Portfolio manager Cale Smith’s riffs on investing, spoke funds, and Islamorada in the Florida Keys.

The latest installment of our recent series, where we boil down others’ contrarian financial advice and let the dust settle where it may.

Part 3: Raising Your Living Standard

Lot of material here, so I will split it up into two parts. 3a is below and 3b will be next week.

Chapter 9: My Son, The Plumber

Who do you think has the higher lifetime living standard – doctor or plumber? You might be surprised. The authors run through a scenario, based on reasonably realistic assumptions, showing that over both lifetimes, a plumber’s standard of living could actually be higher than a doctor’s. After factoring in the cost of medical malpractice insurance, education, loan interest and a delayed start to prime earnings years compared to a plumber, who takes no loans and begins earning income even during his training, it’s at least closer than you might think…even if you find fault with a few of the assumptions.

Bottom line: don’t take your career for granted.

Also, don’t even bother trying to get a plumber to come over on a Saturday. And the PayScale.com site can be useful when figuring out what different careers pay in different areas.

Chapter 10: Does College Really Pay?

I’m keeping most of my notes from this section private, just so they can’t ever be used against me by daughters.

The real question while deciding to attend college is if a higher living standard is achieved over your lifetime given the costs associated with attending college (i.e. four years of tuition, room and food – and with no earnings coming in). Based on pure economics, going to an expensive college is far less beneficial than most people believe.

Chapter 11: Fire Your Job

Suppose you are married and both of you earn $17,500 or slightly over the minimum wage. If either one of you stopped working, you are actually more likely to raise your living standard. This is because (at the time the book was written) a combined household income of $35,000 disqualifies you from most tax credits and benefit programs like Medicaid. Reducing your income by half is more likely to enable you to qualify for all possible tax credits and benefits, and when combined with reduced taxes, your economic gain will likely be an amount close to the earnings you gave up.

The same logic applies to moderate and high income groups. If your earnings are towards the lower end of the tax bracket you fall in, it might make more sense to reduce your earnings to raise your living standard.

To be clear, the authors aren’t necessarily recommending this as a sound financial planning strategy (at least I don’t think they were) as much as they were highlighting this point: the government is guilty of malign neglect in determining the impact of a complex system of taxes and benefits on the work incentives of many Americans. In some cases people would actually have more spending power by not working. Nutty.

Moral of the story: knowing your effective tax bracket might help you easily raise your living standard.

Chapter 12: Location, Location

The following are the prices (pre-bubble, presumably) for similar houses in three very different locations:

Cedar Rapids, Iowa: $174,950
Tampa, Florida: $309,000
Seattle, Washington: $525,000

If you were a cold-blooded economist, in which home should you choose to live?

Yep. Living in Cedar Rapids raises your living standard 34% compared to Tampa and 78% compared to Seattle. That’s, um, kind of a big deal.

You could, however, argue that buying a house in Seattle or Tampa means leaving kids with higher assets or that it provides you with a safety net when it comes to paying medical bills. But if your kids get a better start in life, they are more likely to do better than you and may not require the assets at all. Besides, the major financial risk in your later years is nursing home expense rather than any illness. If you and/or your wife end up in a nursing home (one most likely to be covered by Medicaid), when the last spouse dies, most or all of your home equity will likely go to Uncle Sam, leaving your kids with nothing, anyways.

At this point I had to stop and give the kids the bad news. Then I made a margarita, went to the beach, and reminded myself why I don’t live in Cedar Rapids. Neither do the authors, by the way. So, again, might be another conclusion they made here that is more theoretically interesting than practically useful.

Chapter 13: Whether ‘Tis Wiser

Andrew and Jessica face a dilemna: to buy or rent a house in San Diego? Housing prices have fallen in the recent past but there could also be a sharp hike in the near future. (Reminder: this was written back when housing prices might actually go up again. Seriously. The authors were not drunk.) The same applies to mortgage interest rates.

Andrew and Jessica can never be sure of the correct time to buy a house. The most important consideration in buying a house is the certainty of living there for a very long time. If you are likely to move in the next five years, it’s not worth the risk.

Though renting the house rather than buying may look like greater savings, the opposite is true. Rather than renting, buying the house in San Diego leaves the couple with 4.6% higher living standard per year, despite the higher costs earlier. This is on account of the tax advantages of home ownership. Moreover, as time passes, the real value of mortgage payments fall due to inflation.

