Archives for April 14, 2019

Make saving a cinch with these lesser-known tricks.

Building an emergency fund, creating a nest egg for retirement and socking away money for your children’s college fund are fundamental steps to ensure long-term financial well-being. But how do you save money when you’re on a stringent budget? While it can be challenging to set money aside on a small salary, it can be done. So if you’re looking to pad your savings, use these expert-backed strategies.

Make a game out of saving.

Jacqueline Gilchrist, who manages the personal finance website, Mom Money Map, suggests employing a “no spend” challenge. “A no spend challenge is when you don’t spend money for a certain period of time. It could be a weekend, a week or a month. You can set rules to spend only on essentials or other allowances,” she says. By participating, “it forces you to be creative with what you have and learn new skills to avoid paying for a solution,” she says. “When you feel like you have no money to save, doing a no spend challenge can possibly open your eyes to more ways to save.”

Get a side hustle.

“There’s only so much you can save when you’re barely making ends meet as your savings is your income minus your expenses,” Gilchrist says. However, “what you can make is unlimited,” she adds. She suggests bartending or entering the ride-sharing market. You could also become a personal shopper for the delivery service Shipt, a side gig that’s gained steady momentum. If a side hustle doesn’t appeal to you, Gilchrist has another suggestion: Ask your main employer for a raise.

Modify your income tax withholding.

If you receive a sizable tax refund every year, Elio Alfonso, a professor of accounting at the University of Tampa, suggests that you look at adjusting your withholding allowances. “Basically, you are giving the IRS an interest-free loan during the year for absolutely no reason,” Alfonso says. “You should have more of that money in your bank account earning interest and working for you.” If you opt to withhold less from your paycheck, just make sure that you put some of that money aside from each pay period to go into savings.

Invest your raise.

If you receive a raise in the near future, put that extra money into a savings or retirement account. Too often, “people move into a bigger apartment or buy a more expensive car to reward themselves for receiving the raise. What happens is they are unable to improve their financial condition because they spend everything they make,” says Robert Johnson, a professor of finance at Heider College of Business at Creighton University in Omaha, Nebraska. According to Johnson, “People would be well-advised to pay heed to Warren Buffett’s sage words: ‘Do not save what is left after spending; instead spend what is left after saving.’”

Use technology to save.

Johnson advises downloading the right financial apps to optimize savings. “One popular app is called Acorn. You tie Acorn to your debit card, and it rounds the purchase up to the nearest dollar, effectively allowing you to invest your spare change.” Here’s how it works: If you buy a latte that costs $4.44, when you use your debit card, $5 will be taken out of your account, with $4.44 going to the coffeehouse and $0.56 going into your investment account. “This allows you to save money as you make everyday purchases and you don’t have to make the decision to invest the money,” he says.

Identify areas where you can scale back.

“Take a look at your monthly expenses and see if there are any areas where you can reduce your spending,” says Joshua Zimmelman, president of Westwood Tax & Consulting LLC, in Rockville Centre, New York. “For example, replace expensive dinners out with more home-cooked meals or cancel your cable in exchange for cheaper streaming services like Hulu or Netflix.” Alternatively, you could also negotiate your cable bill or switch insurance providers and go with a cheaper option. “There are probably a lot of spending cuts you can make that will barely affect your day-to-day life but could save you hundreds of dollars a year,” Zimmelman says.

Pay your bills on time.

“Don’t waste money on late fees and penalties. Avoid late fees and interest charges on your credit cards, loans and other bills by always paying in full and on time,” Zimmelman says. If you’re struggling to pay bills, you can get accustomed to a routine where you’re always paying bills late – and seeing that you got it paid at all as a victory. But take a look some time at how much you’re spending on late fees. For instance, late fees on credit cards can set you back $25 or more. If you pay your credit card late every month, aside from paying higher interest rates than you otherwise would on revolving debt, you’d be spending $300 a year – in late fees.

Prioritize saving over convenience.

