How to Take Control of Your Finances after Graduation

[Don’t miss the two free giveaways in this post!  Click here to access our new retirement calculator, and click here to download our comprehensive student loan guide!]

The first 90 degree day of the year (at least here in Philadelphia) means a lot of things to different people.  Memorial Day Weekend.  Weekends at the park or pool.  And, of course, graduation season.

Congratulations to everyone in Class of 2017! If you are finishing your undergraduate career this month, welcome to the working world!  If you are finishing a masters or professional degree program, congratulations on finally (probably?) being doing with school!  And if you didn’t graduate this year, stick around anyway- I have some information here for you, too.

As the excitement of your graduation weekend ends and you begin to take the next steps on your journey, whatever they may be, I recommend that you take a step back and take an assessment of your current financial landscape.  Your life is changing (for the better!), and as such, you should take some time to reflect and take action to set yourself up for financial success in your new endeavors.

There’s a lot to take in here – if you have any challenges in any of these areas, I recommend that you reach out to schedule a free consultation about a one time, quick start session!

Congratulations again, and let me know how you are doing as you progress through this list!

Negotiate Your Salary

If you’re still working on lining up your first job out of school, make sure you prepare yourself to negotiate your salary before you accept a job.  If you already have a job lined up, file this one away for your next performance review.

I’ve discussed this in much more detail before, but it’s absolutely critical that you negotiate your salary when starting a new job.

Over 60% of millennials aren’t negotiating with employers at all regarding their salary.  And the worst part?  Three out of four employers have room to negotiate salary by as much as 10%- but only if you ask for it.  And, truthfully, hiring managers and HR are expecting you ask for it.

I know it’s uncomfortable, but you have to do it.

Set a Student Loan Paydown Plan

The bad news? T-minus six months until your first student loan payment is due.

The worse news? The vast majority of millennials are told by their loan servicer how much they owe and automatically start paying the bill, without double checking to make sure they’re paying down their loans in the smartest way possible.

The good news?  You have the power in your hands to make sure you’re handling your student loans with the care they deserve.

I highly recommend downloading my free guide on managing student loan payments. In it, you will learn:

  • How to review each of your student loans and determine what payment plans each is eligible for.
  • How to know if you are eligible for a loan forgiveness program, and what you need to do to qualify for the program under current law.
  • When you should refinance your student loans, and when you absolutely should NOT refinance your loans.
  • How to set goals around your student loan payment strategy (i.e., should you try to pay down your loans as fast as possible, or should you try to minimize your monthly payment?)
  • … and much, much more!

Go ahead and grab your free copy of “13 Steps to Take Before You Make Your Next Student Loan Payment” today.  It will be worth your while to work through the guide in order to set you up for success with your student loans.

Set Financial Goals for the Next Five Years

I remember graduating college like it was yesterday.  The last thing I wanted to do was to try to imagine what the future was going to be like.  I just had the best four years of my life, and was scared to face all of the responsibilities that I knew would fall on my shoulders in the real world.  If you had told me back then to spend some time setting goals for my first few years in the working world, I probably would have laughed at you.

But, I wish I had taken that advice.  I’ve improved my own personal financial situation significantly after I started setting financial goals for myself. (Not too long after I started my first job, luckily!)  And I recommend you do the same.

Take some time and imagine what you want your life to be like in one, three, and five years from now.  Will you be going back to school to get a graduate or professional degree?  Do you want to buy a new car or, a little while down the line, a new house? Are you gunning for a quick promotion at work, or maybe even thinking about launching a business or side hustle someday?

All of these things are great, and they are much more likely to happen if you (literally) put pen to paper to clearly articulate what you want your life to look like.  And, once you have done this, you can manage your finances accordingly to begin to make progress against these goals.

Set Up Your 401(k)

It can be easy, in the flurry of paperwork that accompanies a new job, to accidentally forget or neglect to set up contributions to your 401(k).  Don’t forget, it’s critically important.  At a minimum, you should contribute at least to your firm’s matching point.

So, if your firm matches up to 3% of your salary, you should contribute, at a bare minimum, 3% to your 401(k).  Not contributing up to your firm’s matching point is, quite literally, turning down free money.

And unfortunately, it’s not enough just to set up how much you want to contribute to your 401(k).  You need to choose how you’d like to invest the money you put into your retirement plan, too.

Unfortunately, firms usually give very little guidance to their employees on how to do this.  Which is why I’ve wrote about how to choose investments in your 401(k) in more detail on this blog.

…And If You Can, Save Beyond The Minimum for Retirement

Retirement might be a long way away (spoiler alert: it is a long way away), but that doesn’t mean you shouldn’t start saving aggressively for it now.  In fact, due to the beautiful thing that is compound interest, the more you save for retirement in your early working years, the much better your retirement picture will be.

There are other things you should be saving for as well (we’ll get to that in a bit), but if you have some discretionary income, I can’t recommend highly enough that you put some of that into a retirement account.  What type of retirement account – either increasing contributions to your 401(k), opening a Traditional IRA, opening a Roth IRA, or even a nonretirement investment account – can vary significantly depending on your circumstances. This is probably something we should talk one on one about, if you have questions.

