Thursday, March 29, 2007

Financial Autopilot

For every minute spent in organizing, an hour is gained. Anonymous
My checkbook has been on financial autopilot for so long now, it's hard for me to imagine it any other way. I spend almost no time at all paying bills, timing my cash flow, or remembering due dates. This enables me to focus more time on my investments, my career, and my family.

My system consists of two simple parts:
  • Automated clearinghouse (ACH) debits and credits
  • Overdraft protection

For each recurring credit or debit in my life, I signed up for "direct deposit" or "automatic debit" directly from the company involved. This includes my:
  • Paycheck
  • Federal Tax Refund
  • State Tax Refund
  • Mortgage
  • Telephone
  • Cell phone
  • Internet Service Provider
  • Water/Sewer
  • Electricity
  • Gas
  • Trash
  • Auto Insurance
  • Others
Note that this involves contacting each company and providing authorization for them to credit or debit your account. For a few years in the mid 90's, I used (what is now called) online bill pay where you control everything from your checking account. I didn't find this approach to be satisfactory at all, as it only seemed to eliminate the postage stamps. First of all, the online bill pay paradigm still requires you to remember to schedule all of your payments. (Most of my monthly bills are not a constant amount of money, and many of the due dates also vary from month to month.) Second, in the case of any billing or payment dispute, the introduction of a third party can be a nightmare for any timely resolution of the problem. The second part of my system is to attach overdraft protection to my checking account. I've had overdraft protection since 1991, when I opened a revolving credit line with my bank specifically for this purpose. (The bank offered it to me when I opened the checking account.) About 10 years later, I decided to simply attach my HELOC (home equity line of credit) as overdraft protection to my checking account. If you don't have a proclivity to rack up debt, this is a truly great tool. I don't think I could make the automated clearinghouse transactions work effectively for me without the overdraft protection. The payments are often very uneven and biweekly paycheck deposits don't always time correctly with monthly bills. Thus, if you let all these debits happen automatically and you don't want to bounce anything, you either have to spend a lot of time tracking everything very deliberately, and/or you have to maintain a large checking account balance as a cushion. I don't like either of those options. Hence, I just have the occasional overdraft onto my HELOC. As soon as I realize there is a balance on my HELOC and I have the money from the next paycheck, then I completely pay it off. For you debt avoiders out there, this is not as bad as it sounds. I only use the HELOC as a bridge to even out my cash inflows and outflows without worrying about what my checking account balance is every single day. I don't use it to borrow money for more than a few days. When used in this way, the interest expense is very minimal. For example, if I overdraft $200 for one week and then pay it off, the interest expense is about 30 cents. (There are no fees involved - only interest charges.) Even if I did this once a month, my yearly interest expense would be less than $4. This is a bargain when you consider that you are giving up $5/year for every $100 you keep sitting around in a checking account versus a brokerage money market account - and perhaps even more, if that $100 was allowed to flow through to longer term investments. I've used this system for a very long time, and even in years where I was very sloppy about recognizing and paying off the overdraft balances, I think I still always incurred less than $10/year in interest. So to summarize the advantages:
  1. Saves time. There are no trips to the bank and the post office. No time is spent writing checks. No time is spent scheduling the payments. It also allows me to block together all the record keeping to once a month, which is also a more efficient process.
  2. Saves money. I probably save about $50/year in postage. There are no bounced check fees ever. There are no late fees ever. At nearly all times, there is very little in the checking account. Instead, the money is earning much higher rates of return elsewhere. And of course the big bang for the buck is with the opportunity cost - the ability to have the time to make a substantial difference in income through focus on one's career and investments.
  3. Reduces Stress. There is no need to remember payment due dates. There is no worry about any of this when you are sick or on vacation or swamped with the occasional 65-hour work week. There is no fear of embarrassment from possibly bouncing a check, and no worry that somewhere in one of the piles of papers there is a forgotten monthly bill lurking.
This is not rocket science. Anyone can do this very easily, but I find very few people do. Certainly there may be good reasons for someone not to use this approach. For example, if you don't have very many recurring bills, it might not be worth the effort. Also, if you have issues with spending control or debt control, overdraft protection of your checking account might play to your weaknesses. (Imagine what a $140,000 HELOC attached to my checking account might do if I had problems keeping spending under control!) And some people do not like the "pull" paradigm of giving authority to another entity to take money out of your account. Or maybe you simply have a better system for yourself that saves you even more time and money. (If so, I'd love to hear about it!) When talking with some people, however, their objections to this strategy often seem to me to involve various mental accounting errors. For example, one friend who continues to occasionally bounce checks does not want to consider overdraft protection because he "will absolutely not pay one cent of interest." A $25 bounced check "fee" is compartmentalized separately from a 30 cent "interest charge". Another friend does not want utilities debiting his charges from his account because of the way in which he tracks his expenses. As near as I can tell, the thinking is that if an automatic debit notice came in the mail, he would account for that immediately so he wouldn't lose track of it, even if the debit date occurred a few weeks later. With an online bill payment, he accounts for it at the time he schedules the transaction. Thus, if he can perform the transfer action a few weeks later than the arrival of the automatic debit notice, he somehow feels wealthier. This makes no sense to me as a $50 electric bill debited on May 30 is still the same in both scenarios, regardless of whether the automatic debit notice comes May 1 or whether you go online May 29 and tell your bank to transfer the money the following day. So if you use a different strategy, just make sure it's for one of the right reasons I outlined earlier. Otherwise, if this system is something workable for you, you may want to consider it. I can't even begin to tell you how great it feels to let the bill paying take care of itself and allow me to concentrate on bigger things in life.

