Money Management

Money Management (or Who Wants to be a Millionaire?) John T. Barber

"Money Management" is not exactly an "academic skill," it is however, just as appropriate (and valuable) for individuals in academia to be "skilled" at it as it is for individuals in any other profession — given the levels of remuneration in academia, maybe more so! Either way, the purpose of this workshop is not to show how to balance a checkbook or budget (limited) financial resources. Neither is it to preach about the responsible use of "plastic money", though in the face of >1.3 x106 personal bankruptcies in 1997, the vast majority of which were caused in part or whole by credit card debt (for a modest sum you can request a credit check from, Equifax 1-800-685-1111: Experian [fka TRW] 1-888-397-3742; Trans Union 1-800-888-4213) there are clearly a significant number of individuals who could benefit from such as sermon.

The purpose of this workshop is very simple. It is to point out that the next few years, potentially more so than the rest of your life, will probably determine when and under what conditions you will retire. Thinking about retirement at this stage in your lives may not seem too relevant or important. That's several decades away! But that is exactly the reason why your actions now can have such a disproportionate influence on your financial situation that far into the future. The following example should provide some perspective:

• Someone invests $2,000 a year from age 22 to 30. Total investment $16,000. If he realizes a 10% return on his investment, at age 65 he will have $666,000.
• Somebody else invests $2,000 a year from age 30 to 65. Total investment $70,000. If he realizes a 10% return on his investment, at age 65 he will have $580,00.

What you anticipate your retirement situation will be and what it actually turns out to be, may be two very different things. A recent (1998) poll by the Pew Foundation (Philadelphia, PA) found that 50% of pre-retirees polled expected their quality of life to be as good or better after retirement (and the younger they were the more optimistic their outlook was), but 60% of the retirees polled said their lives were merely a continuation of life before retirement or were worse. Part, at least, of the explanation for this comes from another 1998 poll that showed that:

• 68% of 22 – 32 year olds had <$10,000 in retirement savings
• 38% of baby boomers (33 – 50) had <$10,000
• 30% of pre-retirees (51 – 61) had <$10,000

More recent surveys (10/99) showed that many Americans believe that playing the lottery is the best way to gain wealth rather than saving over the long term. The Consumer Federation of America and Primerica reported that 40 percent of households earning $35,000 or less saw winning the lottery or a sweepstakes as the means toward a $500,000 nest egg. By contrast, only 30 percent felt this could be achieved by saving and investing during their working years. "Despite the economic boom of recent years, one-half of American households have accumulated less than $1,000 in net financial assets and modest or no wealth," the groups said.

Retirement Income is Usually Derived from Three Sources:

1. Social Security

   Probably the smallest overall percent contribution. Not much you can do about this. Social Security pay roll deductions are mandatory and fixed. As you've probably heard, the S.S. system is in some difficulty as, proportionately, a decreasing number of workers are paying for an increasing number of retirees and the situation is, or will be, aggravated by the upcoming wave of so-called "Baby Boomers" who are expected to overwhelm the S.S. system in the near future. Consequently, it is calculated that, without any changes being made, benefits will have to be cut by at least 25% by the year 2029 (after which, most of you will be retiring). The numbers change with each projection but the general outlook remains the same — gloomy. So, whatever S.S. benefits are currently, they are certainly going to be different, probably less, by the time you retire.

   Another reason for the projected shortfall is that the S.S. system is currently required to invest your payments in government obligations that over the past few years have returned an average of 2.3%. As of now, one solution has been to phase in a progressively later age at which you can collect full S.S. benefits. Currently, the retirement age at which you can receive full benefits is 65. That age will gradually increase until those born in 1960 or later will have to reach age 67 before they are eligible to receive full benefits. Another solution under discussion is to allow you to invest a certain percentage of your S.S. payments in the private market — I would think that even someone with zero investing skills could do better than 2.3%! Yet another solution is to increase payroll taxes. Yet another is to cap cost of living allowances (COLA's) that are designed to keep retirees benefits equal to or ahead of inflation.