If you’re wondering how much you should be saving for retirement, I recommend inputting your data into the free retirement calculator I have right here on my website.  And, particularly, if there’s a big gap between the yellow and blue lines or if you portfolio is projected to run out in the early stages of your retirement, we should talk about ways to close the gap.

Build an Emergency Fund

Like I said, retirement isn’t the only thing you should be saving for.  It’s critical that you gradually build an emergency fund so that if you were to lose your job, you have a way to support yourself during the transition.

The rule of thumb is that you should have enough saved to support yourself for six months (living on reduced expenses, of course – you probably won’t spend as much as you are today if you don’t have an income, after all).  But, when you’re first getting started, I think it’s silly to dwell on six months of savings.  That’s a pretty big and intimidating number for most people.

So instead, start by trying to save up to cover one month of your minimum living expenses.  Once you’ve saved that much, make your next goal to be to save an additional month of living expenses.  And so on, until you’ve hit that six month goal.  By breaking it up into pieces like this, it gives you a very clear way to take small steps, starting now, to work your way up to this major goal in the future.

Keep Your Living Expenses at College-Level For As Long As You Can

If you’re like me, there’s a good part of you that’s sad to be leaving college.  College is hard, sure, but it’s fun!

Do you have that same bittersweet feeling I did about leaving school behind as you enter the real world?  Good!  Hold on to it.  Embrace it.  And channel it into how you manage your finances.

Simply put, if you had a blast in college living on a minimal income, there’s no reason to change that up now that you have a salary.

Sure, you can have some peace of mind that you have some discretionary money at your disposal if you ever were to need it. And there’s certainly nothing wrong with splurging every now and then.

But, since you’re used to keeping your living expenses low, you should continue to do that as much as possible.  Have friends in your new hometown?  Try to get them to sign on as roommates!   Have some more free time on the weekends now that you’re not constantly writing papers and completing homework?  Spend a little of that time learning how to cook so you don’t need to order takeout seven or eight times a week.

Simply put, it’s much easier to maintain your current standard of living today than it is to increase your standard of living, realize you’re overspending, and then try to cut spending back.  You’re better off keeping your monthly spending where it is today, and saving the rest, rather than allowing your lifestyle costs to rise with your income.

And Speaking of Spending…

Yes, you need a budget for yourself.

I’m not the type of person to go through my clients (or my own) spending with a fine-toothed comb, analyzing every little expense here and there.  It’s not fun; it’s not productive; and it’s not an effective, long term, healthy way to manage your finances.

Instead, you should set budget parameters for yourself to make sure you know where your money is going, and track against those.  A free tool like www.mint.com is great for this.

You don’t need to worry if you go a dollar or two over any particular budget category each month.  But, you should pay close attention to your biggest spending areas, and try to find ways to cut back on these highest impact spending areas first, if you’re having a hard time finding the money to save for retirement and build your emergency fund.

Budgeting should be a common-sense driven exercise.  Don’t drive yourself crazy with it, but know your budget numbers and stick to them as best you can.

Increase Your Available Credit (But Don’t Use It)

It can be hard to build your credit score while you’re in college.  After all, most financial institutions aren’t in the business of giving huge lines of credit to college students who have a minimal, if any, income.

But now that you’re out of school, that changes in a big way.  As soon as you have documentable proof of income, you should open up a credit card and use it wisely to start to build your credit score.

Whatever the bank gives you for a credit limit, always keep your credit card balance below 30% of this limit.  Always pay off your bill every month.  In other words, don’t rely on your credit card to bail you out if you don’t have the cash available to make a purchase.  Instead, use it as a tool to begin to build your credit history as an excellent manager of credit.  When you’re ready to buy a house several years down the line, you’ll be happy you did.

An even better way to do this?  Find a credit card that offers some great perks. If you like to travel, find a card that gives good points toward airfare or hotel stays.  If you’d rather just have the cash, find a card that pays you cash back bonuses when you use the card.  There are a lot of options out there, and some of them are fantastic.  If you want to get some more ideas on great credit cards to use, give me a call.

This Isn’t a One-Time Thing

As you can tell, there’s a LOT here.  As you transition in the work force, it’s ultimately on you to set yourself up for financial success.

Start today by downloading my free student loan guide and plugging your numbers into my retirement calculator.  Create a budget, open a credit card, and manage your cash flow (both income and spending) wisely.

But ultimately, most of these things aren’t just for when you make the transition from school to a job.  You should periodically review each of these items to make sure you’re still on track.  Set up a free call with me to talk through how we can implement a system to address each of these items, and more.

What Do I Do With My 401(k) When I Leave My Job?

The average millennial changes jobs four times before they reach the age of 32.  Generally speaking, this is a great thing from a financial perspective- salary tends to go up whenever you change jobs.

