MONEY consumer psychology

7 Reasons to Pretend You Make Less Money

Trick your brain and your wallet will follow.

We all know you can get in financial trouble by pretending to have more money than you actually do — and most of us know that you can’t make an educated guess at someone’s salary by checking out the car they drive. So you can appear to be wealthy even if you’re not. But can you get ahead by telling yourself (and intimating to others) that your paycheck is smaller than it actually is? There are some pretty compelling reasons to do it, and you could find yourself in a far better position than if your paycheck just barely covers expenses.

Here are some reasons to consider pretending your paycheck is just a bit smaller than it really is.

1. Sock Away Money in an Emergency Fund

If you don’t have an emergency fund (or even if you do), you can pretty much count on having an emergency. Car transmissions break, you need to travel unexpectedly or someone in your family ends up needing help. Experts recommend six to 12 months’ worth of expenses in your emergency fund. If you don’t yet have that, you may want to make sure you have access to credit. (You can check your free credit report summary on Credit.com to get an idea of how you would be judged by potential lenders.) But having the money saved is a better alternative.

2. Pay Down Debt Faster

If you pretend you make, say, 10% less than you actually do, you can probably cut expenses to accommodate the reduced pay. But the money you will save isn’t pretend — and you can send it to your creditors, reducing or eliminating debt much more quickly. This little fib helps keep your spending in check, which will free you to direct the money someplace else, making some other dream a reality more quickly. You can even figure out a timeline for getting out of credit card debt with this nifty calculator.

3. Save for a Down Payment or Your Kid’s College

Whether you’re looking to buy a house, educate a child or take a trip around the world, your dream is likely to require a significant chunk of change. And one way to get that is to pretend that earmarked money does not even exist. You can have it transferred into a designated account the same day you get paid so that you are not tempted to use it for the heavily discounted camping equipment that you know about because the advertisement for it popped up in your inbox. (Another money-saving hint: Most of us will spend less if we unsubscribe.)

4. Put More Money in Retirement Savings

Retirement seems a long way off when you are in your 20s, and it is. But most people’s expenses grow with time (particularly if you choose to raise children). It is not going to suddenly become easier to save more, at least not until you have far less time to do it, and the money has less time to grow. How many people have you heard complaining that they wished they hadn’t saved so much for retirement?

5. Friends Won’t Pressure You to Splurge

We’re not suggesting you do away with little luxuries altogether. You and a friend want to go get manicures? Go for it (sometimes). But think about whether all of your get-togethers need to involve a meal out, shopping or manicures. Maybe they made a resolution to move more. Walks can do double duty to help get your body and finances in better shape. And if your friends know you are on a beer budget, chances are they won’t assume you have a champagne salary.

6. Friends & Family Won’t Consider You a Human ATM

Do you often or always pick up the tab for groups because you can afford it? If you say, “my treat” too often, it’s possible you’re sending a signal that because you have more, you have an obligation to share it with your friends and family. You may feel that way as well, and if you do, you would be especially wise to pretend you have a little less money than you actually do. If you do choose to give or lend money to friends and relatives, make sure everyone is clear on what is a gift and what is a loan. Money misunderstandings have the potential to damage relationships.

7. Your Income Could Drop

It’s easy — and tempting — to think your salary will be on an upward trajectory from your first day of work until your last. (Don’t the retirement calculators assume that?) And who plans for a furlough or the loss of a big client? During hard times, it’s not unheard-of for companies to levy across-the-board salary cuts. And if you’re acting as if you make every dime that you actually do, it will be harder to adjust than if you’ve been acting as if you made less.

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This article originally appeared on Credit.com.

MONEY Millennials

How to Set Financial Priorities When You’re Young and Squeezed

man counting coins
MichaelDeLeon—Getty Images

You have a lot of demands on your money—and not a lot of it. Here's what to do first.

The most financially challenging state of life is not retirement, it is early career.

That’s the time when your salary is still probably low, but you have the longest list of expenses: career clothes, cell phone bills, your first home furnishings, cars, weddings, rent—need I go on? You probably don’t have enough money to pay for all of that at once, unless your parents have set you up very well or you are a junior investment banker.

The rest of us have to make choices with our limited “discretionary” income. Here is a rough priorities list for newbies who have shopping lists that are bigger than their bank accounts.

First, feed the 401(k) to the match, not the max. If your employer matches your contributions, make sure that your paycheck withdrawals are high enough to capture the entire company match. That is free money. If you have enough money to contribute more to your 401(k), that is a good thing to do, but only if you’re able to cover other key expenses.

Invest in items that will improve your lifetime earning power. A good interview suit. An advanced degree. The right electronic devices and services for the serious job hunt.

Pay off credit card balances. Chasing those “balance due” notices every month will kill just about any other financial goal you have. If you’re carrying significant credit card balances, abandon all other extra savings and spending until you’ve paid them off, in chunks as large as possible.

Put money into a Roth individual retirement account. The younger you are and the lower your tax bracket, the better this works out for you. Money goes in on an after-tax basis and comes out tax-free in retirement. You can withdraw your own contributions tax-free whenever you want. Once the account has been in existence for five years, you can pull an additional $10,000 out, tax-free, to buy a home. It’s nice to have a Roth, and the younger you start it the better.

Save for a home down payment. Homeownership is still a smart way to build equity over a lifetime. New guidelines will once again make mortgages available to people who make downpayments as low as 3%. Even though interest rates are still at unrewarding lows, it’s good to amass these earmarked funds in a savings or money market account.