Another benefit is that if the house loses value, Andrew and Jessica’s living standard will increase rather than decrease. Why? Because of lower property taxes and subdued homeowner insurance premiums. Now the savings can be spent on things other than housing cost increases, although the net worth the two will leave to their kids will be lower. The opposite is true as well. If the value of their house rises, their living standard will take a hit, but the assets they leave for their kids will rise considerably. (Assuming they don’t end up in a nursing home, presumably.)

(Note: Unless your property taxes and insurance premiums are, in fact, lowered, this argument falls apart. I haven’t heard of any municipalities rolling recent property tax hikes back. And monkeys will fly before insurance companies lower premiums anytime soon.)

Bottom line: buying conveys lifetime tax breaks. It also entails higher short-term standard of living costs but lower long-term housing costs. But determining whether buying or renting offers the highest living standard for you requires careful analysis.

Chapter 14: Pay it Down, Way Down

To truly appreciate the winners and losers when it comes to the tax benefits of owning a home, we will consider three men – Armand, Bart and Chuck.

Armand makes $60,000 a year and has just bought a $180,000 house. Much to his sorrow, he learns that his first year tax savings from deducting mortgage interest is a miniscule $224. Also, his tax savings will disappear after the fifth year, leaving him with a cumulative tax benefit of $616. Due to these tax savings, his family’s living standard has improved only by a piddly 0.75%.

The societal benefit of the mortgage interest tax break is small because you only benefit if you itemize your deductions. A majority of low income households don’t.

Armand’s friend Bart makes $150,000 and has just bought a house for $400,000. The tax deduction for Bart and his wife is $4,098 in the first year and it continues for the next 25 years, making their total tax savings $64,092. The tax break effectively increases their living standard by 3.8%.

Chuck makes $400,000 a year and has bought a house for a whoping $1 million. Chuck and his wife enjoy a tax break of $18,821 annually for the next thirty years, raising their living standard by a handsome 45.1%. Now say his wife inherits $500 million dollars. Their smartest and safest option is paying off their mortgage, despite those tax savings. This is because Chuck would effectively save 2.5% in interest (assuming he pays 7% on the mortgage and earns 4.5% from interest on bond investments). Paying off his mortgage effectively increases his family’s living standard by 0.7% each year afterward.

In summary, those who really gain from deducting mortgage interest are the rich or upper class. The real tax advantage of home ownership has nothing to do with whether or not you have a mortgage on your home – it comes from not having to pay taxes on the rental income and services you earn and received on your house. (Economists call this implicit rent.) So, even those with no mortgage enjoy a tax break of sorts. The authors reiterate that paying off your mortgage is one of the smartest and safest investments you can make.

Chapter 15: Does it Pay to Play?

A simple way to raise your living standard is to proactively decide when and how much to pay in taxes. (Within bounds, of course.) Contributing to 401(k)s and IRAs allows you to postpone taxes, while contributing to Roth 401(k)s and Roth IRAs means you pay no tax on withdrawals, ever.

However, contributing to these plans is difficult for liquidity crunched households – and that represents about 2/3 of America. Making an effort to contribute could mean a significantly lower living standard in the present. For example, a 30 year old married couple earning $100K and contributing 6% until the age of 51 would see a 10.2% reduction in their living standard to get a 20.8% hike thereafter. The pinch in the short-run is big, but the long term gains are even bigger.

The best way to compare the returns of 401(k)s and Roth 401(k)s is to determine their impact on your long term living standard. Generally speaking, contributing to 401(k)s is slightly more beneficial than contributing to Roth 401(k)s, but there can be exceptions to this rule. If you are a 60 year old who is not borrowing-constrained, contributing to either plan gives you the same return; it provides an immediate 0.4% gain in living standard. Other exceptions may arise due to differences in age, earnings and marital status. Speaking purely in terms of net present value, however, at any age, everyone benefits from contributing to either of these 401(k) plans.

The other point to consider while looking at these plans is that money from Roth plans is completely tax free. With the exception of low income groups, contributing to Roth plans is safer as it protects you from tax hikes.

Figuring out whether to contribute to a regular 401(k) or IRA or their Roth counterparts can make you nuts. Ignoring future tax hikes, the regular route seems best – particularly for high earners. If tax hikes are on the way, though, the Roth makes more sense.

The authors give this advice (as they’re pretty confident tax hikes are coming): contribute to regular and Roth 401(k)s with a 40-60 split, but only after you’ve maximized your employer’s match. As explained previously, that match is free money, so even if you have to starve to contribute in an employer’s matching plan, it will be worth it.

