Squirrel Away Money While You Can

The following is a guest post from Marotta Asset Management.

In 1985, Franco Modigliani, an economics professor at MIT, won the Nobel Prize for a simple technique that squirrels know intuitively from birth. You have to squirrel away some nuts during times of plenty so you can survive during times of scarcity.

Modigliani looked at the income and expenses of typical people over the life span. He found that household income was sometimes more than sufficient to meet expenses and that at other times money was tight. Preparation during these times of surplus help families avoid going into debt when they must increase their spending.

Modigliani divided the life cycle into four distinct phases:

• Before having children there is often a surplus of income.


• While raising and educating children, there is often a deficit when the family is spending more than they are earning.


• When children go out on their own, families often have a surplus again.


• In retirement the surplus is small if it is there at all.

Saving during the two surplus periods is crucial to financial well-being later in life. Before the children arrive, squirrel away some money. When the children leave home, you get one last chance to save for retirement.

Here are seven financial life lessons from Modigliani's analysis:

When you are starting out, don't try to duplicate your parent's lifestyle.

Most of today’s college graduates are ill prepared for the real world of financial responsibility. They never saw how their parents lived when they were first married and struggling. Consequently, they may base their after-school expectations on an upper-middle-class lifestyle.

If you are a young adult, you can't afford more house than your budget will allow. If you spend 50% of your lifestyle expenses on housing, you will not be able to live proportionally on the rest of your income. Too much house is one of the most common mistakes young people make.

It is as though we can't feel successful without immediately enjoying the lifestyle of our parents at the height of their careers. To decide how much house is enough, calculate what you can buy for 30% of your standard of living.

Save as much money as you can in your 20s

Early in your career, when the cost of basic needs is small, income often easily covers expenses, allowing the surplus to be used for savings, investment or added consumption. Many young people assume they are doing so well financially that they can simply spend their extra money on more stuff. They do not realize these years of plenty won't last.

During this period, save and invest up to 50% of your disposable income for future expenses. Fully fund Roth accounts, and fund 401(k) plans to take advantage of any employer match. Save 10% of your take-home pay for future large expenses. Put an additional 5 to 10% into long-term taxable savings.

This advice is especially important for those who delay marriage until they are in their 30s. Don't waste a decade of prime saving and investing. You owe it to yourself and your future family to store up nuts now.

Don't just save: invest

You can't afford to keep your money in cash or in a bank account earning very little interest because of inflation. If you had saved $100 in 1970, it would only have the buying power of $16.88 today. You need to earn a return that exceeds inflation. Fortunately, you can.

At 10% market returns, whatever you save and invest doubles every seven years. So $1 saved and invested at age 21 doubles eight times before age 70. At that rate of return $1 saved and invested grows to $128 in retirement. If you wait until age 49 to start, $1 saved and invested will double three times, growing to $8.

Although annual volatility is high, it decreases with a longer time horizon. Given a 50-year time horizon, the odds of your money experiencing a positive average market return are very good.

Put another way, for every seven years you delay starting to save and invest, you risk cutting in half your net worth in retirement.

Avoid debt while raising a family

Expenses multiply once children arrive. The one-bedroom apartment is replaced by a four-bedroom home with a mortgage. If expenses for food, clothing, medical, dental, clubs, camps and lessons aren't enough, children have their own set of endless desires. The average cost of raising a child to age 18 in 2012 dollars totals about $300,000. After a third of a million dollars in payments, the balloon payment comes at the end when college expenses are often financed through student loans and additional mortgages. During these years, many couples wish they had not spent their pre-child surplus.

Families find it challenging to live within their means during this phase of life. But you can live more simply in order to live debt free. The difference between middle income and multi-millionaire is a few hundred dollars a month in saving and investing.

Stop telling yourself you will get your finances in order later

The average American family runs their financial affairs in such a way that if they were a publicly traded company, their stock price would plummet, the business would go bankrupt and the people in the accounting department would be taken away in handcuffs.

You can’t postpone financial faithfulness any more than you can postpone marital faithfulness. Your habits set your financial DNA, and habits are simply habit forming.

Many people mistakenly believe that life comes in three stages: learning, working and recreation. They think that until they are toward the middle or end of the working stage of life, they don't need to worry about finances.

