Financial Literacy

The Affordable Care Act is partially starting in 2014 where individuals have to purchase health insurance from government-run websites. These health insurance policies must now comply with federal mandated rules about covering more illnesses.

A new study from Columbia University on the Affordable Care Act revealed that people are not choosing the most cost-effective plans for their circumstances. The variables for cost-effectiveness are the insurance premium, the deductible, and the co-payment of healthcare treatment. After seeing the results of their study, the writers suggest that websites include calculation aids to help individuals make better choices. By choosing poorer financial options, individuals are expected to pay an extra $10 billion per year.

In the study, when given 8 different insurance options of varying cost to them, they chose nearly randomly. Only 21% chose the most cost-effective plan. Contrarily, MBA students with consumer finance classes chose the most cost-effective plan 73% of the time.

According to this study, the correct analysis is to make an estimate of health care usage for the upcoming year, consider the uncertainties around those amounts, and then select the plan that best minimizes the total cost of that usage.

These are very meaningful decisions because health care costs, after ACA is fully implemented, it can consume as much as 10-20% of a family’s income. This is due to erratic subsidy levels at different levels of income. For example, if a two-income household earns $62,100 they do not qualify for any government subsidy for their health insurance and their insurance co-pay maximum would be 20.02% of their income at $12,431. But, if they earned just $50 less at $62,050, then they would receive a subsidy of $6,536, lowering their maximum co-pay to only 9.5% of their income. As you can see, mapping out and adjusting your income for government subsidies is another critical element to minimize your overall health care cost.

Financially literacy includes considering as many scenarios as possible, and their financial consequences and likelihood, before making major financial decisions. The new health care law highlights how important this skill is to learn.

Every financial decision is a trade-off: now vs. later, this vs. that, you vs. others, etc. Financial trouble begins when there is no restraint, budget, or list of priorities. The best financial starting point is to go over what you and your family value the most. Then, how much of your money can go toward housing, transportation, education, vacations, retirement, and other major goals? The process of evaluating your spending and saving will help clarify your values and priorities. This is important because sooner or later, you’ll need to justify your spending decision-making when you or your family are tempted to spend beyond allocated amounts.

A clarifying question that many have found helpful is: “What are you willing to tolerate?”

For a few examples:

• Are you willing to tolerate never being able to retire? Why?
• Are you willing to tolerate your children being unable to afford an education? Why?
• Are you willing to tolerate not being able to afford dental care? Why?
• Are you willing to tolerate living in a high-crime neighborhood? Why?
• Are you willing to tolerate being paid less than what you are worth? Why?
• Are you willing to tolerate relationships that do not support your financial goals? Why?
• Are you willing to tolerate your own financial excuses? Why?

If you are willing to accept these conditions, that is fine, but have you thought about the impact these will have on your family’s future? What other parts of your life have you accepted what is going on and where it is headed? Multimillionaire Loral Langemeier says, “Money is not the most important thing in life. But it does have the most impact in every area of your life.”

Going back several decades, around every 7 years there is a banking crisis brought on by a loan bubble. A few examples include: real estate investment trusts, 3^rd-world loans, leveraged buyout loans, savings and loan companies, residential real estate, commercial loans, trailer park loans, and car loans.

Banks just happen to have impaired balance sheets around every 7 years and we happen to be coming up on year 7 from the sub-prime housing loan crisis of 2007. Each loan crisis hits a different segment of loans, but there are a few current warning signs.

• Car loans have maturity terms longer than they have ever been
• There is a new classification of worse car loans: deep-subprime
• Britain has increased home loans 37% so far this year
• Commercial loans with fewer covenants has increased by 55% over the last 2 years
• Canada’s household debt-to-income ratio is very high and continues to rise
• U.S. student loan debt is over a $1.2 trillion and default rates are increasing

I asked a banking finance professor about this 7 year cycle and, offhand, he surmised that 7 years is just enough time that the lenders that learned hard lessons during a crisis have moved up or to different departments. So there is little institutional memory or knowledge on the front lines, where it is needed, to head off the next crisis that is building up.