Pay down high-interest student loans. If you had private loans with interest rates over 8%, find out whether you can refinance them at a lower rate. If not, consider paying extra principal to burn that costly debt more quickly. Don’t race to pay off lower-interest student loans; the interest on them may be tax deductible, and there are better places to put extra cash.

Buy experiences, not things. Still have some money left? Fly across the country to attend your college roommate’s wedding. Take road trips with friends. Spend money to join a sports team, theater group, or fantasy football league. Focus your finances on making memories, not acquiring things—academic research holds that you get more happiness for the dollar by doing that, and you’ll probably be moving soon anyway.

Buy a couch. For now, make this the bottom of your list. Sure, everyone needs a place to sit, but there’s nothing wrong with living like a student just a little bit longer. If you defer expensive things for a few years while you put money towards all the higher priorities on this list, you’ll be sitting pretty in the future.

UPDATE: This story has been updated to clarify that Roth IRA holders can withdraw their own contributions at any time and do not have to wait until the account is five years old.

MONEY retirement income

The Single Biggest Retirement Mistake

faucet pouring money into bottomless bucket
C.J. Burton—Corbis

Don't think of your retirement savings as one big bucket of money. Instead, divide up your assets.

The single biggest retirement mistake I see is that retirees don’t set aside funds for income during the early years of their retirement. They go directly from accumulating retirement funds to withdrawing them. And that can be a big problem.

Let me explain. The usual approach to retirement savings is to treat the client’s funds as if they are all in one pile. Under this method, the account is divvied up between stocks, bonds, and cash. A systematic monthly withdrawal begins to provide income, typically starting out at 4% of the client’s portfolio value for the first year. Each year afterward, the withdrawal amount is adjusted upward to match inflation.

This rate is considered by many advisers to be safe in terms of generating sustainable income over a two- or three-decade retirement. Unfortunately, it leaves many clients concerned about outliving their money. Let’s use 2008 as an example. At the time, I saw recent retirees who had $1,000,000 in their 401(k)s and who thought, based on the 4% formula, that they were set with $40,000 of annual income. Within the first year or two of their actual retirement, however, the market crashed and they were then drawing on a balance of $600,000. Most could not decrease their expenses, so they continued to withdraw $40,000 through the downturn, which was an actual withdrawal rate of almost 7%.Worse yet, the market crash caused retirees to lose confidence in their original plans. They pulled most, if not all, of their retirement funds out of the market, thus missing the ensuing recovery.

The compounding errors of higher-than-anticipated withdrawal rates and bad market-timing decisions doomed many to outliving their funds. This syndrome actually has a name: “sequence risk.” Academics are well aware of this risk, but few planners properly address the issue with clients and almost no individual investors are aware of the concept.

The problem can be alleviated by setting aside up to ten years’ worth of income at the inception of retirement. I address this problem with an approach called the Bucket Plan, which segments a retiree’s investible assets into three categories, or buckets.

Here is the breakdown:

  • The “Now” bucket is where the client’s operating cash, emergency funds and first-year retirement income reside. It will typically be a safe and liquid account such as a bank savings account, money market fund, or CD. These are the funds on which the client is willing to forgo a rate of return, in order to keep them safe and liquid. The amount allocated to the Now bucket will vary based on the clients assets and sources of income, but typically you would want to see no less than 12 months of living expenses here.
  • The “Soon” bucket has enough assets to cover up to ten years’ worth of income for the retiree. The Soon bucket is invested conservatively with little or no market risk. That way, we know we have ten years covered going into the plan regardless of what the stock market does.
  • The “Later” bucket funds income, and hopefully an increase in income, when the Soon bucket is exhausted. By then, the Later bucket has been invested uninterruptedly for at least 10 years. We reload another round of income into the Soon bucket, and the process starts all over again. The Later bucket is the appropriate place for capital market participation.

Financial planners have long used the analogies of an emergency fund and an accumulation/distribution fund. The real innovations here are the addition of the Soon bucket for near-term income and the method for communicating the concept to clients.

A client who was recently referred to me had the 4% systematic withdrawal that most financial advisers recommend. This did not seem to make him happy, though, since he could not see how his finances would last in the long run. He was not confident about what might happen if he needed more than the 4% income because of an emergency. He wondered whether there would be anything left over for his children to inherit. He was losing sleep and not enjoying his retirement at all.

I explained our Bucket Plan method. The Later bucket funding the Soon bucket made perfect sense to him. He also loved the idea of the Now bucket for emergencies and unexpected expenses. The real beauty of this approach is it gives retirees great peace of mind. They are much less likely to make bad market-timing decisions because a market correction will have no effect on their current income.

The bucket concept is simple to explain, and clients always understand the role their money is playing and why. Most importantly, they have the confidence to ride out market volatility because they know where their income is coming from. Sometimes simplicity can be quite sophisticated.

———-

Jeff Warnkin, CPA and CFP, of the JL Smith Group, specializes in holistic financial planning for pre-retired and retired residents of Ohio. He incorporates investments, insurance, taxes, and estate planning when building financial plans for clients’ retirement years. Warnkin has more than 25 years of experience in the financial services industry, and is life- and health-insurance licensed.