Wednesday, March 21, 2007

Detailed Social Security Calculations

"We think in generalities, but we live in detail."

- Alfred North Whitehead

I've attempted to perform some very detailed calculations of my expected Social Security retirement benefits with the help of the Social Security Online Calculator from the Social Security Administration.

After entering my entire earnings record all the way back to 1988, I then experimented with various retirement ages. Note that "retirement age" simply means the age at which I stop working. I can't actually draw on Social Security retirement benefits until I'm at least 62. The amounts in the table assume withdrawal starting at full retirement age of 67. This makes planning a little tricky because there will be a long time period between retirement and 62/67 where I will have to depend on other sources of income. Also note that the calculator expresses everything in monthly amounts, but I've converted everything to yearly amounts because that is the way I plan and think about these things.

Here's what I calculate as my benefits:

Retirement Age

My Yearly Benefits
In Today's Dollars

My Yearly Benefits In
Future (Actual) Dollars

My Yearly Benefits
Spousal Benefits
(Today's Dollars)

My Yearly Benefits
Spousal Benefits
(Future Dollars)

Surprised? Yes, that is a lot of money. Even when assuming a retirement age of 45 and a potential reduction of 20% or 30% due to program cutbacks, it is a lot of money! And remember that these are just the initial retirement benefit levels at age 67. They are indexed upward for inflation every year after that.

This is why I mentioned in a previous post not to ignore Social Security retirement benefits if you are planning on early retirement. It's true that you will have to wait a long while for your benefits to start, but when they finally kick in, it may actually be a very significant amount of money. Effective planning for your future cash flow needs should consider your possible Social Security benefits, as they may loom large when you enter your 60's and 70's.

(Disclaimer: I do not work for the Social Security Administration, nor am I an authority on Social Security matters. This article is merely a brief description of my best understanding of how Social Security works and how it relates to my personal situation. For the purposes of making any real financial decisions, please make sure to get your Social Security information directly from the Social Security Administration.)

Tuesday, March 13, 2007

Why I Won't Need 80%

"If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is."
- John von Neumann

The rule of thumb from the financial experts is that you will need to replace 80% of your pre-retirement income in order to maintain the same standard of living when you retire. I suppose that figure may be true for some people, but it clearly won't be the case for me.

The first thing to realize is that after retirement, I won't need to be saving money, so the percentage of my income that I have been saving each year won't now be needed to support my standard of living. And if you retire early, of course, it's a good bet that you had a high savings rate which enabled you to get there so soon. For me, I've been saving around 40% of my income for quite a while, so simply dropping the need to continue to save money would by itself reduce my "magic number" to 60% of pre-retirement income.

Second, after retirement I won't be paying Social Security and Medicare tax on my income because at that point, the sources of my income (i.e. interest, dividends, capital gains, and pensions) won't be considered earned income. This saves another 7.65%, and puts the magic number close to half of pre-retirement income.

Third, a drop in income to one half of my pre-retirement income means a significant reduction in my Federal and State income taxes. This further reduces the percentage of pre-retirement income needed.

Ultimately, I believe my income level at retirement is a poor proxy for my retirement needs. A better choice would be to use my consumption level at retirement. For many people, income level is unfortunately roughly equal to consumption level, so in that case, income may provide a close approximation to consumption and I believe that is probably the origin of the 80% rule of thumb.

Lastly, I would be remiss if I painted the entire story as good news. For while I believe that the required initial level of retirement income is often grossly overestimated, I also believe that the required growth of retirement income is often severely underestimated. I have compiled a number of anecdotal measures of inflation from my own personal experience and the results are not pretty.

Much of my retirement planning for the last several years reflects this reality. Most of my portfolio strategy is centered around dealing with two problems: the order of investment returns and inflation. I hope to address these issues in detail in futures posts.

Thursday, March 8, 2007

Early Retirement and Social Security

"It does not do to leave a live dragon out of
your calculations, if you live near him."

- J.R.R. Tolkien

Calculating your Social Security benefits is complicated, and determining the effect that early retirement will have on those benefits is even more difficult. In an effort to avoid the complexity of the problem, much of the conventional wisdom tends to fall to the extremes: either blindly assume Social Security will take care of all your retirement needs, or ignore it altogether because of potential solvency issues with the program.

