Student Loans Can Be an Albatross

A recent Washington Examiner article quoted some data from the 2017 Student Loan Report, and the results are disturbing:

  • 27% believe the Department of Education will forgive all or part of their loan balance
  • 20% believe there are no negative consequences for the cosigner if they make late payments
  • 22% didn’t know their debt balance within $500
  • 36% didn’t know their monthly payment within $20

The average loan amount is nearly $28K. For that much money, you’d think they’d pay attention to the forms they signed. Worse, many didn’t even know what they were going in debt for. From the survey, almost 55% regret borrowing as much as they did, and almost a quarter plan to have parents help pay the loans.

The survey was based on 400 students polled after a screener question to ensure participants met the requirements (four-year college graduates from class of 2017). We can only hope they’re not representative of the 44M+ student loan borrowers out there… those cosigners really better hope.

Chapter 3 of my book, Basic Personal Finance, opens with “The easiest way to get in trouble with money is to not pay attention to it.” The book also covers the concept of good and bad debt. While student loans can be considered good debt, students really need to consider the benefits relative to the costs incurred. Sadly, only the latter is known up front. (Judging from the survey, some students might not even know that!) Many students go into college without a plan of what to study or what career they want to pursue, making it difficult to really quantify the benefit of college. They’re likely to incur debt with little or no benefit to future earnings.

Here’s a short list of what bachelor’s degrees are worth by major (2016 average annual salary):

Engineering                                     $64,891
Computer Science                           $61,321
Math and Sciences                          $55,087
Business                                            $52,236
Agriculture/Natural Resources     $48,729
Healthcare                                        $48,712
Communications                             $47,047
Social Sciences                                $46,585
Humanities                                      $46,065
Education                                         $34,891

Those are salaries for people who actually get jobs. For comparison, the Bureau of Labor Statistics reports the average annual salary (2015) for workers with a high school diploma was $35,256 (workers over 25 years old in full-time jobs, not starting salaries). So, when thinking about a school loan, consider the difference between your expected salary in your chosen field and a salary with no college. That’s what your investment in education is buying you. From this data, you shouldn’t go into debt if you’re planning to get a degree in education.


Retirement Mistakes Before Retirement

Here’s an article from Yahoo! Finance that points out retirement mistakes many people make well before they get to retirement:

  1. Not starting early
  2. Not having a Roth IRA
  3. Raiding your retirement account
  4. Cashing out your 401(k)

The article quotes a lot from CPA and “retirement expert” Ed Slott. He points out that starting early and maximizing your Roth IRA every year (age 25 to 65) is basically all you need to do to have a million dollar nest egg. If you wait and start 5 years later, you’ll have $200K less in your nest egg.

Mistake #4 is a big one for people who switch jobs. If your next employer doesn’t have a 401(k) plan, or you prefer to manage the money yourself, you can open a 401(k) rollover account. Simply cashing out your 401(k) will incur a 10% penalty, plus a one-time bill for all the taxes owed. Worse, you’ll be giving up the benefit of future tax-deferred earnings.

If you’re unsure what this all means, check out Basic Personal Finance. You can read the first chapter, which lists the 10 rules of thumb for financial success, for free on Amazon. Chapter 6 shows an example of how tax-deferred investments outperform similar investments in taxable accounts.

Retirement Plan Math

A few days ago, I posted the two basic steps of retirement planning.

Step 1: Figure out what quality of life you want during retirement (i.e., how much you want to live on each year). This will determine the size of the nest egg you need to have ready when you retire.

Step 2: Figure out how much you need to start saving now to get there.