What will precipitate the next banking crisis? I have no idea but there are plenty of candidates near the precipice. Unfortunately, the bank in the worst financial shape is the U.S. Federal Reserve: old junk mortgage loans, leveraged 50:1 on its capital, no marked-to-market accounting, and to keep interest rates down it is buying up so many loans that it is shrinking market liquidity. Are your finances in good shape for the next financial crisis?

Every financial plan makes an assumption about income-tax rates. The further into the future you are planning, the bigger effect this tax assumption will build into your finances. The rules for reducing your income taxes continually change. These rules are important even for lower-wage and average-wage earners.

An old assumption was that your income tax rate will be lower once you retire so deferring taxes was your best financial move. This is no longer true because taxes of all kinds are increasing, government debts are sharply increasing, so your future tax rate will likely be the same or higher. The result of this tax-rate change is that your best financial move may be to pay taxes now instead of deferring them, or move money to tax sheltered locations like a Roth IRA.

Another old income-tax reduction tactic was to offset a tax increase by increasing your tax deductions; such as charitable donations, health care expenses, and appliance energy credits. However, law makers in Washington have caught on to this tactic so their new taxes are based upon your adjusted gross income (AGI). This number is not impacted by any deductions, so you need different tactics to reduce your AGI. A new tax-reduction tactic is to re-characterize your income from taxable to non-taxable. For example, if you have bonds paying interest, sell those and purchase tax-free bonds. There are others but tax expertise is required to make sure you are correctly following the IRS rules.

There are only a few weeks left in the year to re-examine and take action on the income-tax rates that you have been assuming. Taxes are your largest expense so take the time to minimize your liability with professional level expertise. Remember, there are always three levels of investment taxation to evaluate: you, the investment, and the entity structure or account it is held within. Your tax planning needs to take all of these into consideration.

While attending college, there is a great temptation to use credit cards debt to fund for vacations, dating, parties, electronics, and a zillion other personal excuses. This is a big mistake.

While you are in college, you’re likely to be earning an erratic part-time income and therefore poorly positioned to pay back the principal balance on any credit card debt. College students are unlikely to be financially literate, let alone skilled in budgeting necessary to take on personal debts. Incurring consumer debt during college forces too many students to leave school in order to pay down mounting debts. If payments are late, damage to your credit rating can even ruin some opportunities for employment.

Let me give you a real example of a common scenario. During college, a friend came to me with her credit card statement because she was baffled. She had charged $1,800 on a credit card (for a Spring Break vacation) and couldn’t understand why the outstanding balance wasn’t going down. She had been diligently paying $20 every month for 6 months but the balance wasn’t going down much. I looked at her statement and pointed out that she was being charged an interest rate of 11% and so $17 of her monthly payment was assigned to pay the interest, leaving only $3 to pay down the principal balance. I showed her that if she didn’t increase her monthly payment dramatically, it would take her 50 YEARS to pay off her one-week vacation. In 6 months she had already paid $105 in interest that did nothing to reduce her outstanding balance. She was unaware she had shackled herself with a 50-year burden when she joined her friends on that trip. A few years later she still had not paid off this vacation that she could barely remember, yet was costing her interest payments every month. How many 50-year debts would you like to have? Here is the painful lesson: if you cannot save enough to pay for a personal expense with cash – then you simply cannot afford that item. This is true for anyone and particularly those with part-time or sporadic incomes.

There are 3 primary retirement plans waiting for retirees. There is a significant gap in lifestyle spending between each of them. Do you know which one you are heading toward?

1) The “Government Retirement Plan” for people who have no savings. This plan consists of social security and other federal, state, and local entitlement programs such as food stamps and housing support.

2) The “Controlled-Crash Landing Retirement Plan” for people who have some retirement savings. This plan consists of withdrawing a small percentage (3-4%) of your account balance each year to supplement your spending on top of social security and possibly, pension income. The size of your withdrawals, your longevity, and investment return determines whether you run out of money too soon for a financial-crash landing.

