Two Hypotheticals: Planning for a Rainy Day

In scenario 1, you invest 5 grand at the end of each year for the next 10 years. After 10 years, you don’t invest a dime until you retire (at the end of year 30). Thus, you’ve invested $50,000 total.

In scenario 2, you don’t invest a penny until 10 years from now, but invest  5 grand each year for the next 20. This makes your total investment $100,000.

Both of your investments compound at a rate of  6% each year. Which scenario would you choose to retire on?

The surprise (maybe not for some)

Scenario 1 returns more money by the time you want to retire! In fact, you’ll make almost $30,000 more than Scenario 2. But how can this be since you invest TWICE as much in Scenario 2??

Simple. Your investments in early years make a great deal of difference, and the interest that compounds year over year (even at a modest rate of 6%) is more than enough to make up for the larger investments made in Scenario 2.

So start investing now. You won’t regret it!

For the last few months, I’ve been hard at work on a comprehensive system for determining what to do with your money. I’ve spoken with financial advisors, friends and family, working to establish the easiest and most effective way to give you a personalized financial report.

And now, it’s ready for an alpha release. As such, I present to you, HapiMoney.

How it’s set up

There are 4 main sections: Basic Info, Budgeting, Balance Sheet, and the Risk Questionaire.

Basic Info: The shortest section, but still very important; just fill in your email, age and when you want to retire. The longer you’ve got until retirement, the better off you are.

Budgeting: Your monthly income and monthly expenses. Using these variables, we can determine the amount you’ll need to retire, how much free cash you’ll generate (for investing purposes), and how much cash you should keep on hand for an emergency fund.

Balance Sheet: This tells us what you own and what you owe. From this information, we can determine which of your debts to pay off and the required rate of return for you to reach your goals.

Risk Questionaire: How risk averse are you? By taking this academically developed survey, we can determine how much of your investable income should be allocated towards risky investments like stocks or towards less risky assets like fixed income.

Your Personalized Report

Given your responses to the 4 main sections, we can give you a step by step analysis of what to do with your money: how much cash to keep on hand and where to put it, give you recommendations on a brokerage account along with some ETFs to buy (and how much), and finally tell you whether you can achieve your retirement goals.

So give it a try, and let me know if you found it helpful. Email me at alex@hapimoney.com. I’d love to hear what you like and what you dislike (and if you find any bugs)!

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Most of us who work for large corporations get granted stock options as part of the compensation package. As a result, many also hold onto stakes which make up huge portions of their net worth.  Make no mistake, Stock is a great incentive mechanism, especially for smaller companies where each individual has more effect on the bottom line.  Company stock is, however, incredibly risky to hold on to in any large amounts.

Aside from the fact that having large amounts of your net worth tied up in any one asset is a mistake, owning your own companies stock compounds this immensely. Why? Because your job security and the value of the stock are incredibly correlated. If the company’s stock tanks, chances are going to lose your job.  If you lose your job AND your retirement fund disappears, you are straight up screwed.  Look at what happened to the employees of Enron? Or the employees of WorldCom? These employees l0st their livelihood and retirement funds and will now have to work for the rest of their lives.

Be smart, and while you should definitely keep some stock, make sure its not an outrageously high amount.

The only difference between these two retirement vehicles is when you get taxed. A 401k allows you to contribute money pre-tax to an account (say when you are 30 years old), and the only time you get taxed is when you retire (say at 62 years old). All capital gains and dividends are tax-free for the 32 years in between.

A Roth IRA, on the other hand, allows you to contribute money post-tax to an account and this is the only time you will be taxed. All future gains are tax free which sounds pretty good.

So what’s really the difference? The rate at which you get taxed. If your tax rate in the future (at age 62 in our example) is higher than your tax rate now, a Roth IRA is comparatively advantageous.  If your tax rate when you retire is lower, then the 401k is superior.

And where does that leave you?

1. If you have no idea about your future tax rates (which most people don’t), just choose one account and stick with it. Unless you are expecting to move tax brackets significantly, it won’t matter in the end.
2. If you are a little bit more informed and know your tax bracket will wildly shift (say you are in an enormously high tax bracket now and think you are going to be a teacher when you retire, or vice versa)  then choose the 401k or Roth, respectively.
3. If you are clueless, but are a little bit more sophisticated when it comes to investing, you can always get both a 401k AND a Roth IRA. That way you are protected against shifts both ways in the tax code and your tax bracket.

The NY Times has an interesting article on lifetime annuities here. Basically, a retirement annuity is when you give an insurance company an upfront lump sum of cash, and they provide you with smaller guaranteed payouts for life.

