CFP Board eNewsletter
March 2008
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CFP Board eNewsletter |
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| Managing Your Money in Tough Economic Times |
The ‘R’ word — recession — seems to be everywhere these days. But financial analysts disagree on whether a recession (defined as two or more successive quarters of negative economic growth) is on its way, has already arrived, or is still a long way off. Regardless of whether a recession actually takes place, one thing is clear: the economy is going through a turbulent period, and for many people finances are becoming increasingly tight. So It’s Your Turn talked to David G. Strege, CFP®, of Syverson Strege & Company in Des Moines, Iowa and 2008 Chair of CFP Board’s Board of Directors, for tips on managing money in tough economic times. The first thing to do, according to Strege, is to look at all the major short-term expenditures coming up in, say, the next 12 months. Maybe you hope to purchase a new car, or you’ve planned a big vacation, or you have a child entering higher education. “Whatever expense you’re planning,” Strege says, “you need to have that money readily available — in a money market or savings account, for example — so that it is not subject to stock market volatility.” A savings account is the safest type of investment. But because interest rates are low — in order to help spur economic growth — your rate of return (the interest the bank pays on your deposit) will be low, too. Still, a savings account is your best bet if you need to have the money available at short notice. For a potentially higher interest rate, you might consider a money market account, another type of savings account that usually requires a higher minimum balance. There may also be limits to the number of withdrawals you can make each month from a money market account. Strege also suggests that your emergency fund — money to be used in case of unforeseen expenses — should be kept in the same type of accounts: “Keeping an emergency fund in a money market or savings account means that if something unexpected happens, like job loss or illness, you’ll have three to six months worth of expenses to see you through.” For more on emergency funds, and how to start saving for one, check out “In Case of Emergency ... Use This Fund!” in the September 2007 issue of It’s Your Turn. Next, Strege advises, take a look at longer-term expenditures, spending that may be one to three years away. “What’s coming up?” Strege asks. “What planned expenditures do you expect over the next one to three years? Maybe you want to make a down payment on a house, or you have a child who will be starting college. This money should be in short-term investments, like certificates of deposit (CDs) or bonds, which are not subject to market risk.” In a CD, you deposit a specific amount of money for a fixed period, anywhere between three months and five years. In return, the bank offers a guaranteed rate of return over that period. The longer you leave the money in, the higher the return. There are usually penalties if you withdraw funds early, so be sure you can afford to leave the money untouched for the full term before opting for a CD. Otherwise, it may be more advantageous to leave the funds in a savings or money market account. Bonds are essentially a way in which corporations and local, state and federal governments borrow money. The amount of the bond represents the amount of the loan, for which the corporation or branch of government pays a fixed amount of interest over a fixed period. You receive your money, plus interest, when the bond matures, though bonds can also be traded like stocks. In the longer-term, five years or more, Strege recommends investors remember, “Stocks always have short-term drops. The worst thing to do is to have an emotional reaction to short-term market turbulence and to get out. If your investments have already lost value, it’s already too late to get out. And you can never identify an upward trend until after it has happened, so you’re likely to miss the benefits of an upward market as well.” Strege cites statistics showing that over the long term — say, 20 to 40 years — stocks have always had better returns than bonds and other types of investments. “But if you can’t emotionally withstand and understand market volatility,” he says, “you shouldn’t have much of your money in stocks.” Finally, if you’re finding it hard to make ends meet in the current economic climate, Strege has some simple advice: “Make more or spend less. You have to do one of the two. Try relying less on credit and paying off your highest interest debts first. When you pay off credit card debt at 17% interest, you free up cash flow that can be used to build up an emergency fund or contribute to a 401(k). If you don’t want to get a second job, then decide which expenses you are going to cut — disconnect the cable service, stop going out for lunch. That may be inconvenient, but it’s a greater inconvenience to have to move out of your house” because you can’t make mortgage payments. Managing your money can be a challenge during the best of times. It can seem even harder during periods of economic uncertainty. If you want some professional advice, CFP® practitioners can help you make decisions based on your personal life goals and financial situation. Consumers can locate CFP® professionals in their vicinity through the Search for a CERTIFIED FINANCIAL PLANNER™ Professional function on CFP Board’s Web site.
