Providing financial advice is much more art than science. Most of the interaction we have with clients could be characterized as “soft sell” rather than delivering hard numbers calculated to the fourth-decimal place.
Not that there is anything wrong with this. Generalizations are OK for casual conversation — as long as the fuzzy figures are based in truth. The problem is that many of the ballpark numbers thrown around don't reflect the real world. Following these aphorisms is like traveling with a map drawn with a crayon: The only way you'll reach your destination is if you're lucky.
Here's some loose talk that is influencing three big calculations in some very unproductive ways, along with some reality-based alternative methods to planning for your clients' financial future.
In a usually well-meaning effort to get the attention of parents of young children, many financial-services organizations portray the cost of college as being a gajillion dollars now, and rising quickly in the future. Since that money will be spent over a just few years, and high-school graduation is right around the corner, the message is clear: “Parents — start saving a lot now or doom your child to a lifetime in the lower class.”
But when confronted with the daunting prospect of saving several hundred dollars per month for future college costs, some families may end up unnecessarily diverting money from more urgent investment needs (like paying down debt or saving for retirement). Or, worse yet, anxiety over the perceived high price of higher education may prevent clients from putting aside any money at all.
Yes, the cost of four years at an Ivy League school is currently well into the six figures (argyle sweater vests not included). But, like most kids, your clients' children will likely attend a less-expensive school. According to the College Board, almost half of all college students attend schools that charge less than $6,000 per year in tuition, and the average annual total expense of sending a student to a four-year public university currently runs about $12,000.
Even that figure may prove to be on the high side, since the College Board says that after grants and tax benefits, the average net cost to families is now around $8,800 per year. That's less than $750 per month — a big number, to be sure, but one that can easily be reached through a combination of accumulated savings, parent and student income and student loans.
The conventional wisdom is that retirees need enough in pension checks and IRA accounts to safely replace about 80 percent of pre-retirement income, a figure based in large part on the fact that retirees won't be burdened by the payroll taxes they paid while working.
This estimate misses the mark on two fronts. First, the amount needed for a comfortable retirement will be determined not by what your clients earn before they get the gold watch, but rather by what they spend afterward.
The other drawback of using a “percentage of income” as a benchmark to retirement readiness is that you have to work backwards to figure out how much return a portfolio has to generate to replace the lost earnings.
There are a couple of ways of looking at retirement from the expense side. First, you can figure out for your clients how much of their portfolio they can spend monthly by dividing their total assets by their life expectancy in months to determine a “safe” withdrawal figure. (We're not taking into account any portfolio gains earned during retirement because, using a conservative investment strategy, we expect taxes and inflation to wipe them out. If you do better than expected, then let the gains be a pleasant surprise to you and your clients.)
If, on the other hand, you want to show them how big their portfolio needs to be to meet their likely expenses, try the following calculations:
|Estimated monthly expenses||(In retirement)|
|- “Guaranteed” monthly payments||(Like Social Security or pension checks)|
|Monthly costs needed to be covered by investments|
Then multiply the result by the number of months in the client's life expectancy. And for good measure, you may want to include $100,000 or so for unforeseen emergencies.
The final total is what clients should have in net worth before they consider hanging up their spikes. A typical client's numbers may look like this:
|-$2,500||(in monthly Social Security checks)|
|$1,500 in uncovered expenses|
If the client has a 25-year life expectancy (300 months), then 300 times $1,500 is $450,000. Tack on a hundred thousand, largely for the unexpected, and it appears that the retiree in question would need a little over a $500,000 before he punches the clock for the last time.
An added bonus of basing retirement planning on expenses is that you can mention to your clients that while you will do your best to earn them the highest return with the least risk possible, a little penny-pinching on their part won't hurt, either.
Industry guidelines generally recommend families obtain policies with death benefits totaling some multiple of parents' annual earnings, usually seven to 10 times yearly income. There are several problems with this thinking, including:
Policies are usually purchased when parents are young, and earnings are low. Inflation and the rising cost of caring for a growing family can erode a once-magnanimous policy's face value down to peanuts in less than a decade.
The calculation ignores the value of services provided by a stay-at-home parent. If he or she were to die, the cost of paying a nanny/housekeeper/cook until the children leave home could be $1 million or more.
Much like the retirement calculation above, a more accurate way to determine life insurance needs is to base the estimate not on current income but on the costs a family will face if one or both breadwinners meet an untimely demise. The process should go something like this:
|Projected future retirement costs*||(For nonworking survivor who will be ineligible to save for retirement)|
|+ Projected lifetime living expenses*||(Net any expected earnings by survivor)|
|- Current net worth|
|Amount of life insurance needed|
|*In present-day value|
Of course, cocktail-napkin calculations are no substitute for high-end financial-planning software. But you'll get to run your clients numbers a lot sooner by first showing them that your wisdom is a little unconventional — in the best possible sense.
|Life Insurance||MSN Money Life Insurance Needs Estimator||moneycentral.msn.com|
|Retirement||Retire Early Home Page||retireearly homepage.com|
Writer's BIO Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com