There are a few situations that can arise when we hop from job to job, though.  For example, what should you do with your 401(k) once you leave a job behind?  Too often, this step gets lost in the shuffle, and it can be easy to lose track of these accounts if you aren’t careful.  So, what should you do with your employer-sponsored retirement account once you leave?

Four Options

There are typically four options that you can pursue.  There’s no universal right or wrong answer here (although one option is significantly worse than the others). But, the most important thing is to develop a system to keep track of these accounts as you move from job to job.  I have a dedicated framework that can help with this- and I’m sharing it for free on my webinar on March 7.  The bottom line- whatever you do, make sure you are able to keep track of where all of your retirement accounts are!

With that being said, let’s discuss the four options in detail.

The Two Not-So-Good Options

Your first option is to cash out your 401(k).  As in, when you leave your current job, you technically can withdraw all of the money from your 401(k) to spend it today.

That being said, this is generally a terrible idea.  Retirement accounts should be kept until you’re ready to, you know, retire.  And, you’ll pay a hefty tax penalty by cashing out of your 401(k) early.  Just because it’s technically one of your four options, doesn’t mean you should actually do it.

Your second option is to leave it with your old employer.  There are some employers that force you to move it to an IRA if it’s a small account, but in most cases you can leave your old 401(k) with your old job.

That being said, there are a few reasons I typically don’t recommend this approach:

  • This is probably the easiest way to lose track of your account. If you leave all of your 401(k)s at old jobs, it can become difficult to monitor all of them.  And, of course, you really should be keeping an eye on your investments over time and adjusting them as you get closer to retirement.  As you have more and more 401(k)s, it can be harder to keep tabs on all of your different investments if they are scattered across account with your old employers.
  • Typically, employers charge fees on 401(k)s for people who are no longer employed with their company. Why pay that fee, that you aren’t getting any service for, if you don’t have to?

If your old 401(k) has great, low cost investments, it might not be a bad idea to keep your account there, but that generally is the only time I recommend this.

The Two Better Options

Two options down, two to go.  And luckily, these options are typically better.

Your third option is to consolidate your old 401(k) into your new one, if your new employer will let you.  The idea here is simple- why have two accounts to keep track of when you could combine them all into one account?  Moving your old 401(k) balance into your new job’s 401(k) is a great way to streamline your accounts.

This doubly goes if the fund options in your new 401(k) are good ones.  If you have good investment options that have low fees associated with them in your new 401(k), combining the two accounts is a no brainer.  You’ll be limited to the funds available in your company’s plan, but if they’re good, that might not matter too much.

Unfortunately, many 401(k)s use high fee accounts that can really eat into your retirement returns over time, and you aren’t getting anything in return for the fee you’re paying.  Which leads us to option four:

You can move your 401(k) into an IRA.  To do this, you’ll need to open up a brand-new IRA for yourself (unless you have one already, of course), and then request your former employer to transfer the balance to your new IRA.  You’ll then need to select the investments you’ll want to use in your IRA, and monitor their performance over time.

A few notes here:

  • When you request your old employer to move the funds to your IRA, make sure they know that you’re moving it to an IRA. Moving a 401(k) to an IRA is not taxable, but if they think you are just withdrawing your 401(k) to your bank account, you’ll need to pay a penalty to the IRS.  So, make sure they address the transfer to your IRA.
  • Make sure the account is a Traditional or Rollover IRA, not a Roth IRA. Transferring a 401(k) to a Roth IRA will cause you to be taxed on the entire balance of the account.  This can be beneficial for some people, but you definitely want to consult with a financial planner before you do this.  The key point- make sure that you don’t open up a Roth IRA by mistake!
  • One of the benefits of moving a 401(k) to an IRA is that you have full freedom over the investments in the account. You aren’t limited to a few funds in your 401(k), you can choose anything.  But, taking this approach means that you’ll need to screen your investments and rebalance your accounts over time.  I’d be happy to chat about this if you have any questions about how to do this.
How to Decide between Consolidating and Transferring to an IRA?

So, let’s take it for granted that you’re trying to decide between the last two options- combining your 401(k)s, or moving your old 401(k) to an IRA.  How should you go about making this decision?  A few key things to consider:

What are you Paying in Fees?- there are some great 401(k)s out there, but unfortunately, many of them aren’t so great.  Many 401(k) accounts only have a few funds to invest in, and they tend to have high fees associated with them.

Use a site like www.personalfund.com to evaluate how much you are paying for fees in your 401(k). If your new 401(k) has a lot of low fee options, it might make sense to combine.  If you have a lot of high fee options, it probably makes sense to go with the IRA.

Do you Need Help? Do you feel ok self-managing your investments, or do you want the help of a professional?  Most financial planners don’t provide direct investment advice on 401(k)s (although I do!), so if you want some help with your investments, usually you’ll need to move it to an IRA.  But keep in mind, that will come with an extra cost.

On the other hand, if you feel confident managing your investments yourself, you could pick either route.  It’s just a matter of which funds you’d like to invest in.  Speaking of which…

What Funds are Available?  As I’ve alluded to multiple times, 401(k)s typically provide some convenient funds to invest in, but they tend to be limited and higher in cost.  If you want a more extensive investment option, including stocks and index funds, you should probably move to an IRA.

