MONEY Investing

Why I Won’t Own Bond Funds in My Retirement Portfolio

Trays of eggs
James Jackson—Alamy

Owning a mix of stocks and bonds is supposed to help protect your portfolio from losses. But bonds aren't the safe asset they once were.

When stocks took a tumble last week, financial pundits were quick to call it a “potent reminder” to investors of the importance of having some bonds in your portfolio for their perceived safety and yield. The classic mix is supposed to contain 60% stocks and 40% bonds, with bonds supposedly cushioning the risk of equities. In the eyes of most investment experts, I would be considered foolish to be 100% in stocks, as I have been ever since I started investing.

But I’m not sure what bonds they’re talking about. Yes, last week the yield on a 10-year U.S. Treasury note surprised everyone by falling sharply to 1.85%, as bond prices soared—when bond prices rise, bond yields fall, and vice versa. Treasury yields edged back up to 2% the next day, as stocks rebounded. Wall Street experts are still trying to determine the reasons behind the 10-year Treasury note’s plunge, which stunned investors and traders.

But that was a one-day event. When you look at the decline in bond yields over the last three decades, I don’t understand how it is mathematically possible for Treasuries—known as the safest bond possible—to protect a stock portfolio against major shocks over the next 20 years.

No question, falling interest rates have been a boon to fixed-income investors over the last three decades. The yield on a 10-year bond has fallen from 14% in 1984 to 8% in 1994 to 4% in 2004 to about 2% today. The decline hasn’t been non-stop—bonds have rallied along the way—but the overall downward trend has most certainly pushed up fixed-income returns. As a result, bond funds have both made money and helped lower risk in a portfolio. This chart created by Vanguard, based on market data between 1926 and 2011, shows the impact of adding bonds to dampen volatility (as measured by standard deviation), while not drastically reducing returns.

Screen Shot 2014-10-20 at 10.04.52 AM

But those conditions, and that steady decline in rates, no longer exist. Today we have an environment where rates have very little room to fall and at some point will go up (we just don’t know when). Once rates finally rise, bond prices will fall, which means investors will lose money. So when someone recommends diversifying one’s portfolio with bonds these days, I wonder: is there some kind of bond that’s immune to interest rate rises that I don’t know about?

Junk, or high-yield, bonds certainly don’t fit the bill as they are also vulnerable to rate hikes. Moreover, there have been warnings that the accumulation of high-risk corporate and emerging markets bonds by mutual fund companies such as Pimco and Franklin Templeton could create a liquidity crisis in the future. Investors have been pouring money into these funds, but shocks could turn into even larger debacles when investors look to liquidate and the large amounts held by fund companies become hard to sell.

Short-duration bond mutual funds might be less affected by rising interest rates. Fidelity has a whole suite of such funds, which the fund group says “can help investors in a low and/or rising rate period.”

There are also mutual funds that “ladder” bonds with staggered durations so that a portion of the portfolio will mature every year. The goal of these laddered bond funds is also to achieve a return with less risk over all interest rate cycles.

The problem for investors saving for retirement is that the returns on such funds are so low that it’s hard to justify allocating anything to them other than savings you will need in three to five years.

I won’t be retiring for another several decades, so at this point, a market crash isn’t really my greatest risk. My greatest risk is not growing my retirement account as much as humanly possible over the next ten to 15 years. To meet that goal, I think I should stick with equities and use any future crashes as buying opportunities. I’m not 100% comfortable with that decision, but I don’t feel I have much choice. I would love to find a bond fund that could be both a safe haven and could provide steady returns, but I just don’t think that exists anymore.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

More on investing:

Should I invest in bonds or bond mutual funds?

What is the right mix of stocks and bonds for me?

How often should I check my retirement investments?

Read next: Why Americans Can’t Answer the Most Basic Retirement Question

MONEY retirement planning

Why I Want a Real Retirement, And You Should Too

Senior on sailboat
Monika Lewandowska—Getty Images

Working longer may improve your finances. But that doesn't mean it will make you happier.

