The Harvard Economist

Bloomberg News published a story on July 16, 2015, about a Harvard Economist who screwed up (and then saved) her own retirement. Alicia Munnell has a Ph.D. in economics and is the director of Boston College's Center for Retirement Research. The short version of the story is, she was overspending to maintain a lifestyle and made a mistake on taking a lump sum distribution on a pension.

I thought it was great of her to put this information out there and let others benefit from her experience. Everyone's financial situation is unique and that means there are no cookie cutter solutions, but there are some general guidelines you can follow. Fred Young in his classic book How To Get Rich and Stay Rich lays the basic formula out nicely.  It is, spend less than you earn and invest it something that will go up in value over time.

The problem with that, and the problem that Mrs. Munnell ran into is, most people aren't keeping track of their income and expenses. It's a rather mundane and unglamorous process, but would you rather be financially successful or in debt? The correct answer is "financially successful" and that will require some effort on your part.

That's what the Harvard Economist learned. When she started looking at her income and expenses in more detail, it became clear it was not a sustainable situation - especially not in retirement. The good news is she caught it and is now making the corrections needed to have a secure retirement.

Here's a driving test.  You are going 70 miles per hour and notice something on the road ahead.  Is it better to (1) continue driving at that speed until you are just a few feet away from whatever it is, and then slam on the brakes and hope for the best, or (2) take your foot off the gas, put a little pressure on the brake and start slowing down well before you actually need to stop? Retirement planning is a lot like that. The sooner you start, the less panic there will at the point of impact.

Extended Warranties

There is always the fear you might have a needed repair if you don't buy the extended warranty every company seems to offer at time of purchase (and many times well after that, via mail offers).  Basically, it gets down to managing risk in your life for your consumer purchases. 

What can you afford? 

Will a $500 repair send you to the payday loan operation for a high interest rate loan?  If so and the item you've purchased couldn't be lived without (like a TV or computer, or something really important like that), then maybe the warranty is the way to go.

But, as you start making the inevitable initial and replacement product purchases over your lifetime, think about how many warranties you can skip and still come out ahead.  In our case, my wife and I could have purchased a warranty on the following items:

* Washer
* Dryer
* Range
* Dishwasher
* TV
* DVR
* Computer
* Printer
* Phones
* Cars

There are more, but those are kind of the basics and it's a round number of ten.  Making a reasonable estimate of how much those ten warranties would have cost us, I'd say around $2,000 (give or take).  That's money we now have available to pay for various repairs along the way. 

And, if we don't have any repairs, then it's money in our pocket for future replacement purchases.

If you do have a problem and it's not covered by warranty, you can always drop a line to the manufacturer saying you really like the product, but expected it to last longer.  Most companies want to retain customers and they will sometimes take care of small items.  Always mention you would like to buy your replacement of whatever it is you having problems with, from them, which indicates you'll be an ongoing customer in the future.

People Who Should Be Fired

The vice president of our local office once lamented to me that we had several employees who were not taking advantage of the 401(k) match provided by our employer.  It was 50% on the first 6% of the salary we contributed.  So, someone contributing $3,000 would receive $1,500 from the company as the "match." He wondered how we could inspire people to make at least the minimum contribution so they would receive this immediate 50% return on their investment. My suggestion to him was, we ought to fire them.  If someone is not smart enough to put even a few dollars in an account where they immediately get a match of 50%, then they may not be smart enough to be working at the company.  That's a little harsh maybe, but anyone who can contribute the money and doesn't might need a refresher course in basic math.

Consumer Protection

While I'm a strong believer in free enterprise, capitalism and democracy, I think we could do a better job in the consumer protection area. We recently received a catalog in the mail and I noticed the payment options showed a credit payoff chart. This is something we didn't see a few years ago. It was an item required by law to help people understand what they are paying in the way of finance charges.

Many years ago finance companies were allowed to calculate the APR (Annual Percentage Rate) using different formulas and the result was, you couldn't tell which of the rates were better. It was possible that an advertised 14% rate was actually less expensive than a 13% rate. But you couldn't tell this because of the way the calculations hid the final amount you would pay. The consumer protection movement helped bring a change about that required all companies to display the actual, final APR for all credit. This put consumers in the position of being able to compare apples to apples, which is the way it should be.