My favorite part of the article is how commission based financial advisors can no longer profit once a client puts their money into an annuity (since they make money for every time you trade) , thus leading them to call this process “annuicide”.

Another interesting issue is based on how low the payouts are. Lets take the example they gave in the article:

So let’s say a 65-year-old man in Illinois turned over $100,000 in exchange for $632 a month for life, a recent quote from immediateannuities.com.

At first glance, $632/month translates to about $7500/year which looks pretty good when you invested $100k (7.5%). Unfortunately, you don’t get the $100k back at the end which means that you have to live 13 additional years just to BREAK EVEN without inflation- and to compensate for inflation you will need to live an additional 5 years on top of that…and to reach a return that would be afforded to you buy the purchase of a long term bond (assuming about 5% yield), you’d have to live until the age of 88.

For those interested in doing this experiment yourself, there’s a function in Excel called IRR, which stands for Internal Rate of Return. In one column type -100,000 (which is your investment in the annuity), and then type the series of payments for each consecutive year below the 100k ($7500 for simplicity’s sake).  In another cell, type =IRR(select the values you entered in followed by a comma “,” then enter a guess, say 1%). You’ll see what the actual return this investment provides you is.

The reason that insurance companies price these annuities so that it takes 13 years to earn back is because the average life expectancy is only 78 years of age. That means, on average, an insurance company will have 13 years just to pay you back with effectively no interest…a no interest loan! So when do annuities make sense? If you were planning on living to 100 is a good choice, or if you just don’t want to deal with the hassle and worry of researching other fixed income investments. Either way, it’s probably better to diversify if you end up going the annuity route, so don’t put all of your eggs in the “annuity” basket.

There are a lot of different ways to do this, and a variety of different results will come because of it. Personally, I choose to stick to more conservative methodologies, but you can be as aggressive as you like.

Here’s how I calculate the amount you need to retire:

1. Figure out what your yearly expenses are: rent, credit cards, groceries, etc.

• It’s probably easiest to figure this out monthly and then just multiply by 12 (to get an annual amount)
• You don’t necessarily have to be exact. The end result is going to vary widely based on your assumptions.

2. Figure out how many years it’s going to be until you retire (warning, this requires basic subtraction).

3. Gross up your annual expenses by inflation for the next X years until you retire.

• Inflation has historically been about 3% per year
• Here’s the formula: annual expenses x (1.03) ^ years_until_retirement

4.  Now you have your cost of living for when you are retired, but since you are no longer earning any salary (you stopped working, remember?), all income must come from your investments.

• Conservatively assume that you are going to earn all of your income from bonds
• Lets assume that the average bond yields about 5% annually
• Divide your expenses from #3 (the grossed up ones) by .05*(1 – T) where T = your tax rate
• Now you’ll have the amount you need to retire.

5. Stop freaking out – it’s going to seem like a lot of money, but keep in mind you will have been saving for all of those years, and your investments will have appreciated significantly.

Here’s an example of how this might work:

• Lets say I’m 30 years old and I have $2500/month in expenses. Multiply this by 12 and I get $30,000. Multiply 30k by 1.03^35 (since I want to retire at 65 and I’m 30 now) and the result is about $85,000. Now back out the amount you need by dividing by 5%*(1-30%) and the answer is $2,400,000.
• Thus, in the year 2045, my $2.4 million will generate $85,000 in after-tax income every year.

Frequently asked questions:

1. Should I Include Payments from Social Security? To answer a question with a question, are you feeling risky? If you honestly believe that Social Security will still be around, funded and viable when you retire, feel free…but it’s a risky proposition.
2. I can’t possibly save that much money by retirement. What assumptions are flexible? Your expenses and the rate of return during retirement are the two easiest variables to adjust for. Stop spending as much money and you are going to see how you need dramatically less to get by on. Also, if you are able to accept higher risk, you can keep more of your retirement fund in stocks which will increase your returns above 5% per year.
3. How can you possibly predict inflation rates? I can’t, but I can use historical rates to give an indication of what the future holds. Here’s a site which does the calculation.
4. Why should I live only off of interest when I retire? Why can’t I just use the notional savings that I’ve accrued? You can certainly do this, but like I said above, I take the conservative approach. Also, what happens when you live longer than you expected and run out of savings? Lastly, do you really not want to leave your family anything? That takes a certain amount of gumption.
5. I’ve got kids, a job, and other expenses now that I don’t expect to have when I’m retired. Should I still include these in my calculation? In theory, no, but you can expect your costs to increase in other areas, like health care, or more travelling. Just be careful when you start lopping off expenses.