Of course, those makes sense to me, but my inner math teacher feels compelled to elaborate for those who need it (even if they won’t ask for it). The calculation for step 1 is a present value formula for an annuity payment. In this case, the payment (PMT) is the amount you want to draw from your portfolio each year in retirement. The present value (PV) is the amount of the portfolio when you retire. (That could be confusing because it’s a present value, but we’re talking about future money; we’ll deal with that later.) You have to specify a real return for the portfolio (r) and the number of years you want to draw this benefit (n). So, if you start with PV in your portfolio at retirement, you can draw PMT from the portfolio each year for n years until you run out of money. You can solve this with the following formula:


If you’re scared of math, you can solve it in Excel: =PV(rate, nper, -pmt). Because Excel looks at time-value-of-money equations as cash flows, enter your PMT value as a negative number. If you don’t, you’ll get the same absolute value, but PV will be negative… no big deal.

For Step 2, you set that present value to a future value (FV), because that’s what you want your portfolio to be in the future. Now use the future value annuity formula and solve for the payment (PMT), which is the amount you need to invest each year (at a real return, r, for n years) to reach that FV. The formula is:


Again, Excel makes it easy: =PMT(rate, nper, pv, -fv). In this case, add a present value (pv) if you already have some savings started.

Note that the second r and n are not the same as the previous formula. This time n is the number of years you have to save for retirement. The previous n was the number of years you plan to draw on your savings during retirement. Similarly, the r in the PMT formula is the real return you expect to earn while you save for retirement. The r in the PV formula is the real return you expect to earn during retirement (which will probably be lower, assuming safer investments).

This (and lots more financial math) is covered in Basic Personal Finance, but now you have the two most important formulas. You can complicate this by simulating returns to add some realism, or you can simply pad your numbers by using a smaller r in either or both formulas. You can also use a larger n and/or larger PMT in the first formula to pad your nest egg.

Retirement Planning Includes Plans During Retirement

CNBC ran a story last week pointing out an obvious part of retirement planning that they think people don’t consider: “make sure you don’t run out of money.”

They start with the 4 percent rule recommended by “many investors”-only draw 4% of your total portfolio value in any given year. That way, you’re basically living on the gains, and your portfolio remains intact (assuming a 4% real return). Research by Wade Pfau suggests that the 4% rule may be optimistic if people transition their portfolios to safer investments after retirement, hence earning less than a 4% return.

The story then quotes certified financial planners who state more obvious points, that you should consider three things when planning your retirement spending goals:

  • Life expectancy
  • Social Security benefits
  • Taxes

I’ll start with the last one. You have to consider the required minimum distributions from your retirement plans. Try to balance your tax-deferred (traditional IRA & 401(k)s) and tax-free (Roth) distributions to minimize your taxes. Avoid unnecessary portfolio reallocations, which could increase your tax burden for taxable accounts (i.e., don’t use actively managed mutual funds).

When looking at Social Security benefits (for those retired or retiring soon who will actually have them), consider your objectives. Do you want to maximize your total benefits, or do you want to maximize your monthly benefit? For the former, take your benefits as early as possible. If quality of life is more important, and you don’t need the money right away, waiting to draw social security will increase your monthly payments. (I’ll follow up with a post on this soon.)

Life expectancy is a somber topic, but you really do have to consider how long you might be around to make sure you have enough to support yourself in retirement. If you don’t want to put a specific number to it, pick something far into the future (say 100 years old… or 40 years of retirement). Use that number when planning your nest egg requirement. Other alternatives are to plan on smaller returns than you think you’ll get and/or using random returns and simulating your retirement, as shown in my book and discussed in a previous post.

One thing the article didn’t point out is that all the “help” these professional financial advisors give you will cost you 2-3% of your portfolio value every year. That’s the real reason you won’t be able to draw 4% for yourself. It doesn’t take a PhD in finance, or even a CFP, to plan for your retirement. It’s fairly basic:

  1. Figure out what quality of life you want during retirement (i.e., how much you want to live on each year). This will determine the size of the nest egg you need to have ready when you retire.
  2. Figure out how much you need to start saving now to get there.

Take the time to study the basics and make a plan. You can enjoy spending/saving that 2-3% fee on yourself instead of paying for advice you can easily get on your own.