Read next: Here’s a Smart Strategy for Reducing Social Security Taxes

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MONEY Financial Planning

5 Simple Questions that Pave the Way to Financial Security

Analyzing 20 years of data, the St. Louis Fed found that five healthy financial habits are the key to future wealth.

Want to know how your bank account stacks up against that of your neighbors? You’ll get an idea by asking yourself five simple questions, new research shows.

The St. Louis Fed examined data from the Federal Reserve’s Survey of Consumer Finances between 1992 and 2013 and found a high correlation between healthy financial habits and net worth. In the surveys, the Fed asked:

  • Did you save any money last year? Saving is good, of course. Just over half in the survey earned more than they spent (not counting investments and purchases of durable goods).
  • Did you miss any credit card or other payments last year? Missing a payment isn’t just a sign of financial stress; it may trigger late fees and additional interest. An encouraging 84% in the survey made timely payments.
  • After your last credit card payment, did you still owe anything? Carrying a balance costs money. In the survey, 44% said they carried a balance or recently had been denied credit.
  • Looking at all your assets, from real estate to jewelry, is more than 10% in bonds, cash or other easily sold, liquid assets? If you don’t have safe assets to sell in an emergency, you are financially vulnerable. Just over a quarter of those in the surveys have what amounts to an emergency fund.
  • Is your total debt service each month less than 40% of household income? This is a widely accepted threshold. A higher percentage likely means you are having trouble saving for retirement, emergencies, and large expenses.

The average score on the 5 questions was 3, meaning that the typical respondent—perhaps your neighbor—had healthy financial habits 60% of the time. That equated to a median net worth of $100,000. Those who scored higher had a higher net worth, and those who scored lower had a lower net worth.

In general, younger people and minorities scored lowest, while older people and whites scored highest. Education was far less relevant than age. “This may be due to learning better financial habits over time, getting beyond the financial challenges of early and middle adulthood and the benefit of time in building a nest egg,” the authors wrote.

It should come as no surprise that healthy financial habits lead to greater net worth over time. But the survey suggests a staggering advantage for those who ace all five questions. One of the lowest scoring groups averaged 2.63 out of 5, which equated to median net worth of $25,199. One of the highest scoring groups averaged 3.79 out of 5, which equated to a median net worth of $824,348. So these five questions not only give you an idea where your neighbors may stand—they pretty much show you a five-step plan to financial security.

MONEY Aging

When Dementia Threatens a Family’s Finances

Grandfather at table of food
Getty Images

One in three adults will suffer from dementia. Here's how to achieve financial security — and a patient's dignity — when that happens.

My client sat across the table telling me about her late husband — first, his diagnosis of dementia, and then, his suicide a few years later.

On the night before he took his own life, she had finally gathered the strength to tell him he needed to turn their finances over to her. Larger than life when he was healthy, he had been a tremendous businessman. But the dementia had robbed him of sound decision-making, and she needed to protect what was left of their shrinking nest egg.

She asked me, “What should I have done?”

In the years since his death, she couldn’t help wondering whether that final financial conversation had been the tipping point in his waning will to live. It wasn’t her fault; she had supported him throughout his illness with an unmatched strength of conviction and marital devotion. It’s pointless to try to judge the effect of a particular conversation, because he had suffered for a decade. The disease had torn through their lives, leaving a series of wreckages: their relationships, his ability to handle even menial tasks, and — perhaps most painful — his self-esteem.

I told my client she had been in a no-win situation. She couldn’t risk her own future welfare by allowing her husband’s disease to squander all they had worked for. She was in her 60s, very healthy, and had a 100-year-old mother whose zest and longevity foretold of my client’s likely need to support herself for another 30-plus years. To protect herself and her husband from risky investments, unwise purchases and even fraud, my client needed to take over the financial reins. But how do you conduct this crucial conversation about control without robbing a dementia patient of his or her already-declining dignity? With the Alzheimer’s Association reporting one in three seniors in the United States contracts Alzheimer’s or dementia, it’s time we start talking about it.

Some advice:

Avoid a crisis. Don’t wait to have one huge conversation. Ideally, you would have a series of talks before anyone is diagnosed with dementia. As part of an overall estate plan, it’s important to discuss all family members’ wishes for the end of their lives and prepare them for the possibility of losing their independence. It may sound trite to say, “One day, Dad, we may take care of you the way you took care of us,” but laying that foundation ahead of time may soften the blow. It’s nice to think that we live on our own until the end, when we quietly pass in our sleep, but that isn’t our current reality. Medical advances have been successful in prolonging our lives, but not at guaranteeing our independence.

Having a big discussion that feels like a dementia patient is the subject of an intervention is stressful for all involved. Save the intervention-type conversations for true emergencies, and recognize the patient needs to feel safe and loved, not confronted.

Understand the backstory. Everyone brings a different money mindset to this conversation. Ask yourself, why is money important to this patient? Is it imperative to provide for the family? Is it a priority to give it away? Open the conversation by affirming the ways the patient has accomplished his financial objectives until this point.

Take into account any major financial experiences that may be coloring this particular conversation. Olivia Mellan, a psychotherapist specializing in money conflict resolution, points out that men and women can have different views of common financial decisions. If a wife wants to open her own bank account, for example, she may simply desire some independence. Her husband, however, may interpret her wishes as a lack of marital commitment. If a dementia patient has had this kind of conflict, structure your discussion to avoid triggering those old memories and feelings.