   The point of the above is that S.S. benefits are, at best, inadequate to retire comfortably on and, at worst, may not even exist when it gets to be your turn. It is therefore, something that's there but not something you can do a lot about (unless you attempt to influence legislation that affects S.S. and the benefits that you will/will not receive). Over the next year the Social Security System will mail out to all taxpayers an "Estimated Statement of Earnings and Benefits". It will be of very little help in terms of providing much information on the benefits you can expect receive when you retire (since you will have paid in very little and, in proportion to the amount that you will eventually pay in, it will be almost insignificant) but I'm confident you will not be quoted an amount that will impress you or that you will want to try to live on. On average, S.S. is almost certainly going to provide the smallest proportion of your total retirement income – in most cases less than 20%!

2. Employment-Based Pension Plans

   
   
   1. Defined Benefits Plans – Plans in which your benefits are guaranteed and the size of them will be determined by your years of service and salary. Employer makes the contribution.
   2. Defined Contributions Plans – Plans in which you create and maintain your own investment program by contributing a percentage of your pay and in which your benefit will be determined by the amount that you contributed and how well you managed it.
   3. Other – Very recently, many employers have converted, or are considering converting, to "Cash Balance" plans. The consensus of opinion is that while these may benefit younger employees, they can result in older employees receiving considerably smaller benefits than they were expecting. While these plans are not well understood by most people (including myself), I think we can safely assume that the end result will be beneficial to the employer, if not detrimental to the employee. However, very recently, as a result of apparent inequities in cash balance plans, the IRS and other Government agencies (e.g. EOC, because of age discrimination implications) are investigating their legality. Therefore, whether or not such plans will ever be an option for you is unclear.

   While you may not have a choice in terms of the employment-based retirement plan to which you contribute, you would be well advised to be knowledgeable about how it works. If you go into an academic career you will probably be eligible to contribute to TIAA / CREF — the Teachers Insurance and Annuity Association / College Retirement Equity Fund — the biggest (>$200 billion in assets) retirement plan in the country (world?), established originally for educators but now open to many other classes of individuals. TIAA / CREF is not only the biggest pension fund in the country but according to Money magazine (Jan., '98) it may also be the best. Depending on the generosity of your employer, he makes monthly contributions to TIAA / CREF — a certain percentage of your salary. May be as high as 16% (the highest I've heard of) or considerably lower. At Tulane, the employer's contribution is 8% but if you, personally, contribute another 2% then Tulane will match it to make a total of 12%. There's a lesson there — anytime your employer will match all or a part of your contribution, take it, to the maximum amount allowable. Whether it's TIAA / CREF, a 401k plan, a 403b plan, whatever. Take it. Your employer is giving money away!

   Nowadays, employers are inclined to provide options for employer-sponsored pension plans, i.e. where you want the money to be invested. TIAA / CREF provides several options but your employer may also allow you to contribute to another plan(s) that is (are) managed by some other financial or investment company. Again, for example, here at Tulane, we have the option of contributing to a 403b account (or a Supplemental Retirement Account, SRA) with Fidelity Investments (the biggest of the financial investment companies) or TIAA/CREF. The choices for your contributions usually boil down to putting your money in conservative, risk-free but not high paying investments versus putting it in something aggressive with the potential for a high return but also the potential for loss of principal. This basically is also the choice between TIAA and CREF — an oversimplification but adequate for this discussion. Money paid to TIAA is invested in secure, relatively low paying but guaranteed instruments that have a known, predictable rate of return, e.g. bonds. CREF is invested in more risky, volatile but potentially high paying instruments, e.g. common stocks. While I will not recommend any particular strategy, I will tell you what my own experience has been. Nobody told me anything years back so when I first started, for lack of a better idea, I had 50% of my contributions put in TIAA and 50% put in CREF. Since I never changed, I can now look at the balance in each account and see how the conservative vs the more aggressive approach has "paid off". There is now 2.3 times as much money in my CREF account than in my TIAA account! In any given year the return from TIAA may have been greater than from CREF and, in fact, some years the CREF account actually lost money but over the long time period that these accounts have been active, the stock account has outperformed, by a significant amount (2.3 x), the fixed annuity account. This seems to be almost a rule — that over long time periods (5-10 years?) the stock market has always outperformed just about every other form of investment. Therefore, if I knew then what I know now, I'd put all of my money in an aggressive stock market fund - but you need to make the choice for yourself. Again, the main purpose of this workshop is to make you aware that decisions made now can and will have an enormous impact on your financial well-being many, many years from now so it's worth (literally) spending a little time educating yourselves.