Pierre Habis, president of PurePoint Financial, a bank headquartered in New York City, says consumers pay money for things they could easily do themselves. According to a survey commissioned by PurePoint, “Two in five Americans would spend four times as much on transportation just to save 20 minutes, and one in four Americans would spend twice as much on food to avoid a 20-minute walk,” he says. Rather than spending money on food delivery services or transportation, consider making “a habit of walking to pick up your food or taking public transit,” he advises. “Paying extra for convenience might seem like a miniscule cost at the time, but it adds up when it comes time to pay your bills.”

Pay yourself first.

“It can be incredibly difficult to save money when you are struggling to make ends meet, obviously. The way to be successful is to set a savings amount and consider it a bill, the same as any other bill like electricity or rent,” says Elizabeth Windisch, a certified financial planner at Aspen Wealth Management in Denver. You have to consider what you put into savings as equally important as that electricity or rent payment, she says, “because you will need money to live off later, or an emergency will arrive.” She suggests putting away what you can, whether it’s $50 a month or $5. “Small amounts add up, and small amounts can be incrementally increased over time.”

Here’s how to save money on a shoestring budget:

• Make a game out of saving.
• Get a side hustle.
• Modify your income tax withholding.
• Invest your raise.
• Use technology to save.
• Identify areas where you can scale back.
• Pay your bills on time.
• Prioritize saving over convenience.
• Pay yourself first.

Retirement can be a complicated topic. From translating all the complex financial jargon to understanding how much you should be saving for your golden years, it can sometimes feel like trying to learn a foreign language.

And because finance isn’t always the most exciting topic to think about, many people simply aren’t very knowledgeable about saving for retirement. In fact, two-thirds of Americans said they don’t know as much as they should about retirement investing, according to a survey from the Transamerica Center for Retirement Studies.

While there are a host of aspects about retirement that many people don’t fully understand, researchers found that there are two factors, in particular, that most people are unaware of that could help them save more money: catch-up contributions and the Saver’s Credit.

What are catch-up contributions?

Regardless of the type of retirement account you use — a 401(k), traditional IRA, Roth IRA, etc. — there are limits to how much you can contribute each year. For 2019, the yearly contribution limit for 401(k)s is $19,000. For IRAs, the limit is $6,000 per year.

However, if you’re age 50 or over, you can contribute more than that. With a 401(k), you can contribute an additional $6,000 per year, while IRAs allow you to save an extra $1,000 annually. These catch-up contributions are meant to help older workers save more as they near retirement age, yet not everyone knows they exist. According to the Transamerica survey, less than half of generation X and only 63% of baby boomers were aware catch-up contributions even existed.

Part of the reason why so many people don’t know about the incentive is because few workers actually max out their retirement accounts. After all, if you’re saving nowhere near $19,000 per year in your 401(k), you’re probably not thinking about how to save an extra $6,000 on top of that. That being said, if you can supercharge your savings and take advantage of catch-up contributions, your retirement fund will thank you down the road.

For example, say you’re 50 years old, you have $50,000 in an IRA, and you’re currently maxing it out by saving $6,000 per year. If you continue saving at that rate, assuming you’re earning a 7% annual return on your investments, you’d have around $289,000 saved by age 65. If you take advantage of catch-up contributions, though, and contribute $7,000 per year, all other factors remaining the same, you’d have roughly $314,000 saved by 65. So while you’d only be saving less than $100 more per month, it would amount to an extra $25,000 over time.

What is the Saver’s Credit?

Not only can you save more for retirement with catch-up contributions, but you may also see a tax break on those contributions with the Saver’s Credit — something only 38% of workers are aware of, according to the Transamerica survey.

With the Saver’s Credit, you can receive a credit of up to $1,000 per year (or $2,000 per year if you’re married filing jointly), depending on your income and how much you contribute to your retirement account. The maximum contribution amount that qualifies for the credit is $2,000 per year (or $4,000 per year if married filing jointly), and you can receive a credit of 50%, 20%, or 10% of your contributions depending on how much you earn each year.

The Saver’s Credit is especially beneficial to those with lower incomes who are struggling to save, because the less you earn each year, the bigger tax break you’ll receive. And if you’re pinching every penny, an extra $1,000 can go a long way — not to mention provide a strong incentive to contribute at least $2,000 to your retirement fund each year.

Retirement may not be the most riveting topic on your mind, but it is important to understand as much as you can about it. The more you know about these types of incentives, the easier it is to jump-start your savings and enjoy a more comfortable retirement.