Back to the credit payoff chart in the catalog. A purchase of $3,200 required a monthly payment of $96, for 31 years. The total paid would be $15,903. If you paid an extra $50 a month, you'd pay a total of $5,321 and it would be paid off in 5 years. Having this information displayed puts people in the position of being able to decide if they want to pay $15,903. or $5,320 or just save up and pay cash of $3,200. People are free to choose, but at least they can make an informed decision.

We've Always Done It That Way

In the business world it's bad form to say "We've always done it that way" as an explanation for a process, procedure or method of doing business. In general I agree. But, as an example of how this can somtimes be a good thing, I realized my wife and I don't know any of the terms, conditions or interest rates on any of our credit cards. Normally this is the type of information you need to stay on top of, but the reason we don't is because we always pay our credit cards off in full, every single month, within a few days of the monthly statement being issued. This one single habit saves us money (by not paying interest), time (we don't need to keep track of "payment due" dates) and any grief that might come about from getting behind on debt payments. Why do we do this? Because we've always done it that way!

The One Thing You Don't Want To Do

The one thing you don't want to do is this: Learn about compound interest too late.

Using an exaggerated example, let's say you saved $1,000 a year for 40 years (from age 25 to age 65) and kept it in your safe at home. That would give you $40,000. Then, you discover the miracle of compounding and manage to double your money just at the end of that last year with a compounding rate of 100%. That would give you $80,000.

But, what if you started out knowing about compounding and had that 40 years to make it work for you? If you saved the same $1,000 a year, but compounded it each year at 10% (the rough average of the historical market over long, long periods of time), you would end up with $486,851.

Either way you're saving $1,000 a year. The difference is simply understanding how compound interest works.

Index Funds vs. Hedge Funds

In 2008 Warren Buffett placed a bet, which essentially totaled $1,000,000, against a group of hedge funds chosen by the people betting against Buffett. Hedge funds are the go anywhere, do anything (almost), hotshot investment vehicles for sophisticated investors. His bet was that the Vanguard Index 500 (Admiral shares) would outperform this carefully selected group of five hedge funds over a 10 year period.

One of the big challenges for those hedge funds will be overcoming their expense disadvantage. Annual charges of 2.5% of the account balance are made regardless of performance. On top of that, generally hedge funds take 20% of any gains made. In a good year when your investments might grow $100,000, the hedge fund takes $20,000 of that in addition to the 2.5% annual charge on the total.

Here’s my thought: If Buffett is willing to make that kind of bet, that some of the best and brightest investment minds out there won’t be able to outperform the S&P 500 index, what makes you think you can find investments that will? If you agree, invest in broad market based index funds and go to the golf course or spend your days doing other things which might interest you more.

As of this date (2011) several hedge funds have closed their doors. Since “the bet” did not include releasing the names of the five chosen hedge funds we won’t know if any of the chosen have gone out of business or not. But, that’s another variable to consider in your investment selection and one you don’t have to worry about with good broad-based index funds.

The expense ratio on the Vanguard Index 500 Admiral Shares? It is .07% currently. That means on every $100,000 you pay $70 each year. For a hedge fund you could pay $2,500 each year on the account value at $100,000 (if they allowed you to invest that little). If the Vanguard fund goes up from $100,000 to $200,000, your total expense would be $140 for the year. A hedge fund increasing by the same $100,000 would charge you $20,000 for the investment increase and 2.5% on the account balance, roughly $22,500. Of course, if the hedge fund increases offset the expenses then you’re set. But, assuming non-offsetting underlying performance would you rather pay $22,500 or $140 in expenses for an investment?

Another nice thing about index mutual funds is, they won’t have a “lockup” period. Hedge funds may have a lockup period when you can’t access your money except at certain times (maybe quarterly or annually). Also, hedge funds do sometimes go out of business. For an example, search the Internet for “Amaranth Investors” or "Long Term Capital Management" and check their history.

Update: At the May 2, 2014 Berkshire Hathaway annual meeting, Buffett said the cumulative return of the S and P index fund has been 43.8%, while the hedge funds returned 12.5%.