Chapter 16: Converting

Conventional financial wisdom says its better to defer your taxes and earn interest on savings. Conventional wisdom also says it’s a bad idea to convert all your 401(k) or Traditional IRA money into a Roth IRA, since you would have to pay taxes immediately. However, the authors calculate that doing just that increases your living standard permanently by 5%.

Converting may allow you to take your 401(k)/Traditional IRA money out at a significantly lower tax bracket if you’re being hit by the AMT. Moreover, converting to a Roth before collecting Social Security reduces your taxable income and limits the taxes paid on Social Security benefits. These two benefits more than offset the gain of deferring taxes and earning interest on those savings.

Starting in 2010, anyone can convert their 401(k), regular IRA or comparable tax deferred retirement account money into a Roth IRA. That’s great news. However, converting is not necessarily a good idea for everyone.

A low income household, for example, will not pay taxes in retirement, so future tax rates don’t affect them at all and the need to convert is gone. Middle income households stand to reduce their living standard if their regular federal income tax rate is lower than the AMT rate (assuming the tax rates stay fixed). If the tax rates increase by 15%, then middle income households will see a 1.5% to 6% hike in their standard of living.

Obviously, future tax policy has a big impact on the benefits (or lack thereof) in converting to a Roth IRA.

That’s it for now. More Book Notes next week.

Notes from the second part of Spend ‘Til The End. Here’s what this is all about, and last week’s notes. Read Kirk’s comments on last week’s post for some thoughts from a fee-only advisor, too.

Part 2: Financial Pathology

Here’s how I would summarize this section on Twitter:

“Wall Street has your worst interests at heart. Prepare to be swindled. But if its any consolation, everyone else is financially clueless, 2.”

140 characters on the nose. Now I will let everyone know what I just fed my cat.

Chapter 6: What, Me Worry?

Most of us dislike thinking about retirement, so we rarely do. It’s just easier that way. Besides, we borrow far too much, far too often and far too long to ever manage to save anything for our retirement. Gambling is the fastest growing industry in America.

Note: this book was written back in the salad days – when the economy was actual growing.

The size of U.S. consumer debt (inclusive of credit card balances, car loans and mortgages) is approximately $12 trillion-with-a-T, or about $108,000 of debt per household. The risk in being unable to pay off this debt is higher for two income households. If one or both partners lose their income, that debt can’t be serviced and things go bad quickly.

One of the major causes of poverty in America is premature death.

This sounded to me like the opening line of a Stephen Colbert joke, but, alas, it was not to be. It turns out that death is, well, another uncomfortable topic to think about. The result is insufficient insurance for the primary breadwinner. His death commonly leaves the family with little to no income.

Our list of mistakes doesn’t end there. We remain largely ignorant about our 401(k) contributions. Consider the dollar-for-dollar match. If an employee contributed $2,600 a year, he would effectively save $5,200 that year since his employer would contribute an equal amount. So he would double his savings at no extra cost and receive greater returns due to compounding. Only half of all workers save enough to capture that match, though. Or in other words, confronted with absolutely free money, one in two people simply ignore it.

In stark contrast to the overspenders are the oversavers. A 2005 Vanguard annual report on defined contribution plans showed that 16% of participants saved between 10% and 14.9%, while 8% saved 15% or more, which the authors consider to be irrationally saving too much. Those oversavers will go from a lower standard of living while they work to a higher living standard during retirement. They deprive their present and their youth to spend in a future which may or may not happen. Consumption smoothing is more ideal.

Other facts cited in this section:

- Roughly half of older households have never developed a financial plan.
- The average American has a credit card balance above $8,500 accruing 18 percent or more in interest.
- Fewer than two-fifths of Americans pay off their credit card balances monthly.
- Casino revenue surpasses annual 401(k) contributions.
- Some 20 percent of 401(k) assets are invested in employers’ stock.
- One-third of secondary-earning wives are severely underinsured against their spouse’s death.

Chapter 7: Understanding Financial Disease

We ape our parental preferences and behaviors. If your parents were spendthrifts, you tend to become a spendthrift; if they were savers, you will likely be, too. So don’t despair – if you’ve recently maxed out your credit cards, it may be your parents’ fault! (Sarcasm mine).

When it comes to personal finance, we tend to take advice from our parents and friends and/or rely on our personal judgment. The problem with relying on someone else’s experience is that it doesn’t necessarily reflect our own situation. The rich often rely on financial planners, software or even financial publications. But none of those help much, either.

(Note: I agree most online calculators are of limited value, and I tend to think of the financial media as peddling porn for investors. But the authors tend to lump all financial planners together with brokers, tax collectors and record company executives. You know, the real scum of the earth. I think this is shortsighted. My experience is that fee-only planners are a breed apart. I think everyone should use a fee-only planner to make sure the advice they receive is free of all conflicts. The authors whiff on making this distinction. Go to NAPFA.org to find a fee-only planner near you.)

