Client Situation
Peter, a single 29-year-old banker, has been trying to save for the past five years but has met with little success. Every month he aggressively sets aside sizeable amounts of money from his salary into various accounts but, at the end of each year, everything is close to empty including the cash surrender values on his life insurance polices.
The only thing that is increasing is his annuity fund value, to which he is considering topping up contributions. Peter lives at home with his parents and pays the water and electric bills.
What makes his situation interesting is that he has also accumulated several small debts ranging from $5,000 to $8,000 and he refinances every so often when short on cash. Peter has been meticulously tracking his asset balances every year on spreadsheets to measure his performance but the results are always the same: a roller coaster pattern.
The following deductions are taken out of his account each month:
sou sou: $1,000
higher interest savings account: $200
money market fund: $300
stock-based mutual fund: $350
credit union shares $250
two life insurance policies: $635
annuity: $1,500
debt payments $850
tithes $900
Peter completely understands how each of his investments works but, for the life of him, he cannot figure out why he is not accumulating wealth.
Nick’s Assessment & Advice
Wealth accumulation is not measured by the number and complexity of accounts and has little to do with how many standing orders he puts in place. Wealth accumulation is simple arithmetic: it is the difference between money that goes out and the money that comes in, multiplied by some investment rate of return over time. If the amount of money that goes out is greater than what comes in, quite naturally wealth is being destroyed and or debt accumulates.
Further, with every debt that is incurred, less money is available for saving and investing each month. In Peter’s case: the root cause of his problem is not so much his attitude toward savings but rather the management of his financial resources. The following are some of the possible reasons for Peter’s dilemma:
• Lack of goals
• Insufficient funds
• Incorrect tracking
• Heavy long-term investing
Lack of goals:
While Peter has a range of instruments from a simple sou sou to the more complicated stock mutual fund, he has to this point, not clearly identified what each investment is supposed to accomplish. While a saving habit in the absence of a plan can be beneficial, it can also get confusing if he has is no way to determine if he is ahead or behind.
Without something to focus on, he is unable to take corrective action with his everyday financial decisions. Not having any goals, Peter would also not have definitive timelines and time gives structure to his plans. Failing this, he will, by default, give himself permission to make withdrawals that compromise his future wealth and not see its impact until the end of the year.
Peter’s best approach would be to:
1. Make a list of all the things he wants to accomplish
2. Think about the reasons why they are important to him
3. Determine a dollar value for each goal
4. Identify which instruments are best suited to each goal
5. Set a “due by” date
6. Calculate the monthly savings needed to fill the gaps
Insufficient funds:
Table 1 is a list of all of Peter’s monthly deductions. If we were to assume that based on his tithes of $900 (10 per cent) his monthly salary is $9,000. If we were to subtract his deductions, Peter is left with $3,015 ($9,000 - $5,985) to take care of utilities, transport, food, clothing, entertainment, mobile calls, gifts, holidays, health and grooming.
These expenses are necessary for everyday living and when a bill comes up he has to pay it. If he doesn’t have the money in his salary account he will naturally tap into his savings. Peter’s challenge is not so much what his expenses are but how much he spends on them. If there are no limits, he will simply spend as much as he believes he deserves especially if he feels a sense of deprivation or a need for rewarding himself for his aggressive saving sacrifices.
Peter should draft up a realistic budget and integrate these expenses with his various saving objectives. By determining what is an acceptable standard of living for himself and knowing what goals he wants to achieve, he can strike a healthy balance between spending today and saving for tomorrow.
In doing so, he would have fewer reasons to go into his investments and, eventually, bring the roller coaster to a halt.
Incorrect tracking:
Peter has been putting too much emphasis on monitoring his balances rather than what causes them to change. Instead of focusing on the result of his spending, he should track the actual expenses every month. Doing so would identify where his money is going, provide information for his budget, in general, and help him to make adjustments which redounds to positive asset balances.
Heavy long-term investing:
Because Peter has not properly identified his short-term needs for cash, he runs the risk of locking into inaccessible investments which could create a cash crunch, forcing him to turn to debt or cancelling plans altogether. Early withdrawals from certain accounts can lead to penalties, charges or loss of value and defeat the whole purpose behind long-term investing.
Further, if these long-term commitments increase, the likelihood of debt also increases and the gains earned on investments could be offset by the cost of borrowing. Therefore if Peter decides to increase his contributions to the annuity it may do more harm than good. What he should consider is temporarily diverting some of these long-term contributions to clear his debt and free up disposable income, which will accelerate his saving.
Finally, regarding Peter’s life insurance policies, whilst they are excellent for the future, he is single with no dependents and, as such, his plans should reflect his current needs: not for life insurance but for disability and critical illness protection.
We recommended that if anyone is in a similar position as Peter they should seek professional financial advice before making any decision regarding their portfolio.
If you have any further questions or need advice on today’s subject please email me at: NickAdvice@gmail.com or web me at: www.FinancialCoachingCentre.com