Looking forward to retirement seems irrational these days. Rising life expectancies and the increasing funding problems for Social Security and private pension plans have led to the recommendation that we defer retirement past the traditional age of 65—perhaps into our 70s and beyond. It’s getting to the point where many in my generation have started to assume that they might never retire at all.

It’s true that delaying retirement into your 70s will likely improve your financial situation. Yet in an age when work has come to permeate most of our waking hours, it seems even more important to delineate at least a decade when you’re still healthy enough to both reap the benefits of that hard work and devote your time to other pursuits. And yet the concept of a real retirement has come to symbolize financial irresponsibility or laziness or both.

This was not always the case. Over the last century, the retirement age has gone through enormous fluctuations, mostly dictated by public and corporate policy, not personal preference. In the period of 1950 to 1955, the median age of retirement was 66.9 for men and 67.7 for women, according to the U.S. Bureau of Labor Statistics. But changes in defined benefit plans increasingly encouraged early retirement as a way to cut the work force, and by 1990-1995 the median retirement age had dropped to about 62 for both men and women.

But as defined contribution plans such as 401(k)s have overtaken traditional pension plans, employers no longer have as much sway over the timing of their workers’ retirements. Instead, that decision is more often dictated by savings rates and the financial markets that drive investment performance. Once again employment rates for Americans ages 65 to 69 and 70 to 74 have begun to rise, a trend only accelerated by the Great Recession. As of September, 60% of workers age 65 or older had full-time jobs, up from about 55% in 2007.

Meanwhile, for anyone born after 1960, the “full retirement age” (meaning the age you get full Social Security benefits) is now 67, and there are strong incentives to delay benefits until 70.

The consequences of working longer on our health and well-being are largely unknown, but researchers at the University of Southern California have recently examined data from 12 countries, including the U.S., and their preliminary results are telling. Contrary to conventional wisdom that working longer provides a buffer for mental health, retirement actually reduces depression, their analysis shows. What does increase the probability of depression, and reduces life satisfaction, is not being bored by not working, but health conditions that impact the ability to go about your daily activities. While household wealth, being married and one’s level of education are all positively related to life satisfaction, income alone does not seem to have a significant effect on depression or life satisfaction.

Granted, many of us still won’t have a choice about when we retire. We may not be able to afford to stop working when we want to, or we may get forced into early retirement by the loss of a job. But we may also want to take a look at whether the work-until-you-drop ethos has become more of a cultural commandment then a financial imperative—“I’d get bored if I didn’t work” is the new corollary to the often-uttered “I’m crazy busy.” It’s as if retirement has become so elusive that we’ve decided to tarnish the whole concept. But there is nothing wrong with looking forward to retirement if one has done a decent amount of saving and planning.

I love working, but two decades from now I think I would prefer to downsize rather than stay in the workforce an extra five or 10 years in order to maintain my standard of living in retirement. (From a purely balance sheet perspective, if continuing to work has adverse effects on well-being, then the fiscal savings from delayed retirement may be offset by increased health expenditures.) Medicine may be prolonging our life, but that doesn’t necessarily mean that it’s improved the quality of the later stages of that life. I want to make sure that I have not just the time also but the ability to enjoy more than just a few years when work is no longer the priority.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY retirement planning

Why Housing Costs Are the Biggest Threat to Your Retirement

House on top of cash
Caroline Purser—Getty Images

We should be looking at smaller "starter" homes as our "stay put" homes.

If there is one thing we have been trained to fear about retirement, it’s crippling medical bills that threaten to force us out of our homes and decimate our nest eggs. But it turns out that we might be better off worrying about our future housing expenses, as these costs are the single largest category of spending in retirement.

Moreover, the costs of maintaining a home remain stubbornly high as we age, according to a new analysis by the Employee Benefit Research Institute. For those 75 and older, housing expenses accounted for a whopping 43% of spending, even as other expenditures (except for health care) dropped.