There’s No Universally Right Answer

Ultimately, when you review the items listed above, you might find that you probably can’t go wrong between options 3 and 4.  It all comes down to personal preference, and how much you care about investment options and fees.  Ultimately, do your homework, and you should be able to sleep soundly with your decision.

And if you have further questions about retirement preparation, sign up for my webinar on March 7th to discuss these strategies in more detail!

 

How to Allocate Your Money Effectively

[Click here to register for my webinar, “How To Organize Your Finances and Create a Roadmap Toward Financial Freedom”!]

Ever since I founded Pacesetter Planning, I’ve worked with my clients on a wide range of financial topics.  I’ve gotten a variety of questions from clients and potential clients, and while everyone’s situation is a little different, generally they fall into the following categories:

  • How do I manage my finances with my husband/wife/fiance/significant other?
  • How much do I need to buy a house?
  • How much should I be saving for retirement?
  • How do I select investments?
  • Should I put extra money toward my student loans or should I direct that money elsewhere?

As you may have noticed, I’ve addressed a good number of these topics at a high level on this blog already (and will continue to do so).  But, you may have picked up on something else.

All of these Questions are Interconnected

It’s hard to make financial decisions in a vacuum.  Often times, the hard part isn’t answering these individual questions, but finding the right answer to them all at the same time.  It often isn’t practical to increase your saving for retirement and buy a house and pay extra on your student loans all at once.  These decisions need to be made together, and there’s usually not a clear right or wrong answer.

That, of course, is where I come in.  I help my clients develop plans to manage their finances, prioritize their goals, and help them allocate their money accordingly.  We set targets and track progress against these goals, updating as needed.

You Need a Framework to Make these Decisions

While everyone’s circumstances are a little bit different, I use a strict framework and process to help clients make these decisions.

And I’d like to share it with all of you.

On Tuesday, March 7 at 8 PM EST, I’ll be hosting a free webinar called “How to Organize Your Finances and Create A Roadmap Toward Financial Freedom”. You can register for the webinar here.

On this webinar, we’ll discuss:

  • How I recommend clients structure their accounts to keep track of their finances
  • How to implement a system to manage your income month to month to pay yourself first
  • How much money you’ll need to retire, and what it will take to get there
  • How to balance your everyday spending with your short and long term financial goals
We Face Greater Financial Challenges than our Parents and Grandparents.  Plan Accordingly.

Sometimes I get pushback when I say this, but I truly believe that millennials face much greater challenges than previous generations.  Think about it for a minute.

Most of our grandparents worked 40 years at the same job, retired and received a pension from their company to fund their retirement.  They have Social Security.  When they were our age and looking to buy a home, housing prices were about twice the average annual salary.

Many of our parents may have had multiple jobs over the course of their careers, but most of them only had one job at a time.  Some of them may still have a pension, but all will (barring some sort of catastrophe) receive Social Security.  And again, the average home price when they were in their twenties was around twice the average annual salary.

Now?  The average millennial changes jobs four times before turning 32. More than 1/3 of millennials have a side job.  The average price for a home has jumped to about 3.5x the average annual salary. Most of us have some type of student loans.

Pensions? Social Security?   ¯\_(ツ)_/¯

We have some big challenges ahead of us.  The good news is that these challenges can be beaten.  But, you need a method and a plan to get you there.  I’ve got it for you.

I Want to Teach You Everything I Know

I didn’t get into financial planning to only work with rich clients.  My goal is to help make all of my clients wealthy someday.  The more people I can help, the better.

Sign up for my upcoming webinar, and let me know if you have any questions you think I should address.  I look forward to sharing my methodology with you all.

How to Pick Investments in Your 401(k)

Stop me if you’ve heard this one before.

You get a new job, go in for your first day, excited to get started.  Six hours into an eight hour onboarding training, you get a packet from HR with a 40 page document about your 401(k).  And, for the most part, you’re essentially left to set it up on your own.

You dig a little deeper and set up a certain percentage of your paycheck to go into your 401(k) directly. Now, it’s time to select the funds in which to invest.  The million dollar question- where in the world to start?

I’ve seen plans have as many as 50 different funds options to choose from. And most plans give very little guidance on how to make your decision.  So, what do you do?

A Very, Very Brief Primer on Mutual Funds

This probably warrants its own separate post, but before we talk about how to choose a fund, it’s important to know what exactly you’re choosing.

The funds available in a 401(k) are mutual funds.  There are a wide variety of mutual funds, but the general idea is the same across the board.  If you put $10,000 in a mutual fund, the manager of the fund will invest it into a wide variety of stocks and bonds.  The fund manager then reallocates these investments over time according to the fund’s objectives.  When you wish to withdraw your money, you recieve your portion of the funds growth (or losses).