Consider Income When Considering Career

In an earlier post, I referenced an article that discussed Bloomberg’s Shift: The Commission on Work, Workers, and Technology. That’s Bloomberg-as in Michael Bloomberg, the former mayor of New York City. I was shocked at the credit given to the capitalist economic system. From the report: “Today, the poorest Americans have higher living standards-and live healthier, longer lives-than the richest Americans in the 19th century.” It goes on to praise technological advances because increased productivity is the only real way to advance our quality of life. Unfortunately, advancement also means some workers are rendered obsolete. The point of the study was to address the state of workers in the near future (10-20 years). The commission had 100 members in 5 cities create 44 scenarios, which were whittled to 4 scenarios to analyze. More importantly, they surveyed workers about their jobs, satisfaction and expectations.

The conclusions and comments aren’t all that productive. The report seems to mostly provide the opportunity for the members to virtue signal (i.e., talk how much they care about workers). That said, some of the survey results are interesting:

1) There’s the disturbing part about unexpected expenses: 28% said they would have to worry about a $10 unexpected expense. That what my previous post was about.

2) The amazing result, to me, was the response to “What matters most to you about work?” While the report highlights the desire for stability (a top 3 response for every income bracket), a higher response was “Doing things I enjoy”… #1 for all income brackets except $50K-$75K, which had it at #2 (behind stability).

While everyone wants to do things they enjoy, they have to figure out how to get paid for it. Basic Personal Finance points out that work is called work because, for the most part, people don’t want to do it. Picking an occupation is about finding a good or service that you can provide that people are willing to pay for. It is important to consider future job prospects when you decide to invest in yourself through any kind of education or training. Studying a subject that you like but with little prospect of a job (either from no demand or abundance of supply) is not a good investment. Going into an industry on the verge of automation (e.g., truck driving) is also not a good investment.

Why Productivity Matters

Bloomberg’s Shift: The Commission on Work, Workers, and Technology report tried to address the problems workers face with technological innovation. It did, however, praise technological advances because increased productivity is the only real way to advance our quality of life. Here’s why:

Consider the most basic model of a firm selling a single product in a competitive market. That means the firm can sell as much as it can produce at the market price, p. The firm’s inputs are labor, L, and capital, K. For simplicity, we’ll assume capital is fixed in the short-run. (It doesn’t affect the result.) The firm’s objective is to maximize profit, so it will produce efficiently. That means it will produce on its production function, f(L, K), a function that defines maximum output for given levels of inputs, L and K.

The firm’s objective is to maximize profit which equals revenue minus cost. Price times output (production function) is total revenue. Costs are wage (w) times labor and rental cost of capital (r) times capital. To keep the math simple, assume competitive input markets as well, so w and r are constant. The firm’s objective function is


This is a simple, unconstrained optimization problem with a single decision variable, L. (The bar over K is to denote that capital is constant.) To solve the problem, take the derivative with respect to the single decision variable (L) and set it equal to zero:


The result: pMPL = w, where MPL is the marginal product of labor (the derivative of the production function with respect to labor).

So, if we define our quality of life based on our income (wage), we want to increase w. That can only be done by increasing p or MPL. The former will raise wage, but not effectively increase real purchasing power because the increased wage will be offset by the higher price. Increasing MPL, however, will increase wage and allow workers to purchase more product (i.e., higher quality of life).

Note that this analysis also explains why you can’t simply mandate a higher wage. Product prices will rise to effectively negate the wage increase. The only real way to advance our quality of life (as mentioned in the Shift report) is to increase productivity.


Under 30? Time is on Your Side. Don’t Waste It.

Nicholas Hopwood has an article in Investopedia (& Business Insider) that says your best asset is your income, not your home or savings. He makes a good point for millennials. (It doesn’t apply to those of us with fewer earning years ahead.)

A home ties up a lot of income and actually increases your expenses. Plus studies show the real return to real estate is negative. For savings, Hopwood is referring to 401(k) balances. There’s not much there for younger workers, but higher income allows you to make the best use of a 401(k) (to reach the $18K maximum contribution).