No one lives forever. So why, 18 years into retirement, have individuals generally spent only 20% of their nest egg? Why, if people want to conserve their assets, do nearly half of Americans take Social Security benefits at the earliest possible age of 62 — receiving only about 70% of the full benefit available at age 67?

Money and rationality don’t always mix, of course. That’s especially true with retirement. The issue is complex and uncertain and can trigger feelings of fear and anxiety that may interfere with rational decision-making.

One way to address these issues is for the industry — consultants, advisors, plan sponsors and asset managers — to apply insights from behavioral finance. We believe this could encourage smarter, more rational decisions as people enter retirement.

Indeed, behavioral insights have played an important role in helping people save for retirement. Automatic enrollment into company-sponsored retirement accounts and default investments such as target-date funds have jump-started asset accumulation and prompted use of more-disciplined investment strategies. These “nudges” transform a cognitive bias — inertia — from a negative to positive.

However, nudging individuals to make more rational decisions as they enter retirement will be more challenging. The decisions that one needs to make at or near retirement, which significantly affect one’s ability to enjoy the “golden years,” are arguably more complex than those made during the accumulation phase. Not only are these decisions complex in isolation, but the complexity is amplified because each decision is interrelated to all of the others, as we outlined in recent research. Indeed, key questions — such as when to take Social Security, how to invest assets, whether to buy an annuity and how quickly to spend savings over an unknown remaining lifetime — can befuddle the most sophisticated minds in finance, let alone individuals with modest savings and limited financial knowledge.

Here are four decisions where insights from behavioral finance may promote more rational decisions and help to improve retirement security for millions of Americans:

Social Security

Our research indicates that individuals with average health and moderate affluence would likely be better off deferring Social Security benefits until age 70.

Nonetheless, about 90% of those eligible claim Social Security before the full benefit age of 67. Without doubt, there are rational reasons to take Social Security early — including poor health, limited financial resources, spousal considerations and concern over the survival of Social Security. Yet it is clear that the vast majority of individuals are not optimizing this decision.

This mass early election may partially be explained by the “present-bias” — the human preference to take an immediate reward over a future one.

Academic research suggests that modifying this behavior may be difficult at best. Nonetheless, solutions may include improved financial literacy and improved communication around the consequences of early election, especially if it intensifies the very powerful human emotion, regret.

Annuities

One of the greatest complexities with retirement planning lies in not knowing how long you will live and therefore how long your assets will need to last. Certain types of annuities, such as deferred annuities, seek to address the risk of outliving one’s assets, commonly known as longevity risk, and therefore greatly simplify the retirement planning problem. Deferred annuities provide guaranteed income for life and commence their payout at a future time. For instance, a retiree at 65 years of age who purchases a deferred annuity with payments beginning at 85 may have greater confidence in consuming a portion of their nest egg.

So why do so few individuals buy annuities? For most defined contribution participants, annuities are simply not made available. And even when available, few buy them, finding annuities expensive and complicated.

Moreover, behavioral science suggests that emotion also may play an important role. Specifically, the best predictor of whether someone will consider an annuity is sensitivity to issues of fairness, according to research by Suzanne Shu, Robert Zeithammer and John Payne — in particular, the belief that the insurance company will keep excess funds when the policyholder dies.

The old adage that annuities are sold, not bought, suggests that personalized education and advice will be required to overcome cognitive biases against annuities.

Of course, it is unlikely that the rate of annuity adoption will change any time soon. Therefore, in order to simulate the relative stability that some types of annuities provide and hedge longevity risk, one must assume a more conservative asset allocation, favoring fixed income over equities.

Asset allocation

Prospective retirees must determine how to invest their savings between stocks and bonds. A key assumption in our modeling is that individuals strive for a stable retirement income stream. Holding more in equities may generate higher retirement income and allow for a higher quality of life, but it comes with greater uncertainty. Conversely, holding more in bonds may increase the certainty of income but likely at a lower level.

Our research finds that those with more wealth should hold less equity exposure than those with less wealth. This is not because of growing risk aversion as one ages. Rather, it’s because as wealth grows, Social Security — which mimics the role of bonds in providing an income stream — represents a shrinking percentage of total income. It follows that wealthier people need to replace that missing fixed-income exposure with bonds within their financial portfolio. Therefore Social Security may be one of the most important factors driving the asset-allocation decision.