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| Understanding Your Tolerance for Investment Risk |
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So far, 2008 has been a wild year for the financial markets. Are you prepared for the volatility, or has every sharp decline in the stock market left you with a sinking feeling? Perhaps it’s time to reassess your risk tolerance – and develop a plan that will let you ride out the peaks and valleys without losing any sleep. Simply put, risk tolerance is the degree to which you are willing to risk losing some of your original investment for the opportunity to earn a higher rate of return. Risk tolerance can be thought of as a spectrum ranging from conservative to aggressive. A truly conservative investor, someone who has little or no tolerance for risk, might feel comfortable putting her money into a certificate of deposit or money market mutual fund – among the safest options available. But neither investment is likely to generate enough of a return to even keep up with inflation, let alone help you reach your goals. An aggressive investor might put all his money in one stock, mutual fund, or perhaps his home – literally putting all his eggs in one basket and risking the possibility of having to sell that asset at a time when prices are down. As a result, neither of these one-dimensional strategies will pay off for the investor in the long run. Investors’ best protection against risk is to spread their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This is called diversification. Diversification can’t guarantee that your investments won’t lose some of their value if the market drops. But it can improve the chances that you won’t lose money, or that if you do, it won’t be as much as if you weren’t diversified. But putting together a diversified investment strategy that fits your capacity for risk takes some reflection and thoughtful analysis. That’s because risk tolerance involves a number of factors: including age, experience, net worth, risk capital (money available to invest or trade that will not affect your lifestyle if lost), and the goals you have for investing. You need to examine all those factors to implement a balanced investment regimen, one that focuses on your objectives, applies an asset-allocation strategy that is appropriate for you and puts you on track to reach your financial goals. The next time you see wild swings in the financial markets, ask yourself: What's my plan? If you've worked with a financial planner such as a CERTIFIED FINANCIAL PLANNER™ professional, you should be able to spell out your plan and explain how it will help you navigate through volatility. If you haven’t sought out the counsel of a competent and ethical financial planner, consider doing so. A financial planner will collect and explore all relevant information about your financial situation. Together, you and the planner will define your personal and financial goals, understand your time frame for results and discuss how you feel about risk. However, an investment strategy is just one part of a comprehensive financial plan. Every decision you make can affect other aspects of your financial life. Your insurance may affect your estate plan. Your retirement account may have tax planning implications. Your educational goals may impact your investment options. Contact a professional investment adviser to learn more about diversification, risk tolerance and long-term financial planning. To find a CFP® professional who can explain the benefits of developing a sound financial plan, visit the Search for a CERTIFIED FINANCIAL PLANNER™ Professional function on CFP Board’s Web site.
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| The Mystery of Mental Accounting |
Economics is known as “the dismal science,” so you might not expect economists to have much of a sense of humor. But there is at least one joke that economists tell that is actually very funny — and very educational. A husband and wife spend a night in Las Vegas, and the man decides to try his luck at the casino. He loves roulette, but vows not to wager more than $5. So he puts his $5 down — on his lucky number, 17 — and wins. He keeps betting on number 17 and he keeps winning, so much so that towards the end of the night he is up more than $10 million. He decides to wager it all one last time on number 17. But this time he loses, and his $10 million gain is gone in an instant. When he returns to his hotel room, his wife asks him, “How did you do?” “Not bad,” he replies. “I only lost $5.” The man could afford to be so relaxed about his multi-million dollar loss because of a phenomenon known as mental accounting, the tendency to value money differently based on where it comes from, where you keep it, how you spend it, and whether you expected more or less of it. As far as the gambler was concerned, the only money that was really ‘his’ was the initial $5. He didn’t have the $10 million before he started gambling and he didn’t have it when he finished, so for him the only real loss he suffered was the $5. That is a common, if completely illogical, reaction to unexpected money. The truth is, the $10 million was just as much ‘his’ money as the initial $5. The only difference was that he never expected to have the $10 million, so he was more easily able to rationalize its unexpected loss. The same kind of thing happens all the time in our day-to-day financial lives. Say you’re out shopping for