make Money in Stocks and 24 Essential Lessons for Investment Success.  If the markets tank 50% how much of a gain is required to get back to baseline? 100%.

Now here is some real math: You invest a dollar and lose half of it. You now have 50 cents. You would have to double your money or get a 100% return to get back to 1 dollar. From its October 9th peak in 2007 of 14,164.53 to its trough of 6547 on March 9th, 2009, the Dow shed 54%. To get back to even, the Dow would have to gain 104%. In other words for you and me to break even and get back to where we were in 2007 at the market peak, the Dow would have to gain 104%. Historical tables show that the S&P lost 36% in 2008. To get back to zero, the S&P would have to gain 72%. The S&P gained 19.7% in 2009. New contributions, even if there is an employee match, are not a legitimate part of our overall investment return. Investment returns are based on the growth of a dollar over time, not the growth of a dollar because you added another dollar to it. In looking at my statement, my 401K is now worth just over what it was at its 2007 peak. That is if I include my ongoing contributions and employer match in the mix. If I don’t and I shouldn’t I am still down 12.2% fortunately I am not exclusively in stocks so the losses were mitigated. Only new math would allow me to think I am on track and can build a secure retirement with returns like that.
Amazing! Fortunately I have investments outside of the market, investments I have greater control over to ensure my retirement.

What is your belief in the stock market as a retirement vehicle?  Please comment.

I’ve been thinking, which is always dangerous, about the 401K. What really started me thinking was a conversation that I had with a friend of mine over a Cashflow game. She invests in real-estate as do I. With a young family and being the primary bread-winner,my friend spent countless nights up reading personal finance books. The conclusion for her: That the 401K as a retirement vehicle made no sense for her. Why? Because the 401K turns gains that would qualify as capital gains into gains taxed as ordinary income. The only way to “win” the 401K game in retirement is if you plan to be in a lower tax bracket in retirement than you were during your working years. Some folks call that planning to be poor. I think I can be a bit more generous than that. Honestly it only makes sense to me to plan to be in a lower tax bracket if you can guaranty the following: 1) you will own your home free and clear. If you don’t own a home and there are many good reasons not to, you will have an ongoing housing expense in retirement 2) Your children grow up, leave the house and never, ever need financial assistance from you 3) You are extremely healthy in retirement and will never need a hospital, assisted living or long-term care facility. 4) tax rates will not increase in order to offset growing budget deficits. In other words if you can guaranty that your expenses in retirement will be lower than your expenses during your working years, it may make sense to plan on retiring on less income than you are accustomed to earning. It is important to understand what the 401K is and where it came from. 401K simply refers to the section of the IRS code that allows for the creation of the 401K deferred income savings plan. Deferred compensation means that you defer receiving some of your income today and in exchange for that you lower your immediate tax burden. In exchange for lowering your immediate tax burden you agree to pay ordinary income tax on the money you withdraw from the plan. The truth is that prior to the creation of the 401K, deferred compensation arrangements were in existence and were created to allow high income wage earners to defer non-scheduled income to reduce their overall tax burden. If you are in the 35% tax bracket when the money goes in and you remain in the 35% tax bracket when the money comes out, you will pay 35% tax on the money. If you are in the 35% tax bracket when the money goes in and you are in the 25% tax bracket when the money comes out, you pay 25% on the money in your 401K. If you are in the 25% tax bracket when the money goes in and in the 35% tax bracket when it comes out you pay, guess what.
The 401K is a savings vehicle. A savings vehicle with many strings attached. Withdrawals prior to 59 1/2 are subject to an early withdrawal penalty of 10% in addition to ordinary income tax. While there are ways to avoid the early withdrawal penalty, but unemployment is not one of them. As a savings vehicle, the 401K is pretty illiquid. If you are unemployed and your primary source of savings is your 401K, you will with- draw at ordinary income tax rates PLUS pay a 10% penalty. The employer match is supposed to be the be all and end all of the 401K. In other words the employer pays you to save by giving you free money up to a certain percentage of pay. For those employers who offer a match, that match can range from 3-4% of pay. But employers don’t have to offer a match and many employers will suspend their match during hard economic times which is exactly what happened during this most recent downturn. For those companies offering a match there may be a vesting period of 3-5 years before employees can keep the matched funds. I have had many friends over the years who have suffered intermittent unemployment, with the 401K often being the largest if not the only source of savings, it gets tapped with now unemployed person responsible for penalties and income taxes. Given that the 401K is a type of deferred compensation savings vehicle originally designed for high income individuals, I have been wondering if this is the right vehicle for everyone especially middle income individuals or individuals with spotty employment histories for whom liquidity might be the most important concern.

What are your thoughts? Do you have a 401K and do you believe it is the right savings vehicle for you?