Time was that retirees were supposed pay down their mortgages or drastically downsize their homes before retirement. But that behavior has changed, perhaps as a result of the refinancing boom or the housing crash—or both. According to the Consumer Finance Protection Bureau, more people are carrying mortgage debt into their retirement years, up from 22% in 2001 to 30% in 2011.

Even as the rate of homeownership has remained stable, the median amount owed on mortgages for people aged 75 and older increased 82% during that same decade, from $43,000 to $79,000. Delinquency in paying mortgages and foreclosures also greatly increased for seniors from 2007 to 2011.

The lesson in all this is that while financing one’s home can be hugely beneficial, mortgages can grow into significant burdens when you’re living on a fixed income. The time to stretch yourself financially on a home is not when you’ve already left the workforce and have no way to make more money.

It’s not just larger mortgages that saddle retirees—it’s everything that comes with homeownership, including property taxes, homeowner’s insurance, home repairs, housecleaning, gardening and yard services. At the same time, transportation, entertainment and travel expenses all tend to decline as a natural course of retirement.

It seems that people have an easier time forgoing vacations and restaurant dining than they do square footage and lawns, which is understandable. The comforts of home can bring great stability during a time of transition. But as we struggle to figure out how much money we will need in retirement, we might need to consider how to defray the expense of these patterns.

For those in mid-career, now is the time to get control of our mortgage costs. As a recent study by Pew Charitable Trusts shows, Gen X has lower wealth than their parents did at their age, in large part because they hold nearly six times more debt, including student loans, unpaid medical bills and credit card balances. And that’s despite having generally higher family incomes than their parents did.

Given these headwinds, we may want to rethink the American way of constantly trading up to larger houses through our 40s and 50s. The more we grow accustomed to more luxurious living, the harder it will be to downsize when it makes sense. Perhaps instead of looking at smaller houses merely as “starter homes,” we should be looking at them as “stay put” homes instead.

Millennials face a different challenge. After taking longer to get started in their careers, they will end up buying houses later in life, which means they risk carrying significant mortgages into retirement. They would benefit from not biting off more than they can chew—putting more cash down than the minimum, not buying more house then they can really afford, and making sure to max out out their 401(k)s or IRAs. Home equity can be an excellent investment, but only if it enhances rather than jeopardizes financial security—now and in the future.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY real estate

The High Cost of Failing to Refinance

Many homeowners have missed out on big savings by not refinancing, new research finds. Here's why.

Until recently, I’d never seen a mortgage rate south of 6%. Of course I’d heard that rates had dropped to almost half that, and yet, for a variety of reasons, I did not take advantage of them by refinancing my existing mortgage. Though illogical, my inertia is not uncommon. According to a recent paper by researchers at the University of Chicago and Brigham Young Unversity, the “failure to refinance” strikes approximately 20% of homeowners who could greatly benefit from the lower interest rate environment.

The costs of this failure can be sizeable over time. Say you had a 30-year fixed-rate mortgage of $200,000 at an interest rate of 6.5%. If you refinanced at 4.5 % (approximately the decrease between 2008 and 2010), you would save over $80,000 in interest payments over the life of the loan, even after accounting for refinancing transaction costs. If you had refinanced in late 2012, when rates hit an all-time low of 3.35%, you would save $130,000 over the life of the loan.

Failing to refinance isn’t completely irrational. Refinancing is a difficult transaction requiring extensive paper work, an appraisal and hefty fees. All of which triggers what the researchers call “present bias,” a psychological phenomenon that makes it harder for people to make decisions that may have upfront costs but longer-term benefits.

My own story illustrates the way that present bias impacts behavior. When I bought my current home in 2007, my rate on a 30-year fixed mortgage was 6.625%. As rates began to drop, I was never entirely clear how to calculate at what point refinancing would make sense financially. At the same time, I was receiving mail offers promising to save me money merely by increasing the number of mortgage payments a year. That made me wary of being taken advantage of by lenders looking to make money in transaction costs off of unsuspecting buyers. (This wariness has also always made me distrustful of any loans with “points.”)