essentials — groceries, for example — and you see some luxury item you would really love to have. You wouldn’t dream of paying for it in cash; that would blow an enormous hole in your budget. So you pay for it with a credit card. That feels better since the mental account in your head called ‘grocery budget’ remains intact, and the bill for the mental account in your head called ‘credit card’ won’t be due for at least another month. But, of course, whether you pay in cash or you pay with credit, all of the money ultimately comes from the same account: yours! Purchases made on credit can feel less immediate because no cash actually leaves your wallet. But the reality is, credit card purchases will end up costing you more money — unless you pay off the amount in full every month, thereby avoiding interest charges. Researchers conducted an experiment in which two groups of people were asked to bid on tickets to a basketball game. One group had to pay cash, while the other could pay by credit card. The average credit card bid was twice as high as the average cash bid. Why? Credit card bidders felt richer because they didn’t have to fork over any actual cash from their mental accounts. Take a moment to think about some of your daily financial transactions, and you’re sure to spot examples of mental accounting at work. Say you have $1,000 stashed away for a rainy day under your mattress. You also have $1,000 in credit card debt, at 18% interest. You won’t touch the $1,000 in savings because it’s in a mental account called ‘emergencies.’ But if you used it to pay off your credit card debt, you would save your self the 18% in interest charges, which amounts to $180. You could then use that $180 to start rebuilding your emergency fund, and you will have cleared some of your most expensive debt in the process. Of course, mental accounting has its upsides, too. Keeping untouchable money in mental accounts like ‘home down payment’ or ‘college savings’ or ‘emergency fund’ is a good thing. But it’s worth examining your mental accounts from time to time to make sure they all add up. The perfect opportunity to balance your mental accounts is tax time, especially if you are due a refund. As part of the government’s economic stimulus package, many households will receive tax rebates — of between $300 and $1,200 — in May. It’s tempting to put that money in a mental account called ‘splurge!’ After all, like the Las Vegas gambler, you didn’t have that money before you filed your taxes, so you won’t miss it if you don’t have it after you filed your taxes, right? Wrong. That money is just as much ‘yours’ as the money in your paycheck. In fact, a tax rebate is nothing more than money taken from your paycheck that the government has decided to give back to you. So consider depositing any refund into mental accounts called ‘401(k)’ or ‘health care insurance’ or even ‘emergency fund.’ For information on how to have your rebate directed to the account of your choice, see "A Tool to Manage Your Tax Refund: IRS Form 8888" in the February 2008 issue of It’s Your Turn. Tax rebates don’t have to be treated as ‘funny money.’ And maybe that’s why economics is called “the dismal science”; because managing your finances is a serious business.
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| Financial Alerts |
Know Your Limits: Why, When and How to Be Sure You’re Fully Protected by FDIC Insurance A deposit in a bank or savings institution insured by the Federal Deposit Insurance Corporation is one of the safest ways to protect your money. The FDIC protects those deposits under federal law, with basic insurance coverage up to $100,000 per depositor per insured institution, for the unlikely event that a bank fails. There may even be situations where your deposits may be covered for more than $100,000. The FDIC provides an interactive Electronic Deposit Insurance Estimator that allows users to calculate the insurance coverage of their accounts and generate a printable report that clearly states if their deposits are fully insured or not. Read more at: Federal Trade Commission Cautions Consumers About Tax and Rebate Scams The tax rebates many Americans will receive this year, as part of the government’s economic stimulus package, will give many a financial boost. Unfortunately, con artists are also seeking to profit from the rebates by contacting consumers with claims to be with the IRS, the Social Security Administration, or some other government agency. The fraudulent phone and e-mail messages claim to need some bit of sensitive personal information to process the rebate check; those who provide such information may be at risk of identity theft. The FTC reminds consumers that neither the IRS nor the SSA collects information about government rebate qualifications by phone or e-mail. Read more about how to recognize and protect yourself from these scams at:
National Flood Safety Awareness Week Good Time to Review Your Flood Insurance Policy March 17-21, 2008 is National Flood Safety Awareness Week, and the National Association of Insurance Commissioners suggests that there’s no better time for Americans to review their flood insurance needs. Floods can take place anywhere across the country, and flood damage is not covered under a standard homeowner’s insurance policy. For more information about flood insurance, visit the National Flood Insurance Project Web site at www.floodsmart.gov or read more at:
Read more financial alerts.