Everyone in America can save something. Whatever you save, the magic of compound interest produces incredible results. It is far preferable to know what you need to save than to arrive at retirement unprepared.

Get a retirement checkup before you turn 50

For most families, expenses drop significantly after children leave home. Although starting younger is ideal, these are the years when many families realize time is running out to prepare for their retirement and they seek professional financial advice. This period provides a second chance to save and secure a financially comfortable retirement.

If you are in this stage of life, you need to know exactly how much you must save to achieve a comfortable retirement. You don't have the luxury of guessing at the appropriate savings rate.

Know your safe withdrawal rate in retirement

Retirement ideally finds the family with income adequate to continue their usual lifestyle. With sufficient assets and good asset management, income from savings and investments, pensions and benefits should cover retirement expenses.

During retirement it is crucial to know what rate of withdrawal is safe. Spend too much and you will run out of money. Be too frugal and you needlessly put a damper on the years you might be traveling and gifting. You must have the right asset allocation to provide enough growth for a long and prosperous retirement but enough stability to weather market upheavals. This is another juncture that does not allow for guesswork.

The lessons to learn from Modigliani's work are simple: "Before the children arrive, squirrel away some money. When the children go out on their own you get one last chance to save for retirement!"

Comments

[Mike Hunt]

Great advice. I'd say for those starting out in addition to saving and investing, spend a lot of time building your career and making nice salary jumps... over the average person in your organization.

And I don't think the 10% assumption on investments applies now, with the US 10 year treasuries (one measure of nearly risk free returns) at below 1.5%!

-Mike

[texashaze]

10% returns?!? You've got to be kidding.

[Rick Francis]

@texashaze

>10% returns?!? You've got to be kidding.

Just because returns are terrible today I wouldn't rule out a 10% average for the next 50 years. Look back at interest rates on CDs in the 80es- there was a peak at around 16% for a CD! Rates may stay low for another 5 or possibly even 10 years, but they won't stay at record lows forever.

-Rick Francis

[Manette @ Barbara Friedberg Personal Finance]

I totally agree when you said avoid debt while raising a family and stop telling yourself you will get your finances in order later. Paying for various loans and debt doubles your expenses; so, instead of using your money to pay your debt, why not put it in a savings account. It is always best to start saving up NOW more than ever.

[Carol]

Choose an occupation that pays you a livable salary and don't go to an expensive school and rack up a boatload of loans. Save from your first paycheck. Hang with frugel friends. Have a cash cushion. Buy an inexpensive car. Just buy enough house; DON'T BE HOUSE BROKE!!!! Don't have more than 2 children and tell you're kids early and often that they have to pay for part of their college education. Make sure that you fund your own retirement first (before kids' education). There's my pound of preachment for the day!

[Old Limey]

The following sentence caught my eye immediately, as it is so true.

................. "Whatever you save, the magic of compound interest produces incredible results." .................

After I retired I produced some software that I made available for purchase to users of a proprietary database that I have used since 1992. During this time I attended annual seminars that the database company held and learned a most important lesson from a well known money manager that also gave a presentation.

The lesson was:
1) Understand the Power of Compounding.
2) Don't Lose Money.

The reason being that having losing years DESTROYS the power of compounding. To be a successful investor you must avoid losing money. Thus, you just CANNOT be a passive investor. You must use methods and strategies that always keep your investments in uptrending stocks or funds. If you have a 50% loss you then have to double your money just to get even again. Doubling your money is very hard to do.

I retired in 1992 and haven't had a losing year since taking over the management of my money when I retired.
From 12/28/92 to 12/7/07 my annual return was 21.44%
I then switched entirely into income investments.
From 12/7/07 to the present my annual return was 4.29%
From 12/28/92 to the present my annual return has been 17.08% and my total return has been 2,090%.

As a result of my investing skills our annual income from pensions, social security and investments is now 5 times what it was when we retired and since the only withdrawals we make are to pay our federal & state taxes, it's still growing at the age of 77.

[Old Limey]

@Rick Francis
You probably don't remember the rampant inflation that existed for a while during Jimmy Carter's presidency, but I do. This was a period when my wife was complaining that the prices at the supermarkets were changing every week. Sometimes she would sort through the cans on the shelves and find ones with lower price labels that had been there for a week or two.