Mutual funds are a great way to diversify your money.  When you put your money into a mutual fund, you aren’t just buying a single company’s stock.  Generally, you’re putting your money into hundreds of stocks and bonds within a single fund.

Every mutual fund has a different objective, and risk level.  On one end of the spectrum, some funds only invest in smaller companies in Africa and Asia.  These are considered very high risk/high reward investments.  On the other end, some mutual funds only invest in US Government bonds. In turn, these are very low risk funds (that in turn, offer much less upside potential). Most funds are somewhere in between.

Your 401(k) Investments Should Be Fairly Aggressive Early in Your Career

There’s no right answer for exactly how much risk you should take with your investments.  The amount of risk you take generally depends on two things- how much risk you want to take, and how long your money will be invested.

This second piece is the key here.  Your time horizon for how long your money will be invested can sometimes override your risk preference.  For example, even if you are a very aggressive investor who wants to take a lot of risk,  it’s not a good idea to invest that money aggressively if you are planning on using your investments to buy a house in six months.  If the market were to crash, you might not have enough money to buy that house.

The flip side is also true.  If you’re investing for a long time, it probably makes sense to take more risk in your investments.

For millennials, the biggest risk to your retirement assets doesn’t have anything to do with the stock market at all.  The biggest risk is inflation.

To phrase it differently, inflation has averaged around 3% every year.  Meaning, that every year, the things you buy tend to get about 3% more expensive.  If your investments for retirement aren’t at least keeping up with inflation, you’re essentially losing money.  The investment risk for a retirement portfolio that averages 6-8% a year is well worth it. Particularly because a “less risky” portfolio averaging a 2-4% return could leave you with less money, inflation adjusted, than what you have today.

All of this is a long way of saying- if you’re in your 20s, you want to make sure you focus your investments on growth to maximize the portfolio’s value by the time you retire.  Swings in value in your 20s and 30s are a small price to pay to beat inflation over time.

…But As You Grow Older, Make Your Retirement Accounts More Conservative

Just because a growth-focused 401(k) portfolio is right for you now, doesn’t mean it always will be.  As you get older, shift some of your portfolio from stock funds to bond funds.

A good rule of thumb is to move 10% of your account from stocks to bonds every 10 years.  That way, by the time you retire, your portfolio is likely to have a good mix of growth and income-focused investments, varying slightly depending on how much risk you’re comfortable with.

So, How Should You Invest? You Have Two Major Options

With all that being said, what funds should you choose in your 401(k)?  While all plans offer different fund choices, you generally have two options:

  1. Retirement Target Date Funds

Almost all plans have retirement date target funds.  The name of these funds varies from institution to institution, but they generally contain “Retirement” or “Target Date” in the name, followed by a suggested retirement year.

If you decide to go this route, choose the fund that corresponds with your expected retirement date.  The target retirement dates are typically stated in five year increments.  For example, a 25-year-old expecting to retire in about 40 years might choose the “Retirement Target 2055”, since 2055 is about 40 years from the current year.

These funds can be a great option for one simple reason: simplicity.  All of the stuff I describe above about how your investments should start out focused on growth, and become more conservative over time?  Target date retirement funds do it all for you.

Target date retirement funds are designed to be, in theory, the only fund you “need” in your portfolio.  They are well diversified, automatically rebalance, and become more conservative over time.

The only problem?  They can be expensive.  All mutual funds have some sort of cost associated with them that come out of your account.  Typically, since target date retirement funds do this work for you, they can be much more expensive than other fund options in your portfolio. This could leave you with tens or even hundreds of thousands of dollars less when you retire.

I recommend doing a cost analysis of the different fund options in your portfolio using a site like www.personalfund.com.  Or, I’d be happy to conduct a 401(k) review to make sure you aren’t leaving money on the table.

  1. Build Your Own Portfolio

If you want more control, or lower fees, on your retirement accounts, you can build your own portfolio.  The great news with this option is that it allows you to customize the portfolio to your liking using the funds available. And, this method typically costs less in those ongoing fees I mentioned above.

If you go this route, you need to make sure you choose anywhere from four to ten or so funds that span the various sectors of the financial markets.  You want to have some exposure to large US companies and small ones.  You should have a certain percentage of your portfolio in foreign stocks.  And adding anywhere from 10-30% of your portfolio in bond funds is a good idea too.

If cost is the downside of the retirement date funds, complexity is the downside to this second approach. How you allocate your investments has a huge impact on your long term portfolio returns.  You therefore want to make sure you have your funds weighted appropriately.

And, unlike with the target date retirement funds, you need to worry about keeping your funds balanced over time.  What do I mean by this?  Hypothetically, let’s say you choose two mutual funds for your 401(k)  putting 80% of your 401(k) into the XYZ Company Stock Fund, and 20% into the XYZ Company Bond Fund. (Obviously, I made these funds these up to illustrate the concept.  And, you probably will want to have more than two funds if you aren’t using a target date retirement fund.  But, let’s keep it simple for now).  Now, let’s say that this year, stocks have a bad year, and bonds have a relatively good year (again, all hypothetical).  At the end of the year, even though you started 80% stocks/20% bonds, your portfolio might be 65% stocks/35% bonds, since the value of the stocks fell and the bonds rose.