3. Personal Savings and Assets

   The first two sources of retirement income are somewhat fixed, i.e. the S.S. check you receive will be determined by your salary over the years (something you unfortunately, don't have as much control over as you would like). An employment-based pension plan and the amount you have invested in it is largely up to your employer though there may be a voluntary component to it. Largely, however, it too is dependent on your salary. The third component however, is totally within your control — personal savings and assets and can have a large influence and could conceivably constitute the largest proportion of your overall retirement income. The options available to you for these personal investments are (in approximate order of increasing return):
   
   

   1. Bank Savings – Unimaginative, low return but safe and readily accessible.
   2. Money Market Accounts – Not much better than a savings account but a higher return and again safe and available.
   3. Certificates of Deposit (CDs) – Better rates of return, secure (FDIC Insured), available for varying periods of time from 3 months to many years – however, during those terms your money is unavailable to you unless the CD(s) is(are) sold through the secondary market or cashed in with penalty which might be quite severe. The longer term CDs will, of course, have the better rates of return but you may not wish to tie up a given amount of money for a long time period. One possible solution is "laddering" – i.e. rather than tie up say, $8,000 in a one-year CD, you would buy a $2000 CD in Jan., another $2000 CD in April, another in July and another in October. Each CD would be earning the 1-year rate but every 3 months a CD would mature and the money from it would become available. The numbers are, of course, infinitely variable and the principle is applicable to other forms of investments.
   4. Treasury Securities – Details can be found at the Treasury's Bureau of Public Debt web site www.treasurydirect.gov. There is a Federal Reserve Bank in New Orleans and the people that answer the phones are very helpful. You can buy securities through a bank or broker — but they'll charge you ($50/transaction?) or you can buy them directly (and for free) through the Federal Reserve Bank — call them for help and the necessary forms. Once you've established an account you can do all your transactions very easily by touch tone phone through the Treasury Direct system. Treasury Bills are available for 13, 26 and 52 week terms, Notes for 2, 5 and 10-year terms and Bonds for 30 year terms. Interest on Treasury Securities is deductible on your State tax return but not Federal. Like CDs you can ladder your investments in Treasury Securities.
   5. IRAs – Can be established in a number of ways – as CDs, mutual fund accounts, brokerage accounts, etc. IRAs were originally designed to allow individuals to build their own retirement accounts with tax-free contributions. Now various kinds (e.g. Traditional, Roth, Non-deductible, etc.) for various purposes and each having specific rules regarding who can contribute, how much can be contributed annually, the tax status of those contributions, distributions, etc. are available. In general, the two most commonly used IRAs are traditional IRAs (uses before tax contributions and is taxed at distribution) or Roth IRAs (after tax contributions but distributions are tax free). You should research the various types to see which best suits your goals.
   6. Bonds – In effect, loans that you make to a corporation, municipality or government agency. Usually however, these are long-term "loans" (many years) but they do provide a higher return than short-term investments. Bond prices fluctuate with changes in interest rates and with the reliability of the issuer – remember "junk bonds"? The earnings on certain types of bonds are taxable at the State or Federal levels or both but for other types of bonds the earnings are tax exempt. Again, do your homework.
   7. Mutual Funds – Allow you to take advantage of the earnings that are available through the stock market but without having to know much about the stock market and without having to spend much time managing your investments. Mutual funds allow you to "pool" your money with that of many other investors to buy a large number of stocks. That way, the performance of individual stocks becomes of decreased significance to your overall investment. However, just like trading in common stock, depending on your choice, some mutual funds are more risky than others. There are literally thousands of funds to choose from. Morningstar compares the performances of the leading mutual funds over the past 3 to 10 years. The various mutual fund companies can be found through the Internet. All you have to do is show a minimum amount of interest and they'll bombard you with brochures, prospectuses, etc. Each fund, offered by each company, has an investment goal and operates under its own set of "rules". Probably the simplest kind are "indexed funds" that