Sometimes it’s just simpler to let others handle our financial decisions. It is certainly easier to let our employers and the government save for/invest for/insure us. And, naturally, they have our best interests at heart. Or do they?

Look back at Enron employees. When the company was on its way to bankruptcy, 11,000 employees collectively lost $1 billion in assets along with their jobs. This happened because they had invested almost two-thirds of their 401(k) assets in the company’s stock. To make matters worse, Enron prevented its employees from selling the stock when its prices were crashing.

Despite the Enron debacle, today over 5 million American workers still have three-fifths of their retirement assets invested in their own company’s stock.

This is bad.

Compulsive behaviors like shopping or gambling are also enemies of consumption smoothing. Just as there are compulsive spenders, however, there are also compulsive savers. In either case, no amount of persuasion can change old habits. One wife may save compulsively because she is unaware of her husband’s earnings. Another may overspend because she thinks she can afford it and her husband is too embarrassed to tell her otherwise. You’d be surprised how often a lack of communication between couples derails the goal of consumption smoothing.

Chapter 8: Financial Snake Oil

Core to the process of retirement planning is usually the concept of the retirement income replacement rate, or replacement rate for short. It says that most people, upon retirement, will need a certain percentage of the income they had earned immediately before retiring. So if you are earning $50,000 at age 65, a replacement rate of 70% to 85% means you’ll need $35,000 to $42,500 in your first year of retirement.

Replacement rates as used by Wall Street, however, typically assume that most of your pre-retirement expenses continue post-retirement. They assume continuation of mortgage payments and perpetual spending on children and college tuition. Most methods of determining replacement rates are made assuming no change is made in your household demographic composition, or that you never spend your accumulated assets. We know none of this is realistic, however. So what gives?

The authors believe “the con begins” with Wall Street convincing you that a replacement rate as high as 70% to 80% is absolutely essential to your retirement.

How do we save that high an amount? The simple solution is to buy any one of 23,000 mutual funds which attempt to provide higher than average returns. However, reality is a little different.

Most fund managers (80% of domestic actively managed stock mutual funds) fail to meet their benchmarks, but the funds they manage nonetheless increase their expenses over time. It’s a zero-sum game: the greater the expenses charged, the greater the losses to the investor.

Those losses, mind you, are in addition to the already high fees charged by the average mutual fund. Mutual fund investors in fact paid a handsome $39 billion in 2002 to brokers for selling mutual funds to them. That’s an extravagant sum to part with – especially for financial services that add no value.

The authors believe that financial planning as practiced on Wall Street offers most investors only two unattractive choices:

1 – Help financial planners make money for themselves while suppressing your consumption during your most vital years; or
2 – Spend your life in anxiety and fear that your retirement will be a disaster.

The best method of planning to the authors remains consumption smoothing. It looks at your entire personalized picture to come up with your lifetime spending power to help you have the smoothest living standard possible, without exceeding your ability or willingness to borrow.

Lastly, a note on annuities, which I mentioned here were a rotten deal for investors. The authors rip equity indexed annuities, too, on page 103:

While equity index annuity products don’t have explicit expenses as mutual funds do, financial economists have calculated that the cost of this safety [referring to the no-loss feature] is extraordinary. Economists have shown that investors would be better off in a simple portfolio of Treasury securities and large-cap stocks 97 percent of the time. They’ve also calculated that the typical equity index annuity purchase amounted to a transfer of 15 percent to 20 percent of wealth from the investor to insurance companies and their sales forces.

And with annual sales of equity indexed annuities reaching $30 billion a year, that’s a staggering loss for investors.

So keep your eyes wide open. At least until we get to Part 3 next week.

As mentioned previously, some notes from Spend ’til The End.

Part I: Smooth Financial Plans

There are three parts to an economics-based approach to financial planning:

1 – Maximizing your spending power. Making financial choices that provide you with more money to spend for the same effort. For instance, whether to collect a smaller Social Security benefit at age 62, or a larger benefit later. Making the right choice doesn’t take any more time or effort than the wrong one, but the consequences on your living standard can be huge. Same for jobs, mortgages, etc.

2 – Smoothing your standard of living. Economists call the spreading of your spending power over time “consumption smoothing.” It ensures you have spending power in good and bad times, and enables you to spend ’til the end. It doesn’t mean starving now to feast later – or vice versa. It means being able to sustain your family’s living standard over time, as you age, no matter what.