3) The “Royal Retirement Plan” for people whose investment income (dividends, interest, rent, etc.) exceeds their living expenses. With this plan, you spend less than your investment income so there is continually new money available to buy more income-producing investments. This reinvestment continually ratchets up your investment income to higher levels.

The difference between which of these retirement plans you’ll have will mainly depend on your level of financial literacy and willingness to act on it.

When someone under age 30 says something similar to, “Money isn’t a priority for me,” or “I don’t care about a career right now,” I know that they are heading down a bumpy road. I am not saying that money and careers need to be central to your life to the exclusion of all other goals, just that they need some continual attention and maintenance.

When someone cares little about money management or career planning, I repeatedly witness the same predictable wake-up calls that they experience as they get older. Here are some of the many markers:

• When they are in their 30’s and have no extra money, they’ll be shocked that others their own age can afford to buy a home, a nice car, and raise a family.
• When they are in their 40’s and languishing in a job with no potential for advancement, they’ll be shocked that others their own age are being promoted to job titles toward the top of organizations like, “Vice President,” ”Director,” “Partner,” and “Senior Management.”
• When they are in their 50’s and have little or nothing saved for retirement, they’ll be shocked that others their own age are talking about early retirement from large retirement accounts.
• When they are in their 60’s and see no financial way they could ever retire, they’ll be shocked that others their own age are comfortably retired and giving money to their kids and charities.

There is a financial gap that starts in high school and continues to grow between those that perform ongoing money management and career planning and people who do not. I’m not recommending that you have to work your way up the corporate ladder, but you need to be aware of the financial choices you are making and the long-term consequences of those choices. Otherwise, you’ll find yourself shocked at what your peers are achieving as well.

40% of an individual’s income is a critical number.

When housing takes up +40% of someone’s income, it is an alert that they are dangerously close to being homeless. The smallest extra bill or cash flow hiccup is likely to get them evicted.

When income taxes eat up +40% of someone’s income, they will scramble and find ways to reduce it. Across the globe, governments rarely collect on tax rates above 40% because citizens will suddenly go very far out of their way to avoid it; when they did not at only 35%. But at 40%, people will hunt for any loophole or deduction, work less to get below that threshold, or move to a different jurisdiction.

When food takes up +40% of enough people’s income, they will collectively revolt against the government. There are many examples, but the French Revolution and the more recent Arab Spring revolutions both had rising food costs as a critical factor in building dissatisfaction with the current government.

There are several important ratios for personal income. Financial literacy includes knowing and following certain ratios that to lead toward financial success. For example, people who are able to retire early, in comfort, save 20% or more of their income. Exactly how much are you currently saving? How many other income ratios do you know and follow?

The recently-released 12^th annual retirement survey by the Transamerica Center concluded from their questioning that Americans are largely unprepared for retirement and few have a backup plan if they are forced into early retirement. Specifically, they found that 44% of workers have no strategy to retire and 39% of Americans expect to work until age 70 or longer. The number one reason cited to work that long was, “Necessity – because they won’t have enough money to retire.” This is disappointing to the financial planning community because after age 50, many people can find themselves out of work and unable to re-enter the workforce at anywhere near their old salary. Plus, after age 55, health issues increasingly prevent workers from full-time employment; the older you become the more uncertainty there is around your career trajectory.

I believe that this survey is revealing the continuing general weakness of the U.S. economy that has been accumulating over the last 5 years with the unemployed, underemployed, and low-interest rates on savings and bonds. Plus there are more financial landmines than normal: pay cuts or zero salary increases are common; companies, universities, and local governments are cutting employees from full-time to part-time to avoid Obamacare; no one knows what medical and health insurance costs are going to do over the next 3 years; and the economies of developing countries are not strong enough to pull the U.S. economy up with exports to them.

In my experience, a comfortable retirement is increasingly reserved only for people who are financially literate. A comfortable retirement before age 60 is only possible with diligent financial literacy. And if you are behind in retirement savings or unemployed, then it is critical to become financial literate and execute offensive strategies that do not rely on an employer. If you want to avoid becoming a retiree with financial difficulties, then raising your level of financial literacy is your best tool to make that happen.