A Short Book About Money
written by my father, and posted here with his permission
Money is a convenience in commerce and a store of value. And that is
all it is. It is more convenient that bartering and you can use it to trade
now or later. Money is not meritorious. Having money is more
convenient than not having it. The lack of it is not a sign of bad
behavior. It is just a tool and as such it needs to be understood,
maintained, and used properly.
I. Financial Literacy
The lack of understanding of money is the cause of more grief in life
than any other single cause. You will have a working life of 40 years or
so, then a retirement period of maybe another 30 years or so. This
means money will be a long-term issue. It will affect your
relationships with your parents, your spouse, your children, your
neighbors, businesspeople in town, and the gov’t. During your
working years, you must balance income with your every-day
expenditures – call it cash flow – as well as with long-term savings for
emergencies and retirement. We will look at income, a budget of
expenditures, the usual mechanics for managing money, and also at
some retirement issues. But first, we need to consider some general
aspects of money.
Gold or Paper? In the modern world, money is actually just paper.
But as long as people believe it is money, then it is money. And it is
lighter to carry than gold. As trade was becoming profitable in early
times, gov’ts stamped out coins, usually with the leader’s image on
them, to be used as convenient money. But when somebody needed
more money, it was easy to clip some of the edge off each coin.
Clipping only 5% off 20 coins got him a new dollar. Free money! (To
make clipping easier to detect, coin edges were soon “milled”, ie
grooved, as are all except the smallest-denomination US coins.) But
eventually national gov’ts realized that since they were in charge, all
they really had to do was print up some paper and call it “legal tender
for all debts, public and private” just like it says right there on our bills
today. This is called “fiat” money. “Fiat” is Latin for “Let it be done!”
We used to be able to trade in a bill for gold at the Treasury, but they
stopped that long ago.
Other People’s Money. Not all money is dollars. Each country uses
its own money, which can be worth more or less compared to other
country’s money at a particular time depending on their comparative
economies. (Except that the countries in the European Union all use
the euro.) The conventional representation of this exchange rate is the
three-letter-code of one country’s currency shown in the second threeletter-code currency. For instance “USDEUR=0.75” means that one
US dollar is worth 0.75 euros.
Inflation The actual purchasing power of money tends to decrease
over time. This is called “inflation” and is defined as an increase in
price without an equivalent increase in value. If the price of the same TV set goes up from year to year, that is inflation. If the new TV is
bigger, or has better resolution, or receives more channels, it has more
value, so the increased price may or may not be inflation. The standard
metric for US inflation is the Consumer Price Index (CPI). It varies
between maybe 2% per year to maybe 5%. It can be caused when the
gov’t simply prints more money without an equivalent increase in their
reserves. Or it can arise when there is a scarce item (like crude oil) that
people want. Those who want it more will pay more money for it,
thereby raising the price when there is no equivalent increase in value.
Things that are valuable and scarce tend to be inflation-prone.
Debt and the Cost of Money. Loans or credit are never free. Every
time you borrow money or buy something on credit, the cost of your
use of that money becomes important. How much you pay depends on
how good your credit is, how long you want the loan, what kind of
collateral you can claim (what you would forfeit if you couldn’t repay
the loan), and the general cost of money at the time. Since this cost is
added to the amount you must repay, it is best if you can buy what you
want without borrowing to do it.
Stay out of debt. Never use a credit card to finance a debt beyond the
monthly billing cycle. The interest rates are way too high. Handle a
credit card like it was a live bomb---or a snake. Credit plans for buying
household appliances or furniture are usually very expensive. Pay your
bills when due to preserve your credit rating, which will enable you to
borrow money (say for a car or a house) at the lowest possible rates.
Don’t let total debt payments, including home mortgage, exceed one third of your total gross income.
Taxes. Gov’ts need funds to provide needed goods and services, so
there will be federal, (maybe) state, and (maybe) local taxes assessed
on your income, your real estate, and your personal property. There are
also sales taxes assessed by the state on most retail purchases. Most
income taxes are graduated (called “progressive”) in that those with
higher income pay a larger percentage of that income as tax. Your total
tax burden might be say 20% of your income. Federal and state tax
forms are complex and it will certainly be helpful for you to buy each
year’s tax preparation software package, and it may even be to your
advantage to consult and pay a professional to prepare your tax returns.
You will need to save all records of wages, interest paid or earned, tax
information, etc for your tax return preparation.
II. Your Working Career
Income. Most of your working life income will probably come from a salary
paid by your employer. Try to get a job that provides reasonable salary
and advancement, plus health insurance and a retirement plan, which
means you will need some marketable skills. The pay schedule is most
likely to be weekly, but maybe semi-monthly, or monthly. Your
paycheck will probably have deductions for Social Security, called
“FICA,” for some kind of retirement plan sponsored by the company,
usually called a “401k” (based on the paragraph in the Income Tax
Code that specifies it), maybe for your health insurance (which the
company may help pay for), and for federal and state income tax. Tax
withholding is for your convenience (to prevent your having to come
up with the whole tax payment in April) as well as for the gov’t (to
provide them with a continuing flow of operating funds throughout the
year.) Retirement and health insurance benefits make up an important
part of your compensation and should be carefully considered when
thinking about a particular job.