Empirical data, however, show that few individuals de-risk their portfolios. Whether viewed through the lens of age or wealth, data suggest that most individuals simply hold portfolios with approximately 60% equities and 40% bonds.

Consumption rates

What is a reasonable level of principal drawdown for a retiree? Too aggressive a pace may deplete assets and impair the retiree’s lifestyle. Conversely, if one spends too little, their quality of life may suffer unnecessarily. Complicating this question is Pimco’s belief that returns from equities and bonds will be lower going forward than in recent decades

With the goal of maximizing high quality, stable income in retirement, according to our framework, most individuals can afford to consume roughly 3.5%–5.0% of their savings every year, adjusting for inflation, depending largely upon one’s willingness to consume from both portfolio returns and principal as well as address longevity risk. If one is willing to allocate a significant portion of their assets to address longevity risk in the form of a deferred annuity, consumption at the higher end of the range can be justified.

Interestingly, regardless of one’s wealth level at retirement, most retirees prefer to consume only income derived from Social Security, their pension or investment portfolio, but not principal. After 18 years, the typical retiree has used only 20% of their assets.

These reasons are far from irrational, of course. The aversion to consuming principal is strong and may reflect one’s desire to self-insure against future expenses, medical concerns, longevity risk and, for a limited few, a wish to pass wealth to heirs.

Clearly, the human preference to spend income and preserve principal should be incorporated into retirement income portfolio design to help overcome this mental accounting bias. Specifically, portfolios favoring returns sourced from income over capital gains may create more stable portfolios, and stimulate greater consumption in retirement commensurate with one’s means.

Conclusion

Making optimal decisions for retirement is inherently difficult. Human emotion and cognitive bias lead many of us to make suboptimal judgments. It’s time for the industry to make better use of behavioral science to nudge retirees toward improved decisions and retirement outcomes.

Transforming one’s personal finances is a complex process. While originally created for a different purpose, Dr. Mary Lippitt’s complex change management model is highly applicable to financial change.

This particular change model illustrates each essential component of complex change and the problem that results when that component is missing. This makes it particularly useful in diagnosing the reasons why previous attempts at change may have been ineffective.

Here is how you can apply the complex change management model to your personal finances to finally make lasting changes.

Vision.

When we combine goals and values, we get vision. A crystal-clear vision of where you want to get financially, and how that relates to your personal values, is absolutely essential.

This step is often skipped or abbreviated, because authenticity values discovery and goal-setting can be challenging. This typically causes people to flounder due to confusion.

However, the clarity and resulting motivation that come with being able to articulate our authentic values and goals can be life-changing.

Skill.

When it comes to personal finances, there is foundational knowledge that is essential for success: an understanding of the financial options available and how those options apply to your own financial situation, combined with a basic understanding of household cashflow.

Our beliefs and attitudes about money shape our behavior, and by extension, our ability to apply our knowledge. The combination of knowledge, self-awareness about our money attitudes, and healthy financial behavior equates to skill in the realm of personal finances.

Incentives.

Financial planning is about building a satisfying life and balancing the needs of our current selves with our future selves. There have to be incentives built-in along the way.

The downfall of some financial plans is a lack of balance. Where there is a focus on financial goals – such as retirement or debt elimination – to the exclusion of all else, it becomes hard to stay focused and make progress. Incentives help us stay motivated and keep our progress on-track.

Resources.

The resources needed to successfully create financial change can come in many forms. One could be having access to the optimal financial instruments to implement the plan.

Another type of resource could be access to the right experts. A financial planner, a lawyer, an accountant, an investment advisor, or an insurance advisor would all be potential candidates, depending on your needs.

Action Plan.

Very often, people may have all of the other elements in place, but aren’t clear on how they come together into a coherent strategy.

The piecemeal approach often results in many restarts and switches in direction mid-stream. An action plan with clear, achievable steps is vital to ensuring that you are moving in the right direction with your finances.

If you feel stuck with your personal finances, chances are that your key to getting on-track lies in one of these five components.