When you are managing individual funds, you need to keep an eye on the portfolio being thrown out of balance in this way.  Typically, I recommend logging into your 401(k) twice a year and rebalancing to bring the portfolio back to 80%/20%, or whatever weighting you choose, to make sure it stays in line with your overall investment objectives.

In practice, once you have the portfolio set up appropriately, it isn’t that hard to rebalance it twice a year.  But, it a) takes a bit of time, and b) involves remembering to do it.  For this reason, I include rebalancing my clients 401(k)s twice a year as part of my comprehensive financial planning package.

Conclusion

You ultimately have two options- use the readymade target retirement funds, and pay a higher cost, or select the funds yourself and manage them independently.  There ultimately isn’t a “right” answer for everyone across the board.  And of course, if you have further questions about your investment options, how to rebalance, or even just to get a second opinion, I’m only a call away.

Thinking About “Investing” In Whole Life Insurance? Don’t!

Last month, I put out a request on social media for topic suggestions to write about on this blog.  The most common request I received, both via email and comments on my request, had to do with life insurance.

And for good reason.  Life insurance companies dominate the airwaves with ads, and sponsor sporting events across the country.  If you’ve ever been to a networking event or business mixer, odds are you bumped into multiple life insurance sales reps.  Insurance is a topic that seems to come up everywhere.  And it’s not something that most people were ever taught about in school.

There’s a lot of information out there about life insurance. A good chunk of it, in my opinion, is misleading, at best.  The good news is that if you do a little homework, this is a relatively straightforward issue for most people.

Unless you are in the top 1% of earners and are nearing retirement, run like hell if someone tries to sell you a whole or permanent life insurance policy.  For millennials, buy term insurance or don’t buy at all.

You Need Life Insurance If…

Let’s keep this simple.  If you just graduated college and aren’t married, you probably don’t need life insurance at all.

You need life insurance when you…

  • Get married
  • Have a child
  • Buy a house and take out a mortgage
  • Generally, you need life insurance when you have a financial obligation that would still need to be met if you were to pass away unexpectedly

In other words, you need life insurance when there is actually a need for you to, you know, have insurance.

This seems inherently obvious.  But, as we’ll get to in a bit, if you sit down to meet with a life insurance salesperson, they’ll likely primarily emphasize the investment benefits of a whole or permament life insurance policy, rather than the insurance itself.  I can’t say it enough, my advice to you when that happens: run like hell.

Types of Insurance

One more thing we need to run through before we talk about why I dislike most life insurance products.  And that is, the difference between the types of insurance itself.

Term Insurance

Term Insurance is insurance that is good for a set length of time, typically from 10 – 30 years.  If you pass away before the insurance expires, your family gets the specified amount of the policy.  If you pass away after the insurance expires, no benefit is paid out upon your death.  Think of it as “renting” life insurance for a set period of time.

In almost all cases, this is the type of insurance I recommend to people who need life insurance.  The reasons are numerous:

  • It’s much less expensive than other types of insurance policies
  • It’s temporary. Life insurance salespeople often argue that the temporary nature of term insurance is a reason not to get it. They couldn’t be more wrong.  Very few people need life insurance once they hit retirement.  Let’s walk through the reasons I specified as reasons to get insurance above:
    • You get married- you need insurance to replace your income if you were to pass away unexpectedly. Once you hit retirement, your income typically goes to zero anyway.  So, get a term insurance policy that lasts until retirement, and expires afterward.  Typically, there’s no need to pay for insurance beyond that point.
    • You have a child- you need insurance to cover the cost of raising your child and to pay for college. So, get a 20-25 year term insurance policy when your child is born to cover that amount.
    • You take out a mortgage- you need insurance to make sure the mortgage is taken care of if you were to die. So, get a term insurance policy that matches the life of the mortgage.
    • Generally, you need life insurance when you have any sort of financial obligation that would still need to be met if you were to pass away unexpectedly- get a term insurance policy that matches the length of the commitment.

Think of it this way: you get health insurance to make sure that you are adequately protected in the event something bad were to happen to you.  Life insurance should work the same way.  Quite frankly, if the money is “wasted” in that you never actually have to “use” either your life or health insurance policy, that’s a good thing!

Permanent Insurance

Permanent Insurance, of which Whole Life Insurance is the most common type, does not expire.  These types of insurance policies (of which there are numerous variations that work slightly differently) will automatically pay a death benefit when you die, and they do not expire as long as you continue to pay the premiums.

When you hear people refer to “investing” in life insurance, this is the type of policy they are referring to.  The premiums you pay are invested by the insurance company, who in turn passes on a portion of the resulting gains to you in the form of a “cash value”.  This cash value is an amount of money you can either take out of the policy to pay for [insert financial need here], or kept in the policy and paid out as a life insurance benefit upon your death.