Pick your battles. Can the patient retain investment control over a $10,000 account? Is there room in the budget for a weekly allowance so he can continue making spending decisions? Both tactics can distract the patient from participating in larger financial decisions.

Steven A. Starnes, an adviser with Savant Capital Management, tells a story about his late grandmother, who passed away from Alzheimer’s. Out shopping with her daughter, she found a relatively expensive necklace she just had to have. The family had created room in the budget for one-time splurges that would bring joy to her remaining years. As long as the purchase didn’t thwart the family’s long-term financial plans, it was okay. So Starnes’ grandmother came home with a new necklace that drew her focus away from the other losses she was experiencing.

Utilize helpful resources. Some financial advisers are a tremendous help in facilitating these conversations. A person’s declining financial abilities are often the first sign of dementia, so advisers are well-positioned to help a family. Just having an outside party to ask the tough questions can ease the pressure. In fact, some advisers, including Starnes, specialize in clients with dementia.

A growing number of professionals specialize in different end-of-life issues. The National Association of Professional Geriatric Care Managers provides information about care management and a directory of professionals who can help clients attain their maximum functional potential

Another source to locate a professional is the Society of Certified Senior Advisors listing of certificants who have demonstrated expertise in a range of core competencies involving the aging process. Among those holding CSA accreditation are financial professionals, caregivers, gerontologists, and clergy.

To help a family prepare for a discussion of changing financial responsibilities, circulate the book Crucial Conversations, by Kerry Patterson. Another great resource is The Other Talk,by Tim Prosch, which specifically addresses end-of-life conversations between aging parents and adult children. Do some research on the best ways to communicate with dementia patients. It’s difficult work, but it is possible to absolve a dementia patient of financial responsibilities while helping him maintain his dignity.

———-

Candice McGarvey, CFP, is the Chief Story Changer of Her Dollars Financial Coaching. By working with women to increase their financial wellness, she brings clients through financial transitions. Via conversations that feel more like a coffee date than a meeting, her process improves a client’s financial strength and peace.

MONEY Tech

What the Girl Scouts Are Doing at the 2015 Consumer Electronics Show

Girl Scouts mark the start of National Girl Scout Cookie Weekend in Vanderbilt Hall in Grand Central Terminal in New York.
Richard Levine—Alamy Get ready for Digital Cookie.

Attendees of the annual CES in Las Vegas expect to be overloaded with new gadgets and hi-tech wizardry. Skechers, AARP, and old-fashioned cookies are more of a surprise.

The Consumer Electronics Show, which kicks off in Las Vegas on January 6, is undeniably a big deal. The latest tech trends and exciting new gadgets aren’t the only things featured at the show; a broad spectrum of celebrities ranging from 50 Cent to Dr. Phil will also make appearances. In 2014, more than 160,000 people attended the conference (including more than 50,000 exhibitors), and 20,000+ new products were introduced to the public. The 2015 version of the World’s Largest Trade Show, as Bloomberg News put it, will feature two miles of floor space, and attendance should again surpass the total number of hotel rooms available in Las Vegas.

This year’s list of exhibitors at the CES is 125 pages long, and includes 32 separate entries alone that start with name Guangzhou, the third-largest city in China. The event draws the attention of such a vast global audience—via the media, not just in terms of actual attendance—that many organizations with seemingly nothing to do with tech and electronics feel compelled to run booths alongside, you know, actual electronics companies. Here are three surprising examples.

The Girl Scouts of the USA
This one makes more sense than you might at first think. It was recently announced that Girl Scout cookies will soon be available for sale online for the first time, and the organization is attending the 2015 Consumer Electronics Show to showcase Digital Cookie, the new program that will enable girls to sell cookies online while learning about business and tech. “Digital Cookie will introduce vital 21st-century lessons about online marketing, app usage, and ecommerce to more than one million excited Girl Scouts who will be in the driver’s seat of their own Digital Cookie businesses,” a Girl Scouts press release explains.

What’s more, venturing into online sales and attending the CES are in line with the Girl Scouts’ overarching push to keep up with the times. The organization has recently demonstrated an interest in trying to keep up with foodie trends. A gluten-free cookie was introduced in early 2014, and three new cookies go on sale in 2015: Toffee-tastic (a toffee butter cookie that’s gluten-free), Trios (peanut butter and chocolate chip, also gluten-free), and Rah Rah Raisin (oatmeal raisin with chunks of Greek yogurt—which has been a hot food trend too).

Skechers
The “innovation” that Skechers is probably best known for is the “toning shoe,” a product that supposedly helped wearers get in shape and lose weight simply by walking around in them. Those claims have since been shown to be unfounded, and in a settlement with the Federal Trade Commission Skechers agreed to issue refunds worth $40 million to customers who bought the Kardashian-endorsed sneakers.

So what’s Skechers doing at the CES in 2015? The answer has nothing to do with more dubious ideas about how wearing a sneaker will tone your legs and butt. Instead, according to Gizmodo, Skechers will be showcasing kids’ sneakers that are a “wearable version of Simon,” the classic musical memory game. Called Game Kicks, the sneakers have colored buttons that light up and make sounds, and are meant to keep kids entertained while testing their memory. Mercifully for parents, there is a mute button so kids can play silently. They’re expected to retail for $65 when they go on sale in early 2015.