By 2011, however, rates had clearly fallen enough to justify a refinance. But by that point I was considering moving, and I didn’t want to go through all the paperwork and hassle if I was going to be selling soon anyway. Then, like many others, I found that my house’s assessed value had fallen sharply from my purchase price. Given the weak real estate market at the time, it made more sense to stay put. Even though I knew that refinancing would still benefit me, the uncertainty about my future brought about by market forces only delayed my decision more.

Finally, in 2013, I refinanced. I wound up borrowing more as part of another financial transaction, but at an interest rate of 3.46%, my monthly payments are almost the same as they were before. I have since heard of wise colleagues who, instead of lowering their monthly payments, refinanced from a 30-year mortgage to a 15-year mortgage and as a result will own their homes outright in half the time while making about the same payments.

Which, if you think about it, means that they overcame “present bias” twice: first in the act of refinancing, and then by forgoing having extra cash on hand to spend now in order to be debt-free in 15 years. At the end of the day, refinancing isn’t just about saving money; it’s about what you do with that money that can make a huge difference to your long-term financial security.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY 401(k)s

Why Your 401(k) May Only Return 4%

Faucet dripping coins
peepo—Getty Images

The biggest dilemma in retirement investing may be how hard it will be to grow our savings in the next decade.

There have been a lot of predictions from professionals lately about what kind of returns we can expect on our investments, and it doesn’t look good. In June PIMCO bond guru Bill Gross announced at the Morningstar conference (and subsequently to almost every media outlet in existence) that a close-to-zero interest rate was the “new neutral.” Gross envisions a market where bonds return just 3% to 4% a year on average, while stocks return a modest 4% to 5%.

Gross’s forecast echoes that of a number of other investment experts, including Ray Dalio, the head of Bridgewater Associates, the world’s largest hedge fund, who called this post-Recession era we are in “the boring years,” during which investors are likely to earn returns of just 3% for bonds and 4% for equities.

These low-return predictions are based, in part, on diminished expectations for the U.S. economy, with the IMF recently warning that our GDP growth may get stuck at 2% for the long term unless Washington adopts significant reforms.

A 4% return would be a huge decline from the historical performance of the U.S. stock market, which has earned an average annual 10% over the last 40 years. Many financial planners still use 8% to 10% as the expected return for stocks in 401(k)s and other investment portfolios. All of which presents a real predicament for those of us in the middle of our careers who have been assuming strong growth will carry us over the finish line.

You see, the real benefit of starting to invest early, the reason people in their 20s are exhorted to open retirement accounts, has always been the power of compounding in the last 10 or so years of a 40 year horizon—the hockey stick uptick on a line graph. But in order to experience that exhilarating growth curve, you need to earn an average annual return in the high single digits, not the low single digits. Compounding simply doesn’t have as much power if you start off earning 10% for 20 years and then earn only 4% for the second 20 years.

If these predictions come true—and I hope that they won’t—it will be much more difficult to make money off of money in the future. This will impact just about everybody age 40 or older: current retirees and people living off fixed incomes, those hoping to retire in five to ten years, and those in mid-career who will need to rethink their strategy moving forward.

The only real solution, as far as I can tell, is to save more and spend less. You can try to earn more, but another strange feature of this recovery-that-doesn’t-feel-like-a-recovery is that while unemployment has dropped, wages have remained stagnant. Besides, depending on your tax bracket, you would have to earn a lot more to get to the same amount after taxes that you could put aside by saving.

So while the investment pundits are making their predictions and coining their phrases, allow me to offer my own: we may now be entering the era of the New Frugal. After three decades of a declining personal savings rate, from 10% in the 1970s to 1% in the 2000s, the financial crisis of 2008 brought savings back up above 5% where it continues to hover. My prediction is that if stock market returns become stagnant, we might continue to see a reduction in consumption and an increase in savings.