Anyway, some buddies of mine at work realized that our company Credit Union wasn't keeping its loan rates up to date with the rapidly rising interest rates.

A group of us went over to the Credit Union one lunchtime and took out the maximum unsecured loan that they allowed. I believe it was about $10,000 and the interest on the loan was about 6%. Once we had the checks in our hands we all went down to a brokerage office in town and purchased short term CD's that were paying about 12% interest. We collected the 12% interest for the life of the CD and paid the Credit Union 6% interest for a nice return on our money. By the time the CD had matured the Credit Union had got their loan rates back in sync again.

[Rick Francis]

@Old Limey

I only vaguely remember Jimmy Carter and the rampant inflation- as I was born in 1970... However, it was great hearing that you were able to take advantage of the rates and get a 6% net return on loaned money.
It strikes me that today with rates abnormally low it would be a great time to borrow money to invest. A 30 year mortgage is listed at 3.56%... I can't see how rates could stay below 3.56% for the next 30 years.

I'm not very keen on the idea of managing rental properties but it certainly seems like it would be a great time to buy a rental if you ever planned to do it with both rock bottom rates + depressed housing prices.

-Rick Francis

[Jonathan]

Rick - you're right, it is! I just ran a quick calculation of the difference in monthly payment on a 30-year mortgage using the rate I got on my last rental purchase (4.375%) and a 16.5% rate like I read existed in the '70s - the payment was 2.77 times what my payment is! Housing prices were surely lower back then but I don't think we'll see market conditions as good as we have today (for rental property investors that is) again for a long time. And I'm sure not going to pay off my mortgages early unless I have a darn good reason!

[Mark]

My first IRA was a 1-year CD paying 10%. I didn't take a longer term because I didn't want to lose out if interest rates rose. Of course in hindsight, I wish I had picked the 5 or 10 year deal!

I have just refinanced my house with a 15-year 3% fixed rate loan, anticipating that over a 15-year timeframe my investments will beat 3%.

[Shannon-ReadyForZero]

This is a very interesting breakdown of what each decade can bring and seems pretty accurate to what I've seen in my family. Yet another reminder to focus more on our finances when we're young - even though that can be the most difficult time to remember how important this is.

[Old Limey]

@Shannon
My wife and I watched a very interesting NETFLIX movie this afternoon, it was an "American Experience" production called "Riding the Rails" and illustrated the conditions during the Great Depression that forced huge numbers of young teenagers and men to ride the rails in search of work. We were mentally comparing their experiences with those of young teenagers of wealthy couples we know living in Silicon Valley. The contrast between then and now was staggering. The pampered teenagers we know are being sent off to Ivy League colleges, the teenagers back then were riding the rails in the hope of finding some transient work that would enable them to eat, others were working in Roosevelt's Civilian Conservation Corps helping to build our national parks and earn money to send back home to their out of work parents. In some cases women were disguising themselves as men since nearly all of the job opportuntities, including picking fruit, were for men only. The event that finally ended the Great Depression was WWII, the welfare programs helped a lot but they weren't enough to end it. WWII was also the most formative event in our lives since I was 5 and my wife was 6, in England, when the war started, and living through it is what has made us so thrift conscious. The Great Depression in the USA also produced what are very justifiably called, "The Greatest Generation".

[Terry]

This is great for typical people with typical incomes, but did Modigliani say anything about or to people with low incomes?

Just about half of all low-income renters spend more than 50% of their income on shelter according to Mortgage News Daily.

The affordability burden is most acute among the lowest income (duh). Among low-income renters 49 percent had severe burdens and 28 percent had moderate burdens; among the extremely low income 63 percent reported severe burdens and 15 percent moderate.

[[email protected]]

This is great advice for young adults to keep in mind, especially because it seems like these days many are putting off marriage into their late 20's early 30's. Like you said, don't be naiive to what your future family will need simply because you haven't found/had them yet. I'm sure any amount saved to put toward a home and comfortable lifestlye for a family in the near future will be much more worth it than extra clothes in the closet, or a vacation this winter.