are not actively managed (and therefore have lower costs); they seek to duplicate the Dow Jones, the S&P 500 or some other market index. Given that only 3.5% of all (several thousand) open-ended equity funds out-performed the market average (S & P 500) from the end of 1993 to the end of 1998 (Lipper Analytical Services), indexed funds seem like a good idea plus, because they are not actively managed, they tend to have low costs. Which brings up another consideration, costs. Check them out. I believe there is no evidence to suggest that "load" funds perform any better than "no load" funds. Other funds, such as the "sector funds" (funds that invest in a certain sector of the market, e.g. biotechnology, electronics, precious metals, Pacific Basin, etc.) will from time to time outperform, by a wide margin, other types of funds but also have the potential to drop precipitously. One way to offset market fluctuations is by "dollar cost averaging" — rather than invest a large sum all at once (never been a problem for me) the same amount is invested over a long period of time by systematic buying — when the market is up, your certain amount of money buys a few shares but when the market is down that same amount of money buys a lot of shares. Over time, the cost of buying your shares evens out. Of course, if you could time your purchases right you wouldn't need to dollar cost average but one thing that even the experts agree on is that it is impossible to time the market. There are of course many other types of mutual funds with a wide variety of investment goals and strategies. Before investing in any of them you should ask for and read their prospectuses (the company is required by law to provide you with one before you invest).
   8. Stocks – There have, since WWII, been only two 5-year periods in which you would have lost money by investing in the stock market (as determined by the S & P 500) and there have been no 10-year periods in which you would have lost money. However, note the time periods, they are long — 5, 10 years. Simple illustration: $1 invested in 1950 in something that duplicated the performance of the S & P 500 would be worth >$1,200 today. More impressive, $1,000 invested back then would have grown to $1.2 million today. Wouldn't even have taken much creativity or any research. Just put it in an unmanaged fund and forget about it. If you were more creative (and insightful and/or lucky) you could have bought an individual stock (Texas Instruments or, later, IBM) and made considerably more (or lost it all) or been more conservative and bought stock in a Blue Chip company. The point is that over time, the power of compound interest can result in some surprising returns but the key is time. If you got very, very lucky you could have bought Microsoft in the early 80's and made 28,000% in less than 10 years - apart from making himself extremely wealthy, Bill Gates also made "instant" millionaires of at least 5,000 of his employees by way of stock options. Incidentally, if you go to work for a company that offers stock options as a part of their benefit package check them out — some have been very successful (e.g. Home Depot) others have been a disaster! Similarly, following the UPS IPO (Initial Public Offering) earlier this month (11/99), there are probably quite a few men in brown uniforms driving delivery trucks around the country who are now millionaires or very close to it! I'm sure there are several "Microsofts" out there at this very minute; there are many, many more "DeLoreans". Picking the former and not the latter is the trick and the odds are against you. Mutual funds won't provide you with the incredible returns of the "Microsofts" but it is unlikely that they will lose everything for you.

N.B. "The Rule of 72"

To find the interest rate that results in your money doubling, divide 72 by the number of years involved, e.g. if you want your money to double in 9 years it will need to earn 8%; or, a rate of 10% will result in your money doubling every 7.2 years, etc. Thus, if you "want to be a millionaire" when you retire 40 years from now, you could invest just over $31,000 now in something with an APR of 9% or you could start a more modest program of systematic investment that extends over the entire 40 year-period but which produces the same end result.

General Information

There is a multitude of investment books. Here are a few:

• Junius Ellis. "Your Top Investing Moves for Retirement" Money Books. $29.95
• Eric Tyson. "Personal Finance for Dummies". IDG Books. $19.99
• Kenneth Morris and Alan Siegel. "The Wall Street Journal Guide to Understanding Personal Finance". Fireside. $13.95
• Andrew Tobias. "The Only Investment Guide You'll Ever Need". HarvestHarcourt Brace. $12.00
• Peter Lynch and John Rothchild. "Learn to Earn". Fireside Paperback, $13.00
• Thomas Stanley and someone else, "The Millionaire Next Door"

I am not recommending any or all of these books. Some I haven't even seen. Stop by the bookstore and check out the "Personal Investment" section.