What this all means for the economy as a whole I will leave to the experts to ponder. All I know is that if I can no longer expect a 10% average annual return on my retirement fund, I’m going to be a heck of a lot more conservative about how much I spend.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY retirement planning

How Today’s Workers Can Dodge the Retirement Crisis

For Millennials and Gen X-ers, it all depends on whether we can rein in spending after we stop working.

Trying to figure our whether mid-career folks like myself are adequately preparing for retirement can get a bit confusing. If you look at Boston College’s National Retirement Risk Index (NRRI), as of 2013 as many as 52% of households aged 30-59 are at risk of falling at least 10% short of being able to produce an adequate “replacement rate” of income.

That doesn’t sound too good, does it? But a discussion of the methodology of this survey and others at a recent meeting of the Retirement Research Consortium in Washington D.C., shows that things might not be so dire after all.

It turns out that the NRRI might be setting an unrealistically high bar for retirement income. The index’s replacement rate assumes that a household’s goal is to maintain a spending level in retirement that is equal to their pre-retirement living standard. It also includes investment returns on 401(k)s and IRAs in its calculation of pre-retirement income, even though those earnings are specifically earmarked for post-retirement. By including those investment gains, the NRRI may be targeting a replacement rate that is too high, causing more households to fall short, as Sarah Holden, director of retirement and investment research at the Investment Company Institute, pointed out in the meeting.

It’s already hard for someone in their 30s or 40s to figure out how much they need to be contributing today to replace the income they will have right before they retire. Adding to this guessing game is the debate over whether spending really goes down in retirement. You’ll pay less for work lunches, commuting expenses, and so on, but you might spend more for travel in the early years of retirement and, later on, more for health care costs.

In contrast to the NRRI calculations, many financial planners assume that would-be retirees will automatically cut spending when their children turn 21, and therefore only need to replace about 70% to 80% of their pre-retirement income. But as Frederick Miller of Sensible Financial Planning explained at the consortium’s meeting, that’s simply not the case anymore. He sees many clients continuing to support their adult children, helping them to pay for health insurance, rent, graduate school or a down payment on a home. While generous, this support obviously detracts from retirement savings.

So which assumption is correct? Should we be saving with the expectation of spending less in retirement or not? In reality, we should certainly prepare for eventually reducing consumption since, in the long run, we may have no choice about doing so. When spending does decline after retirement, it is almost twice as likely due to inadequate financial resources rather than voluntary belt-tightening, as Anthony Webb of Boston College discovered in a small survey of households.

The question of how much is enough will vary greatly by household. But it’s clear that my generation, and those that follow, face stiff headwinds—longer life expectancy, a likely reduction in Social Security benefits, and low interest rates, which greatly reduce the ability to generate income. Cutting back on spending during retirement, as well as during our working years, may be the single greatest contributor to our financial security that we can control.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY Social Security

Why Millennials and Gen Xers Shouldn’t Diss Social Security

Don't fall for the myth that Social Security runs dry after Baby Boomers retire. You'll still get most of the promised benefits.

Ask your average American born after 1964 what they think about Social Security and they will probably say something like, “I’ll never see any of it. When I get those statements in the mail I just throw them away.” For this we have to thank (among others) novelist Douglas Coupland, author of Generation X, who back in 1991 said in an interview, “I don’t think anyone honestly expects to collect a single penny they pay into Social Security…The day you want to go collect your money the system will have just gone bankrupt buying a jewelled stereo system for Jane Fonda’s walker.”

It is true that timing is terribly unkind to me and my peers—the Social Security trust fund reserves will be depleted in 2033, the same year I will be turning 65, according to the most recent board of trustees report.

And it is equally true that this depletion will be due to ballooning expenditures for Baby Boomer beneficiaries that will begin to create a steeply rising deficit in about 2019. But this does not mean that Social Security will not be there for me when I retire—which is what more than 80% of Millennials and Gen X-ers believe, according to a survey released last monthby the TransAmerica Center for Retirement Studies.