See the problem here?  Keep reading…

Why I Hate Permanent/Whole Life Insurance Policies

Let me count the ways…

  • They’re expensive. Premiums for whole life policies can be significantly higher than term insurance policies.  I’ve seen quotes for whole life insurance be 10x higher than quotes for 30 year term insurance for the same person.
  • They’re complicated. Go back and re-read the paragraphs I wrote summarizing permanent insurance policies above. “Cash value”.  “Death benefit”.  Quite frankly, it was really freaking hard for me to summarize permanent life insurance policies in just a couple paragraphs, and I still ended up using technical terms.  Not to mention I didn’t get into any of the details.  These policies are incredibly complex, and it can be very easy for salespeople to highlight the alleged benefits of the policies and gloss over the complicated details.
  • Life Insurance is an inefficient way to invest: If I were to ask you to come up with a good way for you to invest your money, your answer would probably be a variant of “put my money into the stock market” or “buy a few stocks or bonds”. What you probably wouldn’t come up is the following: “I think it would be a great idea to pay my money to an insurance company, have them invest the money I give them into the stock market, that investment will make money, then the insurance company will take the profits from the investment, keep a portion for themselves (since, after all, they’re in business to make money), and then give me the remaining share”.  Your gut is probably telling you that that last sentence is insane.  Your gut is right.
  • It’s hard to take money out of life insurance: If you were to ever need to access money you have invested in the stock market, almost all of the time you’re able to get your money into your checking account within 24 hours. Money that’s “invested” in a whole life policy is much less liquid- meaning that it’s much harder to take money out of the policy than it would be for other investments.
  • “Guaranteed” does not equal “Better”: Whole life insurance generally has a “guaranteed” investment return associated with the cash value of the policy. Very conservative investors tend to highlight this as the primary reason to invest in a life insurance policy.  The only issue?  These guaranteed returns are usually way below the historical average for investments in the market.  Again, investing in life insurance is just a terribly inefficient way to invest.
  • Hidden Fees and Commissions: Finally, there are a lot of hidden fees and charges baked into the premiums you pay for whole life insurance. And, they can be huge.  Frequently, the life insurance salesperson who tries to sell you whole life insurance gets paid 100% of your premium for the first year you buy the policy, and a good cut of the premium each year thereafter. No wonder these life insurance reps almost always recommend whole life insurance over term insurance!  Simply put, life insurance salespeople are paid an astronomical amount to push whole life policies, even when term life insurance may be more appropriate.  Just say no.
So, What to Do?

If you need life insurance, find a fee-only insurance agency or financial planner to discuss appropriate coverage amounts.  “Fee-only” generally means that the advisor isn’t paid by commission and charges a level fee regardless of what you buy.  This helps to put you and the advisor on the same side of the table and removes conflicts of interest, to allow you to get the best advice possible.

An advisor who charges a flat fee is able to analyze your situation and get paid the same amount regardless of what type of policy they recommend.

And whatever you do, look for low-fee, low-cost term insurance first when you are considering life insurance.  If you want to invest, invest in the stock and bond market.  Use your life insurance for just that- life insurance.  Your wallet will thank you!

Should I Pay More Than the Minimum Toward My Student Loans, or Should I Save More for Retirement?

Over 40% of people under 30 are currently making student loan payments.  That’s a staggering number.  And while we often think of how these payments affect our current financial picture (I certainly know how it feels to see that withdrawal come out of my account every month!), the effect on our financial future is very much overlooked.

Simply put, how will our student loan payments affect how much we save for retirement?

Well, that’s not a hard question to answer.  If we can’t save as much now, we’ll have less later.  Thanks for that, Bill.

Fair enough.  Let me rephrase the question.  Say you are at a point in your career where you have some flexibility in your budget.  Even after you’re making your loan payments, you’re still able to save for retirement each month.

The question then becomes- is it better for you to pay down you loans quickly by making more than the minimum payment, rather than putting that money into a retirement account?

That’s a much more interesting question.  Let’s take a look.

Research Says…

Earlier this year, HelloWallet (a Morningstar-affiliated company) produced a report on the relationship between student loan debt and retirement.  The results, while not unexpected, were alarming.  They found that student loan balances directly correlated with having less money to spend in retirement.

HelloWallet even puts a number on it- for every dollar in student loan debt you owe, you’ll have $0.17 less in retirement.  Financial guru Clark Howard (one of my biggest influences) extrapolated from the report that because of the negative effects student loans have on retirement balances, “… in most circumstances, it’s better to save more for retirement than pay extra toward your student loans…”

Generally speaking, they’re right.  If we are just looking at two goals- paying off your debt versus saving for retirement-  most borrowers will come out ahead in retirement if they make the minimum student loan payment every month now and put their excess savings toward retirement, rather than trying to pay off the student loan ASAP at the expense of retirement saving.

It’s All About Compound Interest

What to do with the money you save each month comes down to the rate you earn and the length of time you are saving.  Investing more for retirement early in your career has exponential benefits to the money you’ll have available at retirement.