AARP
For the second year in a row, the AARP (formerly the American Association of Retired Persons—now just AARP to include everyone 50 and older) has announced it will “unleash 50 tech-savvy seniors” to roam the CES in Las Vegas to test the latest tech and see just how practical and user-friendly (or not) the innovations are for older consumers. The seniors, who will wear AARP T-shirts featuring the hashtag #DisruptAging, will be sharing their thoughts and observations in a CES panel discussion.

The point, AARP senior vice president of thought leadership Jody Holtzman said in a press release, is that tech and electronics companies should be paying more attention to the needs of older Americans: “AARP is committed to showing the tech industry that people over 50+ make up a powerful longevity economy, representing 106 million people responsible for at least $7.1 trillion in annual economic activity, a group that successful businesses won’t want to ignore.”

MONEY Medicare

The Huge Health Care Expense Medicare Won’t Pay

BurwellPhotography.com—iStock

For peace of mind, you need more than Medicare.

Medicare helps more than 55 million Americans with their health care expenses, with most people age 65 or older qualifying for coverage. With benefits for everything from hospital stays to doctors’ visits, Medicare is an essential part of retirement financial planning for older Americans in dealing with one of the largest expenses they bear. Yet there’s a huge gap in Medicare coverage that doesn’t provide financial assistance for services that an estimated 70% of senior citizens will need at some point during their lives. In order to prepare yourself for those expenses, you’ll need to make separate provisions outside Medicare to ensure that you’ll have the financial resources necessary to cover the costs of care.

Nursing homes, long-term care, and the Medicare gap

Medicare covers many things, but the coverage it provides for nursing homes and other types of long-term care are extremely limited. Medicare Part A, which covers most inpatient care such as hospital visits, does make a provision for covering the costs of a skilled nursing facility. If you qualify, Medicare will pay 100% of the cost of skilled nursing facility for 20 days, and it will cover all but a $157.50 per day copayment in 2015 for the next 80 days of approved care at such a facility.

However, in order to qualify for those services, you need to have had a qualifying hospital stay of at least three days, and the care you receive at the facility must be connected to the treatment you were getting in your initial hospital visit. Once your 100 days is up, you’re responsible for all costs — and you’ll need a break of at least 60 days in a row in order to end your current benefit period and renew your benefits for future coverage.

More importantly, many people in nursing homes aren’t receiving skilled nursing services and therefore don’t qualify for Medicare benefits at all. If the only kind of care you need is custodial care such as helping you get in and out of bed, bathing, or getting dressed, then Medicare won’t cover those costs.

When it comes to home health services, Medicare also has limits. You’re entitled to up to 100 home health visits under Medicare Part A following a hospital stay, and Part B also provides certain home health benefits. But to qualify, your doctor has to certify that you’re homebound, and you must need skilled nursing care or certain other treatment such as physical therapy, speech-language pathology, or occupational therapy services. Again, Medicare won’t cover purely personal care, making seniors responsible for much of their own costs for getting in-home help.

How to bridge the gap

Unfortunately, the costs that Medicare doesn’t cover play a part in most retirees’ lives at some point during their retirement. According to a study from the Department of Health and Human Services, almost seven out of every 10 Americans turning age 65 will need long-term care at some point in their lives.

Most traditional insurance, including medical and disability insurance, follow Medicare’s rules in limiting coverage to those whom are medically necessary and involved skilled, short-term care. Even supplemental Medicare policies typically only cover the $157.50 copayment for covered services and provide nothing for long-term care.

In order to get insurance coverage for long-term care needs, you’ll need a specific long-term care insurance policy. These specialized policies cover a wide array of services, ranging from assisted living facilities and nursing homes to home-healthcare and personal care needs. Premiums depend on the age at which you buy insurance, the maximum daily coverage you choose, and the lifetime maximum benefits the policy will provide. In general, the older you are when you obtain long-term care insurance, the higher your annual premiums will be. Moreover, many long-term care policies include what are known as elimination periods, which define initial time periods of three months or longer during which you’ll be solely responsible financially for covering costs of care.

In addition, some states provide programs that assist with certain care needs for senior citizens. Nutrition programs deliver meals directly to many retirees’ homes, and transportation and personal-care assistance are aimed at making lives a little easier. Those services by themselves won’t address many of the major needs people have, but they can nevertheless help bridge some of the coverage gap in Medicare.

Medicare is a vital part of your long-term financial security in retirement, and it covers many different services. But to protect yourself against the needs for nursing and other long-term care, you’ll need to turn to alternatives to Medicare to give yourself the peace of mind that you’ll be able to cover those extensive costs.

MONEY investment strategies

Why Even “Proven” Investment Strategies Usually Fail

Monopoly money
Alamy—Alamy Beware investment strategies that haven't been tried with real money.

Anyone with a computer can find a stock picking strategy that would have worked in the past. The future is another story.

You probably know, because you’ve read the boilerplate disclaimer in mutual fund ads, that past performance of an investment strategy is no indicator of future results.

And yet, funnily enough, nearly everyone in the investment business cites past results, especially the good results. Evidence that an investment strategy actually worked is a powerful thing, even if one knows intellectually that yesterday’s winners are more often than not tomorrow’s losers. At the very least, it suggests that the strategy isn’t merely a swell theory—it’s been tested in the real world.

Except that sometimes you can’t take the “real world” part for granted.