Social Security gets money to make payments to retirees in three ways: through taxes on current workers, through taxes on the benefit payments, and through interest income on a trust fund of about $2.6 trillion as of the end of 2013. (The Department of the Treasury invests the trust fund in special, non-marketable government securities, which may explain why it only made 3.75% last year—more on that later.) As the program begins to run a larger and larger deficit, the shortfall will be made up by eating into the reserve fund itself. That’s what will be depleted by 2033, but not the entire program, which anticipates being able to pay approximately 75% of scheduled benefits between 2033 and 2088.

75% isn’t as good as 100%, but I’ll take it. (I’m not as sure about deferring benefits to age 70, even though the economic advantages of doing so make Michael Kitces describe deferral as “the best annuity money can buy.”)

According to projections done by the Employee Benefit Research Institute, between 73% and 76 % of people in 401(k) plans will still have a “successful” retirement (defined as being able to replace between 60% to 80% of pre-retirement income) even with reduced Social Security benefits, compared to between 83% and 86% of people reaching “successful” retirement at current Social Security benefit amounts.

Those projections assume a retirement at age 65. They also assume that nothing will be done to “fix” the projected shortfall, such as raising taxes or more actively managing the trust fund investment to get a higher return, both of which would be extremely controversial solutions. Something must be done, if only, as the trustees warn, to avoid the increasing strain that the trust fund deficit will also put on the unified Federal budget. If there’s one fiscal issue Millenials and Gen Xers could both rally around, this should be it, and yet the problem seems to be met with apathy, perhaps owing to the misunderstanding that we no longer have anything at stake.

I used to like getting those statements of estimated benefits, the ones called “what Social Security means to you.” After suspending those mailings due to financial cutbacks, Social Security will once again send estimates but only at five-year intervals (you can also get them online.) Don’t disregard them. Social Security will still mean an awful lot.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management.

More on Social Security:

 

MONEY 401(k)s

Why This Popular Retirement Investment May Leave You Poorer

140718_REA_TARGETFUNDS
slobo—Getty Images

Target-date funds are supposed to be simple all-in-one investments, but there's a lot more going on than meets the eye.

Considering my indecision about how to invest my retirement portfolio (see “Do I Really Need Foreign Stocks in My 401(k)?”) you would think there’s an easy solution staring me in the face: target-date funds, which shift their asset mix from riskier to more conservative investments on a fixed schedule based on a specific retirement date.

These funds often come with attractive, trademarked names like “SmartRetirement” and are marketed as “all-in-one” solutions. But while they certainly make intuitive sense, they are not remotely as simple as they sound.

First introduced about two decades ago, the growth of target-date funds was spurred by the Pension Protection Act of 2006, which blessed them as the default investment option for employees being automatically enrolled by defined contribution plans, such as 401(k)s. And indeed, investing in a target-date fund is certainly better than nothing. But the financial crisis of 2008 raised the first important question about target-date funds when some of them with a 2010 target turned out to be overexposed to equities and lost up to 40% of their value: Are these funds supposed to merely take you up to retirement, or do they take you through it for the next 20 to 30 years?

The answer greatly determines a fund’s “glide path,” or schedule for those allocation shifts. The funds that take you “to” retirement tend to be more conservative, while the “through” funds hold more in stocks well into retirement. Still, even target-date funds bearing the same date and following the same “to” or “through” strategy may have a very different asset allocations. For a solution that’s supposed to be easy, that’s an awful lot of fine print for the average investor to read, much less understand.

Then there is the question of timing for those shifts in asset allocation. Some target-date funds opt for a slow and gradual reduction of stocks (and increase in bonds), which can reduce risk but also reduce returns, since you receive less growth from equities. Others may sharply reduce the stock allocation just a few years before the target date—the longer run in equities gives investors a shot at better returns, but it’s also riskier. Which is right for you depends on how much risk you can tolerate and whether you’d be willing to postpone retirement based on market conditions, as many were forced to do after 2008.