3 – Price your love. No, not on Craigslist. This refers to knowing what it costs in terms of your living standard to do the things you love. For instance, taking a wonderful but low-paying job.

The authors believe we are all financially sick. (Literally. Chapter 1: “I Am Financially Sick.”) We spend too little, save too much, take too many risks, take no risks, gamble, shop compulsively, buy lottery tickets, under-insure, hold the wrong stocks, make spontaneous buys, fail to diversify, max out our credit cards, take on too much debt or drown in it. And that’s just on Monday.

But consumers aren’t fundamentally irresponsible. There’s a ton of bad advice out there, much of it coming from institutions who make money by selling financial products. Common rules of thumb like “save 15% of your income” are woefully lacking. Most institutions’ online calculators are biased towards oversaving, since those institutions make more money by selling “riskier” products to make up for a lack of savings.

Consumption smoothing should be the goal – an even, sustainable living standard throughout your life. Financial planning as practiced on Wall Street, though, leads to consumption disruption. Small mistakes in initial assumptions often become huge mistakes in how much you’re told to save and how much life insurance you buy. Because the probability of making planning mistakes is quite high, conventional advice often transforms oversavers into undersavers and vice versa. To the authors, financial planning is often just a marketing tool.

Chapter 4 was called “Pimping Risk.” For some reason I found this hilarious. Also, Wall Street is not your friend.

Eleven tips to maximize and protect your standard of living.

1 – Setting spending targets is asking for trouble. Small initial errors can cause huge downstream mistakes.

2 – Typical households should hold relatively more stock than the rich. Low and middle income groups have fewer financial assets as a percentage of income. In addition, their living standard is reasonably safe due to labor earnings and government benefits. They therefore stand a lower chance of suffering a drop in living standards compared to a family living exclusively off investments.

3 – Diversifying your portfolio is generally a bad idea. In the margin here I wrote “buy these guys a beer.” As the authors point out, a majority of our economic resources are already tied up in bond-like resources such as social security, retirement benefits or other nonfinancial assets. In that light, diversification would actually mean concentrating financial assets in stocks.

4 – Stock holdings should rise, fall, rise and fall with age. Take that, life cycle funds! The amount of stock you hold should reflect your commitments and capacities throughout life. The authors recommend having just a bit in stocks when very young, considerably increasing your allocation to stocks in middle age, reducing your holdings as retirement approaches, increasing it again in early retirement and then, finally, reducing it again in late retirement – assuming you can remember. I’ll be happy if I’m still wearing pants then.

5 – Having children may lower your need for life insurance. No, not because kids drain the life out of you. (Just kidding, guys!) In the economic sense, the more kids you have, the more you lower your living standard. So, you can reduce the protection level required because there is a lower standard to maintain. Children also come along with their own life insurance polices on their parents’ lives, such as social security children’s survivor benefits. Only an economist can get away with this argument, by the way.

6 – Spouses or partners with the highest earnings may need the least life insurance. If your spouse is younger than you or expects to retire later, that spouse may have more lifetime earnings to protect than you.

7 – The rich have bigger saving and insurance problems than others. Because of its progressive benefit formula, Social Security retirement and survivor benefits replace a much larger fraction of the earnings of most workers than the rich.

8 – Maximizing retirement account contributions is generally undesirable. The majority of young and middle age households are cash-constrained due to mortgages and home/auto loans bundled with other off-the-top expenses. When such households maximize retirement contributions, it often translates into a cut in current living standards…leading to a higher living standard in old age. Again, the idea is to smooth that consumption.

9 – Waiting to take Social Security can dramatically raise your living standard. If you wait just an extra year to collect benefits, they are permanently increased by approximately 8% (over and above inflation) due to compounding.

10 – Oversaving and overinsuring are very risky. Oversaving will result in a cut in your present living standards, and should you meet your demise as soon as you reach retirement, it will have all been for naught. When you overinsure, you risk living too long and never benefiting from the insurance money, despite cutting your current living standard to pay those premiums.

11 – Mortgages offer no tax advantages for most households. A majority of low and middle income households are unable to deduct mortgage interest since they don’t itemize their deductions. Itemizing is not very beneficial even for those who do it as there is no real tax advantage of having a mortgage. That logic is explained via an example: Assume you can pay off your mortgage but don’t and instead invest in bonds. The interest you earn from bonds is lower than the mortgage interest, and interest received on bonds is also taxable. So, the vast majority of people would better off by paying off the mortgage.

We’ll pick it up from there next Thursday.