Just before Christmas, an investment adviser called F-Squared Investments settled with the Securities and Exchange Commission, agreeing to pay the government $35 million. According to the SEC, F-Squared had touted to would-be clients an impressive record for its “AlphaSector” strategy of 135% cumulative returns from 2001 to 2008, compared with 28% in an S&P 500 index. Just two problems:

First, contrary to what some of F-Squared’s marketing materials said, the AlphaSector numbers for this period were based solely on a hypothetical “backtest,” and there was no real portfolio investing real dollars in the strategy. In other words, after the fact, F-Squared calculated how the strategy would have performed had someone had the foresight to implement it. Underscoring how abstract this was, the backtest record spliced together three sets of trading rules deployed (hypothetically) at different times. The third trading model, which was assumed to go into effect in 2008, was developed by someone who, the SEC noted in passing, would have been 14 years old at the beginning of the whole backtest period, in 2001. (The AlphaSector product was not launched until late 2008; its record since it went live is not in question.)

Second, even the hypothetical record was inflated, says the SEC. The F-Squared strategy was to trade in and out of exchange traded funds based on “signals” from changes in the prices of the ETFs. But F-Squared’s pre-2008 record incorrectly assumed the ETFs were bought or sold one week before those signals could possibly have flashed. The performance, says the SEC, “was based upon implementing signals to sell before price drops and to buy before price increases that had occurred a week earlier.” Not surprisingly, a more accurate version of even the hypothetical strategy would have earned only 38% cumulatively over about seven years, not 135%.

Call it a woulda, shoulda—but not coulda—track record.

Steve Gandel at Fortune has been following this story for some time and has the breakdown here on how it all happened. This kind of thing is (one hopes) an extreme case. But there’s still a broader lesson to draw from this tale.

Although it’s a no-no to say that a strategy is based on a real portfolio when it isn’t, there’s not a blanket rule against citing hypothetical backtest results. In fact, backtesting is a routine part of the money management business. Stock pickers use it to develop their pet theories. Finance professors publish papers showing how this or that trading strategy could have beaten the market. Index companies use backtests to construct and market new “smart” indexes which can then be tracked by ETFs. But even when everyone follows all the rules and discloses what they are doing, there’s growing evidence that you should be skeptical of backtested strategies.

Here’s why: In any large set of data—like, say, the history of the stock market—patterns will pop out. Some might point to something real. But a lot will just be random noise, destined to disappear as more time passes. According to Duke finance professor Campbell Harvey, the more you look, the more patterns, including spurious ones, you are bound to spot. (Harvey forwarded me this XKCD comic strip that elegantly explains the basic problem.) A lot of people in finance are combing through this data now. But if they haven’t yet had to commit real money to an idea, they can test pattern after pattern after pattern until they find the one that “works.” Plus, since they already know how history worked out—which stocks won, and which lost—they have a big head start in their search.

In truth, the problem doesn’t go away entirely even when real money is involved. With thousands of professional money managers trying their hands, you’d expect many to succeed brilliantly just by fluke. (Chance predicts that about 300 out of 10,000 managers would beat the market over five consecutive years, according to a calculation by Harvey and Yan Liu.)

So how do you sort out the random from the real? If you are considering a strategy based on historical data, ask yourself three questions:

1) Is there any reason besides the record to think this should work?

Robert Novy-Marx, a finance professor at the University of Rochester, has found that some patterns that seem to predict stock prices work better when Mars and Saturn are in conjunction, and that market manias and crashes may correlate with sunspots. His point being not that these are smart trading strategies, but that you should be very, very careful with what you try to do with statistical patterns.

There’s no good reason to think Mars affects stock prices, so you can safely ignore astrology when putting together your 401(k). Likewise, if someone tells you that, say, a stock that rises in value in the first week of January will also rise in value in the third week of October, you might want to get them to explain their theory of why that would be.

2) What’s stopping other investors from doing this?

If there’s a pattern in stock prices that helps predict returns, other investors should be able to spot it. (Especially once the idea has been publicized.) And once they do, the advantage is very likely to go away. Investors will buy the stocks that ought to do well, driving up their price and reducing future returns. Or investors will sell the stocks that are supposed to do poorly, turning them into bargains.

That doesn’t mean all patterns are meaningless. For example, Yale economist Robert Shiller has found that the stock market tends to do poorly after prices become very high relative to past earnings. It may be that prices get too high in part because fund managers risk losing their jobs if they refuse to ride a bull market. Then again, the same forces that affect fund managers will probably affect you too. Will you being willing to stay out of the market and accept low returns while your friends and neighbors are boasting of double-digit gains?

And even Shiller’s pattern doesn’t work all the time—stock prices can stay high for years before they come down. Betting that you can see something that’s invisible to everyone else in the market is a risky proposition.

3) Does it work well enough to justify the expense?

Lots of strategies that look good on paper fade once you figure in real-world trading costs and management fees. A mutual fund based on the AlphaSector strategy, by the way, charges about 1.6% per year for its A-class shares. That’s eight times what you’d pay for a plain-vanilla index fund, which is all but certain to deliver the market’s return, minus that sliver of costs. And there’s nothing hypothetical about that.

MONEY best places to retire

Retire to One of These 5 Great Small Cities

Love the culture and excitement of urban life, but loathe the congestion and cost? One of these “Second Cities” could be your first-choice retirement spot.

Does the thought of retiring to a sleepy beach town or country hamlet bore you silly? Spending your post-work years in a city has plenty of perks, including easy access to the arts, cutting-edge health care, and a diverse set of neighbors. That said, the cons of urban living (like cost) can be daunting.