In short, no one particular portfolio is going to meet everyone’s needs, so there’s a lot more to consider about target-date funds than first meets the eye. If I were to go for a target-date fund, I would probably pick one that doesn’t follow a set glide path but is instead “tactically managed” by a portfolio manager in the same manner as a traditional mutual fund. A recent Morningstar report found that “contrary to the academic and industry research that suggests it’s difficult to consistently execute tactical management well, target-date series with that flexibility have generally outperformed those not making market-timing calls.”

Maybe it’s the control freak in me, but I prefer selecting my own assortment of funds instead of using a target-date option where the choices are made for you. Granted, managing my own retirement portfolio was a lot simpler when I was young and had a seemingly limitless appetite for risk. But even as I get older and diversification becomes more important, I still want to be in the driver’s seat. Anyone can pick a target, but there is no one, single, easy way to get there.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management.

Related links:

 

MONEY retirement planning

Saying No Put Me on the Path to Financial Independence

House key in ring box
Dmytro Lastovych—Alamy

How I learned delayed gratification means opening the door to your true goals, like a home or a comfortable retirement.

I was raised around a lot of money—not my own, but other people’s. Granted, by any reasonable national standard my family was well-off, but growing up in New York City meant that my playmates were the children of media moguls and Wall Street titans, so my comparison group skewed upwards several tax brackets. For a while this environment created both a sense of longing and, unfortunately, entitlement. Everyone else has a summer home, why can’t we?! That feeling of financial inadequacy turned out to be a blessing in disguise however, because it taught me what those moguls and titans probably already knew, which is that the most satisfying wealth is the kind that you create for yourself, dollar by dollar by dollar.

Financial independence is certainly easier to achieve with a good income. But you can also get there, or at least come close to it, by saving and investing no matter what your salary is. (See The Millionaire Next Door.) And so at the most fundamental level, independence requires that you always live well within your means. If you are not living within your means, then you are not saving, and if you are not saving, then you are not creating wealth, you are creating the opposite: need. Financial independence means not having need.

There is no saving without delaying gratification, saying no when you want to say yes—not just every once in a while but pretty much constantly. Saying no not just to the big trips or a car, but also to the expensive haircuts and the overpriced appetizers and the ballet flats with the big logo on them when a pair from DSW will do just fine. It means being chronically cheap and enjoying it. Because every no is a yes to getting things that you really, really, really want and can truly fulfill need, no matter what stage of life you are in.

In my 20s and early 30s, my biggest need, after I had established myself on a career track, was to have a place of my own. I had bounced from illegal sublets to 4th floor walk-ups and had literally begun dreaming of “discovering” an extra room in whichever cramped apartment I was occupying, a dream that I later found out was shared in the collective unconscious of similarly space-starved young Manhattanites.

At the outset, buying my own one bedroom seemed an impossibility. But after a job switch and salary raise, I began automatically withdrawing money from my checking account into a house fund. After several years, I had saved $60,000, at which point several of my relatives generously gave me gifts to increase my down payment and create enough of a cushion to meet co-op board approval. Buying that apartment at age 32 was my first major milepost on the road to financial independence, but I didn’t do it alone.

Related: Where are you on the Road to Wealth?

They helped me, I believe, because I had shown them that I understood what building wealth entailed: being a good steward of your own money, understanding that you have to teach yourself the things you don’t know, whether that’s fixed-rate versus adjustable mortgages or the value of compound interest, and yes, delaying gratification. Granted, timing was on my side—I bought the apartment in the early stages of the real estate boom as was able to later profit not only on its sale but the sale of a subsequent, larger apartment.

But having saved for a purpose once, I know that I can do it again in the future, although not whenever I want but whenever I am able. I would love to be putting aside money to install a master bathroom in my house, but right now it’s more important that my children, with whom I currently share a bathroom, have good childcare, and that I increase my funding to my retirement accounts. The master bath will have to wait.

So here’s where I’m going to get really preachy, because there’s actually another important lesson that all this delayed gratification has taught me. There will always be more and more things to save for: sleep-away camps, college funds, maybe even someday a summer cottage. Today, as I write this on a beautiful day at the end of June, I can honestly say that the path to financial independence also means being profoundly grateful for what you already have.