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| Reverse Mortgages: A Tool to Use with Caution |
If the ripples of the sub-prime mortgage crisis haven’t touched you directly, rising consumer prices certainly have. The prices of gas, groceries, medications and other necessities have risen noticeably in most parts of the country. Those who have retired and live off a fixed income have probably likely noticed the higher prices more than most and may be looking for ways to raise additional income to make necessities more affordable.
Many at or near retirement have owned their residence for some time and have paid off the mortgages used to purchase the homes or are close to doing so. Many have built up a significant amount of equity in their homes, and that equity is something that can be converted to additional income. In the past, taking out a home equity loan was the primary way to generate income from a home. Now, a relatively new method of generating additional income is being marketed aggressively to individuals near or at retirement: Reverse Mortgages.
A reverse mortgage is a loan arrangement that allows homeowners 62 years of age or older to convert part of the value of their home into cash. Unlike standard mortgage loans or home equity loans, which typically involve a monthly repayment schedule, reverse mortgages do not require repayment until the homeowner sells the home, permanently moves out of the home, or dies. When one of those events occurs, the loan becomes due and must be paid off, often by the homeowner’s heirs selling the home and using the sale proceeds to pay off the loan.
Reverse mortgages don’t require a minimum level of income from the individual taking out the loan, as do most types of loans, so they are available to individuals on a fixed income. But reverse mortgages are not for everyone – they involve high fees and closing costs and reduce the assets one can leave as inheritance to one’s heirs. Reverse mortgages can also be complicated. Unlike a standard mortgage, which sets up a specific timeframe for repayment of the loan, the repayment date for a reverse mortgage loan is uncertain, and the amount owed grows over time as the loan balance accrues interest. If the loan accrues interest for a long time, or if the value of the home decreases, the loan balance may be greater than the equity the homeowner had accrued before getting the reverse mortgage.
One important factor to consider when evaluating a reverse mortgage is how the loan will be used. There are good and sensible uses for reverse mortgages, as there are for any other financial tool. They can have great benefit for people who have no other source of funds to pay unexpected expenses such as medical bills. They can also be helpful to homeowners who want to stay in their homes but who are having trouble keeping up with their mortgage payments.
Unfortunately, some salespeople have encouraged consumers to take out reverse mortgages to purchase investment products that clearly aren’t in their best interest. A recent New York Times article highlighted the ways some seniors have been bilked by investment salespeople who pressure them to take out a reverse mortgage and use the cash to buy investments that generate high commissions for the salespeople. “When an unscrupulous salesman combines a reverse mortgage with a deferred annuity, it makes it all too easy to mislead seniors,” wrote Kevin R. Keller, CEO of CFP Board in a letter published in March 9, 2008 edition of the New York Times. “What may look like a sensible investment to an elderly American rarely is.” Reverse mortgages have lasting and serious effects on the value of one’s home and estate, and such loans should be used only after serious consideration. If a salesperson pressures you to use cash from a reverse mortgage to make a purchase or investment, your best bet is to walk away.
If you’re considering a reverse mortgage, or if you’ve been approached by someone recommending a reverse mortgage, take time to think about it carefully and to discuss your options with a CERTIFIED FINANCIAL PLANNER™ professional or other qualified expert who will put your interests first. “CFP Board believes that a client’s best interests are served by a financial adviser who has earned a reputable credential and adheres to an enforceable code of ethics that articulates a fiduciary responsibility,” says Keller. “Seniors can and should demand transparency, accountability and honesty when choosing how to invest their life savings.”
Online Resources
AARP provides information about reverse mortgages, including five key questions to ask when considering a reverse mortgage, in the Reverse Mortgage section of its Web site.
FINRA gives information to help individuals make informed decisions about reverse mortgages in its recent investor alert, “Reverse Mortgages: Avoiding a Reversal of Fortune”
The November 2007 edition of It’s Your Turn provides an overview of traditional mortgages in “The Meaning of Mortgages”
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| About This eNewsletter |
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CFP Board's "It's Your Turn" eNewsletter is sent monthly to those who have subscribed through CFP Board's Web site, www.CFP.net/learn. CFP Board exists to make people aware of the benefits of financial planning and to encourage people to seek out individuals who can help them apply the financial planning process to improve their financial lives. This eNewsletter is designed to provide information about financial planning, financial planning tools and resources, consumer alerts and more. Suggestions and feedback are welcome at mail@CFPBoard.org.
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