Take a look at the numbers.  The chart below shows how much you’ll have at age 65 if you start saving $100 a month at certain ages, assuming a 6% growth rate:

blog-post-3-chart-1

Notice anything?  Take a look at the difference in retirement values if you start saving at age 25 versus age 30.  For the 25 year old, over 25% of the account value at retirement comes from the $100/month invested between ages 25 and 30!

This idea of compound interest clearly illustrates the perils of paying down student loans at the expense of your retirement savings.  The earlier you start saving for retirement, the exponentially better off you will be when it comes time to retire.  The degree to which your student loans impact your saving will directly impact your retirement picture.

Let’s take a look at an example.

Meet Sarah

Sarah is a 25 year old lawyer who is hoping to retire at age 65.  She has a total of $25,000 in loan debt (point taken, after 3 years in law school, she probably has a lot more than that, but let’s keep the numbers easy to work with, OK?) and is on a standard 10 year repayment plan, paying $265.16 each month.  Her loans have a 5% interest rate.

On top of these loan payments, she’s able to save $200 extra per month to put toward retirement.  Once she’s done paying off her loans in ten years, she will put that extra $265.16 toward retirement as well, increasing her total monthly retirement savings to $465.16.  Sarah’s retirement savings earns 7% a year (about what the stock market has historically made on average).

Sarah is wondering whether or not she should continue to save $200 dollars per month for retirement now, or whether it might make sense for her to, say, put $100 of that money each month as an “extra” payment on her student loans to pay off the loan faster, and keep contributing the remaining $100 toward retirement.

What’s Sarah’s Best Option?

In the first scenario (saving $200 a month), by the end of her 10 year loan payment period, the loan is paid off and Sarah has ~$35,000 saved for retirement.  She then increases her payment amount as scheduled, and by the time she retires, her retirement accounts are worth $853,399.48.  Not too shabby!

But, what happens if she uses half of her monthly savings to pay off her loan faster? She is able to pay off her loan in just over seven years, and the second she pays off her loan, she increases her retirement savings per month from $100 to the full amount of $465.16.  Even though she’s able to contribute more over the first ten years in this example, take a look at her retirement account value.  She only has $823,844.59 at retirement this time.

blog-post-3-chart-2

This is a great example of the power of compound interest.  The more Sarah starts to save for retirement today, the more she’ll have at retirement.  Even if she has to pay a higher amount on her student loans.

Some Caveats

Again, there are a lot of factors at play here.  Not everyone is in the same position as Sarah.  This example doesn’t take into account a few points:

  • If your situation is an outlier, I’d recommend crunching the numbers to evaluate the strategy before you make a decision. What do I mean by outliers?  Cases where one of the factors we are looking at is either very high or very low.  For example, If you have a very high student loan balance, or very high interest rates, or are a very conservative investor (ie, you might not want to invest in a way that will lend itself to a 7% annual growth rate as identified above), carefully evaluate these factors before making a decision.
  • Of course, in this post we’re only looking at two goals: paying down student loans and retirement saving. If you have multiple goals you’re trying to save for at once, a more detailed plan is needed.  In particular, if you are weighing paying down student loans quickly versus a more near-term savings goal (ex: buying a house in five years), this decision is much less clear cut and needs to be evaluated.
  • This whole exercise assumes that you can afford to save beyond your monthly budget. If you can’t, definitely make the minimum payments on your loans.  In addition, you should review whether an income repayment plan may be a good fit for you.  Finally, review your budget to see if there are any ways to trim back on spending or increase your income.
  • We haven’t even addressed that most employers offer a match on funds that you invest in your 401(k). If your employer matches, putting extra money toward your loans at the expense of retirement saving becomes even costlier.  Employer matches on 401(k)s are the closest thing out there to free money, after all!
  • Most importantly, Sarah in the example above is incredibly disciplined financially. Not only is she diligently saving $200 a month (either in her retirement account, or split between retirement savings and making payments on her loans), but she also has the discipline to redirect her entire student loan payment amount into her retirement savings the second her loan is paid off.  This is much harder to do in practice than it is on paper, so it’s important to plan ahead and hold yourself accountable.

A Word on Interest Rates

Interest rates on student loans vary wildly.  Some can be as low as 2-3%, others can be in double digits.

Like I mentioned earlier, the average return in the stock market has historically been about 7%.  If your student loan interest rates are higher than this, it’s not a bad idea to prioritize payments to pay down the high interest rate loans first.

Particularly if these high interest rate loans are private loans, refinancing into a lower rate loan is a great option for those who have good credit scores.  For more information on this, sign up for my newsletter to download a free copy of my eBook on student loans.

Conclusion

There’s some good research out there that recommends to usually save for retirement before making extra student loan payments.  Don’t take that as the gospel truth, but generally speaking, this approach is the correct one.  In most cases, the benefits of having money in your retirement account to compound in value over time will outweigh having to pay your student loans a little bit longer.

Carefully look at your personal budget, student loan balance, interest rates, and retirement goals to make these decisions.  And don’t be afraid to reach out to an expert for a second opinion.