For young people, time is on your side because of the power of compounding. Anything you do to increase future earnings will be amplified by that extra time. Hopwood says your early income will be tied to your degree or technical expertise, a polite way of saying you should study something that will actually get you a job. Over time, he says attitude, personality and communication skills are most important to income growth.

Just make sure you save at least 10% of that income… and increase that percentage with each pay raise.

Make Your Own Savings Plan

We’re definitely in a period of “fake news.” Two stories on Yahoo make me think April Fool’s Day was postponed to May this year. The first story claims millennials save for financial freedom rather than to leave the workforce and retire. It cites a Merrill Edge study that claims the 18-34 age group is saving more money than any other age group. That’s hard to believe, given a Consumerist article two weeks ago that said nearly half of Americans are not able to cope with a $100 surprise expense. CNBC has run several stories on a March 2016 Economic Policy Institute report that shows median savings are pathetically low: only $480 for ages 32-37.

From the Merrill Edge study, “average income they say they’re saving per year”:

Millennials:   19%
Gen X:             14%
Boomers:        14%
Seniors:           12%

I started to question those numbers, but then realized it’s self-reported. (Re-read that quote above the numbers.) Digging through the article, it says millennials are more likely to spend money on travel, dining, and fitness than to put it into savings.

Sadly, the only thing in the article that rang true was this line: “they’re not thinking about retirement as a phase of life”

Curiously, another article about millennial savings by the same Yahoo author claims millennials are “more eager to pay their own way at younger ages than when baby boomers think they should.” That one claims a Bankrate survey. The funny thing is the conclusion: “The dream of financial independence and the reality of their current financial situation continues to be at odds for many millennials.” Don’t forget, this is the same author that just claimed millennials save more than other generations.

The take away (besides don’t print fake news): don’t make your decisions based on what other people are doing (or claim to be doing). Figure out what quality of life you want during retirement (i.e., how much you want to live on each year), and then figure out how much you need to start saving now to get there. My book helps you figure out how to do that. The important part is to start now. Compound interest isn’t something you get back later.

Don’t Let Your 15 Minutes of Fame Be as a Bad Example

CNBC seems to be highlighting people’s financial mistakes . They started in January with a story about a woman spending $700 a month on Uber. This month, they have two stories: one about a guy with $100K in debt spending $1,100 a month on takeout (nearly 30% of his income!); the other is someone who wasted $41,000 at Amazon on over 1,400 items, none of which she can remember. That last one also links to a story about how consumers underestimate their online purchases.  OpenUp studied 1000 subjects in 2016 and found a big disparity between self-reported purchases and actual purchases (22 items vs 41 items). Fortunately, the personal articles go on to explain the mistakes and show how these people have turned their financial lives around.

It’s not hard to avoid the big financial holes these people dug for themselves. You can learn about financial discipline in Basic Personal Finance (or just about any consumer finance website… of course, my book is better). Don’t let your brief 15 minutes of fame be as a bad example for others to learn from your mistakes.

10-Year Forecasts are Fairy Tales

The Wall Street Journal just had a great article on the pathetic job the Congressional Budget Office (CBO) has done with predicting costs and coverage from the Affordable Care Act. It’s about time someone points out the idiocy of these projections from Washington (not just the CBO). If you’ve had any statistics classes, you know the standard error for a prediction gets bigger the further away it is from your data. For a time-series model, the error as little as three periods into the future is so big that any predictions are practically meaningless.

I’ve never understood why we always get 10-year forecasts from every agency in Washington. I suspect the reason can be summed up by National Security Advisor Jeffrey Pelt in The Hunt for Red October: “I’m a politician, which means I’m a cheat and a liar, and when I’m not kissing babies I’m stealing their lollipops.” This raises the question: do lollipop makers take election years into account when forecasting future sales?

Anytime you see “10-year forecast,” you can replace that with “Once upon a time,” and you’ll be better prepared for what comes next.