There is a happy medium. We set out to find places that won’t ding your nest egg with high taxes and nosebleed prices, yet still have great attractions and plenty of your peers. Read on for five affordable small cities (populations of 150,000 to 500,000) you may one day want to call home.

 

  • Raleigh, North Carolina

    The North Carolina Museum of Art
    Karen Malinofski—NC Museum of Art

    STATS

    Population: 431,700

    Population 62 and over: 11.3%

    Median home price: $210,000

    Cost of living index: 92.3

    TAXES

    Like all the states in this story, North ­Carolina does not tax Social Security benefits. The state has no inheritance or estate tax.

    Income tax: 5.8% flat

    Sales tax: 6.75% (combined state and local)

    Median property tax: $1,800

    WHY IT STANDS OUT

    This state capital’s thriving economy and proximity to top universities have long made it a prime relocation destination. And ­recently more of those new ­faces have had a few wrinkles: from 2000 to 2010 the city’s population of 55- to 64-year-olds shot up by 97%, according to the Brookings Institution. It’s not hard to see the draw: Raleigh provides a big-city feel with a low cost of living; mild, four-season weather; and, thanks to all those medical schools, world-class health care.

    WHERE TO LIVE

    Midtown/North Hills: Retirees looking for an attractive price and a practical location should shop north of downtown, says local real ­estate agent Kim Crump. There you’ll find spacious townhouses and condos starting at around $200,000.

    Downtown: Prefer to be in the center of things? Those willing to pay about twice that price may consider the new condos and lofts downtown.

    WHAT TO DO

    Food: The city has a diverse restaurant scene, with everything from Afghan cuisine to Southern barbecue.

    Music: The 5,000-seat Red Hat Amphitheater hosts the big acts, while the opera and symphony perform at the Duke Energy ­Center for the Performing Arts.

    Art: A range of work is on display in galleries, public spaces, and parks. Or take in the 30 Rodin sculptures at the North Carolina Museum of Art.

    Education: North Carolina State University’s lifelong-learning program offers affordable courses and study trips on topics including American poetry, digital photography skills and Civil War history.

     

  • Pittsburgh, Pennsylvania

    Saturday Farmers Market on The Strip District, Penn Avenue, Pittsburgh, Pennsylvania
    Philip Scalia—Alamy Saturday Farmers Market on The Strip District, Penn Avenue, Pittsburgh, Pennsylvania

    STATS

    Population: 305,700

    Population 62 and over: 17%

    Median home price: $143,000

    Cost of living index: 98.8

    TAXES

    Distributions from most ­retirement plans, including qualifying 401(k)s and IRAs, are largely ­exempt.

    Income tax: 3.07% flat for Pennsylvania, 3% for Pittsburgh

    Sales tax: 7%

    Median property tax: $1,700

    WHY IT STANDS OUT

    Talk about a comeback. At the turn of the 20th century Pittsburgh was an economic and cul­tural hub, home to Andrew Carnegie and ­other captains of industry. Then came deindustrialization and job losses in the 1980s. Now the city is polishing its rusty image by converting old factories and warehouses into office space, galleries, and lofts. The once-dwindling population is also bouncing back; Pittsburgh’s population is growing for the first time since the 1950s. For retirees, Pittsburgh offers a true urban experience, including good public transportation, pro sports, and a host of colleges and universities, all at a bargain price.

    WHERE TO LIVE

    The northeast and south: Homes in popular neighborhoods like Highland Park are now going for around $400,000, says Maryann J. Bacharach at Howard Hanna Real Estate. The South Side, where homes tend to be a bit smaller, is slightly more affordable, with prices coming in around $300,000 or so.

    WHAT TO DO

    Museums: The four Carnegie Museums span art, science, natural history, and a collective 1.3 million square feet. The Andy Warhol Museum is a local favorite (the artist grew up here).

    Performance: Renovated concert halls are home to a thriving symphony, ballet, and opera.

    Sports: Thanks to the Steelers, Penguins, and Pirates, superfans can stay busy all year.

    Outdoors: There are four large city parks under the Pittsburgh Parks Conservancy, including the 644-acre Frick Park, where you can try lawn bowling or tennis.

  • Lexington, Kentucky

    Triangle Park with Victorian Square (shops) in background, downtown Lexington, Kentucky USA
    Blaine Harrington III—Alamy Triangle Park with Victorian Square (shops) in background, downtown Lexington, Kentucky USA

    STATS

    Population: 308,400

    Population 62 and over: 13%

    Median home price: $151,000

    Cost of living index: 92.6

    TAXES

    There’s no local tax on retirement income in Lexington. Homeowners 65 or older get a property tax break. Some family members are exempt from the inheritance tax; there is no estate tax.

    Income tax: State income tax is 6%. There’s technically no local income tax– there is, however, a tax on gross wages of 2.25%.

    Sales tax: 6%

    Median property tax: $1,700

    WHY IT STANDS OUT

    Retirees looking to mix city activities with country charm will find a lot to love here. Lexington’s historic downtown is packed with galleries, restaurants, and boutiques. But drive just a few minutes and you’re in the rolling hills of Bluegrass Country.

    The city is also home to one of the country’s oldest and most robust lifelong-learning programs, as well as the top-scoring Univer­sity of Kentucky Albert B. Chandler Hospital, which has received accolades from the American Heart Association and National Cancer Institute.

