Development of Capital Through Life Cycles
Our lives and objectives are very different from one another. There is no turn-key solution to managing finances and meeting financial goals. Worries about money have generated some of the greatest anxieties of our day. We can, however, plan to achieve much more success through the planning process as we pass into each life cycle event.
The Early Years
In the early years, usually between ages 19 and 25, we direct ourselves on a course which defines our earning potential. For some people the process involves an investment of time, gaining experience and skills on the job. For others, it involves an investment in trade school or college. This investment is continuously modified as we progress throughout our working careers.
Once the investment begins to pay dividends in terms of earnings, we begin to redefine the management of our money. By managing expenses and budgeting for the future, the savings process takes on more significance to meet the long term financial objectives.
As savings accumulate, an emergency fund should be established to cover unexpected short term needs. It may be far more helpful to use cash to meet these short term needs rather than leverage future earnings through costly loans. Generally, the emergency fund should represent the same standard of living to which you are accustomed, and should permit the same standard of living to continue for six months.
A major disability, the loss of a family member that provides a high level of income, or a significant medical condition can generate devastating financial hardships. The risk of such tragedies can be well controlled by sharing the risk with very large groups of people with the same concerns – through an insurance policy. Life insurance, disability insurance, medical insurance, and other vehicles all have a place in the life cycle planning.
Long Term Funding For The Future
Once we have accumulated sufficient funds to cover emergency needs, and to create protection against significant financial risks, we can begin the process of investing to meet long term goals for the future. It is a well known fact of economic life that a dollar received today is worth more than a dollar received tomorrow. The relationship between time and money therefore impacts every financial decision. Whether you are investing money for a future event, or thinking about loans for a current financial need, the time value of money remains a significant consideration for the process.
For example, a dollar received today can be invested to earn interest or appreciate in value, thus improving its worth with time. Inflation impacts the value invested as well. As the cost of producing goods may increase with time, the price of the product may increase in response – same product, higher price. That same dollar therefore loses significant purchasing power over time.
If a loan is used to meet a current financial need, the cost of the product that is purchased increases with the interest paid on the borrowed monies. That cost must be balanced by the return (real or perceived) when the product is purchased currently (vs. deferred to the future).
There are some valuable tips to consider when making time value decisions. For example, the longer you have to prepare for the purchase, the less your purchase may cost. Assuming that you invest early to make the purchase, and secure a positive return, your investment will earn interest and the interest will earn additional interest – a process called compounding. The price of the product is impacted accordingly.
The longer you have to prepare for the purchase, the amount of risk you are willing to assume on the investment may also impact your long term rate of return. The greater the risk on the investment, the greater the potential return (or potential loss!) to be achieved, and the price of the product may be adjusted accordingly.
It is often helpful to invest in programs that postpone paying taxes to the future. When you have the choice, a delay in paying taxes on investment proceeds means you may continue to generate potential gains on the money normally used to pay taxes, and those earnings generate additional gains to the future. You may therefore wish to consider investment in ‘growth’ oriented assets, as opposed to interest oriented programs to create a ‘triple compounding’ effect on the money (see the earlier discussion regarding compounding) – a phenomenon Albert Einstein once labeled ‘the ninth wonder of the world.’
Finally, factor inflation into your planning process. Over the last 20 years, inflation has averaged about 3 – 4% per year. The cost of some financial objectives can be greater than the rate of inflation (e.g., college expenses, or medical care for the elderly), and the investment should be planned accordingly.
Once you have completed the process of getting the children through college, you begin to place much more emphasis on accumulating enough monies for retirement, to enjoy vacations, to enjoy the grandchildren. It is important to remember that money, more than any other factor, will dictate most of your retirement decisions. Your decisions will impact when you retire and what type of lifestyle you will create for you and your family.
Recent government studies have found that the average person requires between 60 and 80 percent of their pre-retirement income to maintain their standard of living. You will probably need less money than before – how much less will be, in large part, a function of your spending habits. For example, you may be supporting children now that will be self-sufficient (hopefully) by the time you retire. Your work related expenses (commuting costs, clothing, licensing fees, etc.) may be dramatically reduced. Housing expenses may be substantially reduced if the mortgage is paid off, or will be paid off within a few years of retirement. The money you are setting aside for investment/retirement during your working years may be redirected to other ventures. Finally, you may pay less in taxes as you find yourself in a lower income tax bracket with reduced level of income.
Retiring at an Early Age
Many people consider age 65 to be their target for retirement. Social Security laws in the past have reinforced this position by permitting a full benefit beginning at that age. If you wish to consider retirement at an earlier age, be aware of some of the costs associated with the retirement. For example, Social Security payments can be reduced for early retirement (the ‘full benefit’ age may now be imposed at age 67). Early retirement can eliminate some of the most productive years of earnings, thereby removing much of the monies that would normally be set aside for investment for the future. The benefit provided by employer sponsored pension plans may be impacted by a reduction in years of service and higher levels of earnings. Even health care expenses (premiums for medical coverage and out-of-pocket payments) that were once paid by the employer may become the responsibility of the employee.
Sources of Income
Once you have determined the level of income desired at retirement, you might evaluate what sources of income will be generated to meet your needs. The federal government, for example, has created a partial ‘safety net’ through Social Security. The amount you receive will be based on the income earned during your working years. Secondly, many employers offer company sponsored retirement plans. Defined benefit plans, for example, are normally funded entirely by the employer and guarantee a retirement benefit based on a combination of earnings and years of employment. A defined contribution plan, however, may be funded by the employer, the employee, or a combination of the two. The employee owns a value (subject to vesting) made up of contributions and earnings – at retirement, the employee withdraws monies from the balance accumulated. Finally, a major source of income may be found through one’s own personal savings – IRA accounts, stocks, bonds, real estate, and related investments.
Changing Directions – Bridging the Gap
If you find that your current program is not sufficient to achieve your objectives, it may be helpful to modify your direction. The more time you have available, the more changes you can make to improve your position for retirement.
In years past, retirees often based the majority of their retirement income on Social Security benefits and traditional employer sponsored plan benefits. Unfortunately, Social Security payments have been watered down in real terms, and the age one needs to qualify for benefits has been steadily going up. Given current population demographics, Social Security payments will prove to be far more difficult for the Government to maintain at the current level. (Note: You can get a copy of your earnings record from the Social Security Administration by filling out Form 7004 and mailing it to the SSA – call 1-800-772-1213 for details. The SSA encourages you to check the earnings records every three years or so to verify information – the earlier a problem is detected, the easier it is to correct the mistake).
In addition, employers have begun to move away from costly traditional retirement plans, forcing employees to take responsibility for funding their own invesment programs. Your personal long-term investment plan therefore may have a more significant impact on the difference between relying on a fixed income provided by others, and a financially independent lifestyle.
Fixed annuities can present a very effective option to generate current income which is guaranteed for the rest of your life, or deferred income on a tax-favored basis. We have added a special section on Guarantees Through Annuities – please visit that section for further details.
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The material presented above should be used for informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources thought to be reliable, individual positions can vary and the respective professional advisors should be consulted as necessary.