Ruth Davis Konigsberg, a fortysomething journalist and consultant to Arden Asset Management, writes weekly about retirement planning.

MONEY retirement planning

Your Biggest Financial Asset Is You. And That May Put Your Portfolio At Risk.

A lot could go wrong at once if you invest in the same industry that employs you. Work in real estate? Avoid REIT stocks.

You may think of your chosen career as something completely separate from your investing strategy. But according to David Blanchett, the head of retirement research at Morningstar Investment Management, your profession should play a bigger role in your investment decisions, and not just as a measure of future income. By ignoring the connection, you may be taking on more risk than you should—especially these days.

In economists’ terms, the value of an individual’s skills and talents is called “human capital,” a field pioneered by Gary Becker, a Nobel-prize winning professor at the University of Chicago who died last month. Becker’s models of human capital became the underpinning for the generally-accepted rule that young people should invest in stocks since they are still building human capital, while those in retirement who have “depleted” their human capital should have a more conservative asset allocation (although that theory is now being challenged by financial adviser Michael Kitces, among others.)

Blanchett believes that we need to go one step further and look more specifically at which industry workers are in to measure the inherent risk of an individual’s human capital. At the recent Morningstar Investment Conference in Chicago, he unveiled model portfolios for different professions (my nominal profession, journalism, wasn’t one of them, although “manufacturing” might work as a proxy—more on that later.)

How exactly do you measure the risk of human capital? Blanchett and his co-author Philip Straehl started with an equation for the variability of its return created by Roger Ibbotson. They then plugged in industry-specific wage growth rates, along with a bunch of other factors, such as the yield on the corporate bond index, for each industry to measure its relative health. (“We assume that the certainty with which the average worker within an industry gets paid a salary is the same as the certainty, priced into the bond market, with which the average company represented in the corporate bond index is able to meet its coupon and/or principal payments,” the authors explain.)

Blanchett and Strael then examined at the correlations between industry-specific human capital and the returns of 13 different asset classes. Some of the connections were intuitive—construction and real-estate had the highest correlation to REITs and high-yield bonds, while utilities had the lowest correlation to large and small growth stocks.

For investors, there are obvious implications: You should reduce your exposure to the asset classes with which your industry is already highly correlated, and increase your exposure to those with low correlation. “It’s sort of an extension of the rule that you should not hold a large amount of your own company’s stock in your portfolio,” explains Blanchett. “People tend to want to “buy what they know,” so someone who works in the tech industry buys tech stocks. I would recommend against this, with the exception of a small ‘play’ portfolio.” The same applies for health care, real estate, finance, etc., so it makes sense to prune your portfolio of specific stocks that are too closely tied to how you get your paycheck.

At a portfolio level, try to think of your profession as an asset class. In some examples Blanchett cited, if you’re a tenured professor, your job is more bond-like—low-risk but low-return—but if you work for a hedge fund, your job is more stock-like, so allocate accordingly.

When I later asked Blanchett what journalism was akin to, he responded, “Journalism would be an interesting case study. Our initial analysis is based on historical risk/correlations so I don’t think it would capture the risk of journalism today. I’m pretty sure both manufacturing and journalism are not likely to grow at the same rate as other occupations, so that’s a different risk that’s included in our model, and definitely complicates the issue.”

The fact that Blanchett and others are now looking at occupations to build portfolios points to a larger trend, which is that since 2008 human capital in general has gotten riskier across almost all professions. “In the past, a tenured professor was probably 100% bond-like, but today it might be more like 80% bond-like and 20% stock-like,” notes Blanchett. In today’s disruptive economy, stable jobs may not remain that way. Your human capital may need replenishing in the future, just like any other asset.

Ruth Davis Konigsberg, a fortysomething journalist and consultant to Arden Asset Management, writes weekly about retirement planning.

Your browser, Internet Explorer 8 or below, is out of date. It has known security flaws and may not display all features of this and other websites.

Learn how to update your browser