    WHERE TO LIVE

    Downtown: Over the past decade, a crop of new condos and loft conversions has transformed the center of Lexington. Indeed, developers got a little overzealous during the boom years, says realtor Casey Weesner, so prices stagnated and condos sat empty in the wake of the housing crash. The market has since picked up, he says, but there are still some downtown bargains to be had. You can find modern two-bedroom condos starting around $200,000.

    WHAT TO DO

    Sports: Welcome to basketball heaven. The Wildcats, the University of Kentucky’s powerhouse team, play at Rupp Arena, which also hosts shows and big music acts.

    Education: Locals age 65 and older can register to sit in on university classes, sans tuition, when­ever there are open seats. University of Kentucky’s lifelong learning initiative is celebrating its 50th anniversary in 2014 and is one of the oldest of its kind in the country. The school’s Osher Lifelong Learning Institute offers classes for the 50-plus set.

    Arts: The campus also boasts the Singletary Center for the Arts. Downtown, the Kentucky Theatre shows independent and classic films.

    Outdoors: Churchill Downs, home of the Kentucky Derby, is 90 minutes away. Bikers can hop on the 12-mile Legacy Trail, which leads to the equine events at Kentucky Horse Park.

     

  • St. Petersburg, Florida

    Beach at Pass a Grille, St Pete Beach, Gulf Coast, Florida, USA.
    Ian Dagnall—Alamy Beach at Pass a Grille, St Pete Beach, Gulf Coast, Florida, USA.

    STATS

    Population: 249,700

    Population 62 and over: 20%

    Median home price: $148,000

    Cost of living index: 91.3

    TAXES

    Retirement income is not taxed. Permanent residents get a property tax exemption of up to $50,000.

    Income tax: None

    Sales tax: 7%

    Median property tax: $1,500

    WHY IT STANDS OUT

    Can’t imagine retirement without a beach? In St. Pete you can dip your toes in the Gulf of Mexico or Tampa Bay—plus play a round of golf, eat virtually any type of cuisine, and see famous art, all in a single day.

    While St. Petersburg is undoubtedly a ­retiree hotspot, the city has also drawn more young families in recent years, says St. Petersburg agent Rachel Sartain. The mix helps keep the city vibrant and stocked with boutiques, galleries, and restaurants.

    WHERE TO LIVE

    Downtown: The market for new apartments and condos was flattened by the bust, but developments are now back on track and in many ­cases selling out quickly. New two-­bedrooms downtown start at around $300,000, says St. ­Petersburg agent ­Rachel Sartain.

    Surrounding neighborhoods: If that’s too expensive, going five or 10 minutes outside of downtown brings ­prices down ­dramatically; condos in many central areas start in the $200,000 range, says Sartain.

    WHAT TO DO

    Beaches: One of the nation’s best (according to Trip­Advisor readers), Saint Pete Beach, is about a 20 minute drive from downtown.

    Art: Try the Dalí Museum for works by the Spanish surrealist, or the Museum of Fine Arts for Monet and O’Keeffe.

    Sports: Tropicana Field is home to the Tampa Bay Rays. There are also plenty of golf courses, including Mangrove Bay, a par-72 championship course.

  • Boise, Idaho

    A mountain biker rides through the foothills above Boise, Idaho.
    Joshua Roper—Alamy A mountain biker rides through the foothills above Boise, Idaho.

    STATS

    Population: 214,200

    Population 62 and over: 15%

    Median home price: $208,000

    Cost of living index: 94.3

    TAXES

    There is no inheritance or estate tax.

    Income tax: Highest is 7.4%

    Sales tax: 6%

    Median property tax: $1,400

    WHY IT STANDS OUT

    Moving to a mountain town means easy access to skiing, hiking, golf, fly-fishing, and more. Unfortunately, it also usually means jaw-dropping home prices, a dinky airport, limited health care, and tourists galore. Not in Boise. Yes, locals here can ski at Bogus Basin 16 miles from downtown, stroll or bike 85 miles of trails, and paddle or fish on the Boise River, which runs through town. But they’ll also find low taxes and affordable homes. Plus, Boise has become a nucleus of culture and health care. Saint Alphonsus Regional Medical Center has been ranked in the top 5% of hospitals nationwide for clinical performance by HealthGrade.

    WHERE TO LIVE

    North and east of downtown: Prices in the city center are steep, so buyers looking for value typically concentrate on the surrounding neighborhoods. You’ll find two-bedroom condos or small single-family houses priced at about $300,000 in the North End, says Michael Edgar of Team One Elite Realty.

    WHAT TO DO

    Outdoors: Walk along the Boise River Greenbelt or explore the trails winding out of Hull’s Gulch or Camel’s Back Park. The city has two open-air Saturday markets, which are a great place to find produce and bump into friends.

    Art: The Boise Art ­Museum has more than 3,000 permanent works and presents diverse exhibitions ranging from site-specific installations to collections of ancient artifacts.

    Performance: Grab tickets for the opera, philharmonic, or ballet. Boise State’s Morrison Center hosts national tours of Broadway shows, stand-up comedy, and live music, while the Shakespeare Festival fills a 770-seat outdoor amphitheater. And there’s more to come: Construction is under way for a new $70 million, 65,000-square-foot cultural center, slated to open in 2015.

    This story originally ran in the November 2013 issue of Money magazine

     

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