For the typical person contemplating early retirement, however, Social Security benefits are far too important to be casually dismissed. Compared to most traditional pension plans, the Social Security program is considerably more favorable toward the early retiree. The reasons for this good fortune will be apparent as we consider the details of exactly how the retirement benefits are calculated.

Let's examine the effect of early retirement on these key items:

(The above items are all linked to their relevant sections in the Social Security Online website. There you can find out almost anything you want to know about Social Security in excruciating detail.)

1. You need 40 credits to qualify for Social Security retirement benefits, and you can receive up to 4 credits per year that you work. You need about $1,000 of earned income for each credit, so if you have wages of at least $4,000 for the year, you receive your maximum of 4 credits for that year.

Implications for early retirement: It does not matter when you earn the credits. If you work for 10 years and have at least $4,000 in wages in each of those years, then you qualify, regardless of whether you work any more years. In my case, I already have the necessary 40 credits, so I will always qualify for benefits even if I stop working at 45.

2. Your wages for each year are indexed to their current value, based on the average wage increase in the United States during that time period. All your wages up to age 60 are indexed. (Wages after age 60 are not indexed.)
Implications for early retirement: This one is huge! Most employer pensions are based on your final salary when you stop working. The basic idea is that you will receive raises throughout your working career, so that basing your pension upon your final salary has the effect of compensating you for the inflation that occurred throughout your career. However, this only happens if you are working for that employer right up until the time that benefits can be paid. Otherwise, you are not compensated for inflation.

For example, suppose you work from age 25 to 45 for Company A, which has no pension plan. You then leave Company A and work from age 45 to 65 for Company B, which has a typical pension plan based upon final salary. Further assume that both Company A and Company B treat you reasonably well by giving you the average wage increases for your line of work. When you turn 65 and retire, your pension is roughly based on your salary at age 65. The wage increases throughout your career compensate you for all the inflation that occurred throughout your career.

However, suppose you worked for Company B first for 20 years, and then worked for Company A for the remaining years. Assume your salary for each year was always the same as the first scenario. In the second scenario, your pension will be based on your final salary 20 years ago at Company B. It will likely be less than half of the first scenario! The bottom line: A typical employer pension is worth much more if you work for that employer right before you draw benefits.

I have a pension plan with my current employer. Assuming I retire early at 45, it will be based on my final salary at age 45, but won't be payable until 65. This means inflation will eat up that pension value for 20 years. This is in stark contrast with my Social Security retirement benefit calculations. If you work 40 years, your benefits will obviously be greater than if you only work 20 years. However, the point is that with Social Security, it doesn't matter that my 20 years of work occurred early in my life, rather than right before I start receiving benefits. Social Security can be very important for many early retirees because it doesn't have the same penalty for early retirement that is built into most pensions.

3. The amount of your retirement benefits is based on your highest 35 years of income. All other years are ignored!

Implications for early retirement: First of all, if you have always been a high wage earner, your last few years of working may not increase your Social Security benefits at all. For example, suppose you start working at 25 and are over the maximum every year for 35 years. At that point, you are 60 years old, and your Social Security wage base is essentially maxed out. If you continue working until you are 65, you will pay into the Social Security system for 5 more years, but it will not increase your benefits at all.

Second, it's clear that the inclusion of a lot of years with zero wages will have a considerable effect on your retirement benefits. However, it may not be as bad as you imagine. If you start working at age 22 and you are eligible for full retirement benefits at 67, it's not true that 45 years of wages contribute toward the calculation of your benefits. Only the top 35 years will be included. Thus, if you retire at 45 with 23 years of wages, only 12 years of zeros will be averaged into your calculations -- not 22 years.

4. Your retirement benefits are calculated relative to two "bend points". (The bend points are adjusted each year for inflation.) You receive 90% of your income up to the first bend point, 32% of your income from the first bend point to the second, and 15% of your income from the second bend point up to the taxable maximum amount.

Implications for early retirement: The amount of your retirement benefits benefits are not linear with respect to your wages. Higher and higher total career wages result in smaller and smaller increases to your retirement benefits. Thus, eliminating one half of your career will not result in your benefits being cut in half. The effect will typically be much less.

5. If your spouse also qualifies for retirement benefits, your spouse can choose the higher of his/her benefits or half of your benefits. If your spouse doesn't qualify for benefits, he/she is still entitled to half of your benefits!

Implications for early retirement: The spousal benefit does not seem to be widely understood. Don't assume that because your spouse never earned a lot of income, there won't be much coming from Social Security. Your spouse will at least get half of your benefits, even if your spouse never paid into Social Security! The only restriction is that your spouse must be of retirement age (or is caring for a child of yours under the age of 16).

(Disclaimer: I do not work for the Social Security Administration, nor am I an authority on Social Security matters. This article is merely a brief description of my best understanding of how Social Security works and how it relates to my personal situation. For the purposes of making any real financial decisions, please make sure to get your Social Security information directly from the Social Security Administration.)