Just about any financial institution, mutual fund company, etc., will be happy to shower you with advice, e.g. www.fidelity.com (the largest of the mutual fund companies); www.vanguard.com; www.janus.com. Most mutual fund companies have very well-developed web sites that provide all manner of information, 'personal investing' pages and downloadable software for financial planning.

There is, of course, a wealth of information on financial matters of every conceivable kind on the Internet. If you have ever thought of investing in the stock market there is at least one site that allows you to do so without risking any real money www.etrade.com. The company (E*Trade) has a game (the E*trade Game) in which they "give" you $100,000 of play money at the beginning of every month and allow you to buy, sell, trade, etc. (anything you would do with real money and real stocks) for the month. The two individuals who end the month with the best returns get $1,000 each in real money. The winners usually are the ones with at least a million or two — shows you what's possible, though you probably wouldn't do what it takes to get that kind of return if you were using your own, real money. Of course, if you want to invest your own, real money, E*Trade will be happy to oblige, as will a number of other online trading companies (e.g. www.tradingdirect.com; www.ameritrade.com). However, "day trading" is definitely NOT recommended (<13% of those doing it make money and many "lose their shirts").

I know of at least two graduate students who used to research the stock market and, routinely, invested a small percentage of their stipends in the stock market. Don't know how they did but I imagine that by the time they retire they'll be quite good at it and will probably have made significant amounts of money doing it. While these two individuals acted independently, investment clubs are becoming increasingly popular, e.g. the once famous but now somewhat discredited Beardstown Ladies Investment Group. Similar groups have formed in New Orleans and Metairie, with varying degrees of success. I also know one faculty member who "plays the market" (sounds a little like "plays the horses" and can have the same results — unless you do your research). As of 11/99 he was showing a 22% return but, with the current market and the way it's performed for the past several years, this kind of return is only average or even below average. Most blue chip or indexed funds will have done as well (and will have required no effort and minimal research).

Conclusion

None of the above should be construed as a recommendation(s) either for or against any particular investment strategy. Its purpose is merely an attempt to raise awareness levels at a time when you are in the best position, temporally though probably not financially, to determine the timing and the quality of your eventual retirement. It should also be stressed that desirable as long-term investments may be, there are immediate financial needs that have to be met and should not be neglected, i.e. it is (or should be) obvious that first and foremost your own needs (and those of your family) have to be provided for. To do this, it is usually recommended that between 3 and 6 months of living expenses should, ideally, be available for emergencies, between-job expenses, etc. Of this, probably approximately 25% should be readily accessible (i.e. bank accounts, money market accounts, short term CDs, treasury bills, etc.). The remainder (75%) may not be immediately available but should be available for a serious crisis. The optimum situation is one in which you establish a well-balanced portfolio that accommodates both short term needs while accumulating long term wealth and that will take care of anticipated future needs as well as supplement traditional sources of retirement income that come from Social Security and employment-based pension plans.

The rule of thumb that is used in financial planning is that it will take about 80% of your current earnings to maintain the same lifestyle after retirement as before. Personally, I was hoping for something considerably better – most people would. However, if you come to that decision late in your career there's usually not a lot you can do about making it happen. Think about it!

P.S. I am by no means an expert. Don't take my word for any of the above. It wouldn't take a lot of effort to be better informed than I am. There are other forms of investment available that are not mentioned, e.g. insurance annuities. It is suggested that, before investing any of your money, you educate yourself. As noted above, literature is available from any number of sources – books, investment companies, the Internet, etc. You might also consider taking a course – "Investments for Beginners" or whatever it's called – most colleges and universities offer such courses through their adult education divisions. Also, most financial companies periodically offer free seminars, in hopes of getting to manage your finances for you (check the financial page of your local paper).