Cost of Living. Your expenditures will be set by your salary and the by the cost of living in your location. The cost of living is much higher on the US
coasts than in the interior, but salaries are usually higher there to
compensate. You will need to budget your expenditures as well as
manage the process.
Cash Flow. The total and entire secret to financial happiness is a positive cash flow, which means having more money coming in than is going out. First, get all your debts on (or at least organized as if on) a monthly basis.
For instance, if you have an annual insurance bill, divide in into twelve
monthly parts. Monitor your cash flow every month by checking your
bank balance. If it is going up, relax. If it is not, you must take
immediate action. If you find yourself carrying a credit card debt from
month-to-month (which is even worse than a negative cash flow
because it costs you high interest payments), you must also take
immediate action. Do not wait! You must get on a budget!
Budget. The first and easiest expenditure to reduce is probably food. Do more of your own cooking, using less prepared (expensive) foods. Eat out
less. The next thing to check is housing. It might be better to move to
a less expensive place. See if it might be cheaper to ride the bus than to own a car, considering fuel, insurance, and maintenance. These are big
cost items and are therefore the most available to reduce expenditures.
The temptation to cut back on savings should be avoided if at all
possible. Long-term savings must keep growing to be useful, but it
makes little sense to put money aside to earn 5% while carrying a loan
Housing. One of your biggest expenses will be housing. Renting is convenient in the short term. Unless you are quite sure that you are going to be inplace at least six years, it is more cost-effective to rent instead of
buying a house. Owning a house has substantial extra costs for
insurance, maintenance, etc. A general rule is “Spend a week’s pay on a
month’s rent.” Some rental housing may call for a lease, or a guarantee
that the property will be paid for over a given time period, say a year.
A house is a place to live, not an investment. It probably won’t
increase much in value beyond inflation. And it is not liquid, that is it
is hard to sell and there are substantial transaction costs. It will be
necessary for you to borrow (take out a mortgage) to buy a house. Most
of the first ten year’s house payments go into interest and not into
equity, so you are not really buying ownership you can sell later. The
purchase price of the house should be less than three year’s gross
salary, and closer to two if possible. If houses are more expensive than
that, you should rent.
But by far your biggest decision will be if and when to buy a house,
and how to finance that purchase. The typical situation is that the
buyer pays some of the cost at purchase time. This is the “down
payment.” The rest of the cost (“mortgage”) is borrowed from some
bank or similar lender. The lender, of course, has to be paid for the
loan, so there will be interest due as well as payments on the loan. In
any case, a general rule is not to borrow more than 2.5 times your
annual salary for the mortgage, although houses on the US coast cost
more than those in the interior of the country.
Savings. It will be necessary for you to save some money for long-term
needs such as children, a car, a house, and emergencies not
conveniently covered by insurance. It is also necessary to save for
retirement, which will be discussed later in this paper. The first savings
need is to have maybe 6-12 months of living expenses conveniently
available to cover any periods of time between jobs. This money can be in any readily available “liquid” asset, such as cash, checking
account, or a mutual fund from which you can easily withdraw cash.
It is good practice to save about 15% of your gross wages after age 30
for retirement. There are too many calls for spending your money
before then. At about age 40 or so, you will begin to have enough
information to enable you to lay out a specific retirement plan and
schedule. The 2007 book “Getting Started in a Financially Secure
Retirement” by Henry Hebeler, available in the library, is the best
source for details that I have found thus far. Most salaried workers will
have some kind of company pension or company-assisted retirement
savings plan so it might not be necessary for you to save the whole
amount by yourself. If your employer matches some of your
contributions, that counts as part of the required percentage.
The remaining savings should be set aside for longer-term needs not to
be used for day-to-day operations and can be in less liquid assets.
The best savings vehicle for young savers is an index mutual fund, ie a
mutual fund in one of the major fund families (Vanguard, Fidelity,
American Century, T. Rowe Price, etc) invested in the general US
stock market. This will provide reasonable return while controlling the
risk of loss. Individual stocks are not appropriate for young investors
because of the costs of buying and selling them through a broker as
well as the inherent risk of loss. Mutual funds also have expenses
(about 0.5% of assets), but this is usually less than stock broker
transaction charges. What you want is a passively managed fund (it
just tracks an index, which minimizes expenses) with “no load,” that is
no buying and selling expense. Investments in collectables, ie coins,
stamps, artwork, etc are not appropriate for young savers.
About (110 minus your age)% of your savings should be in stock
funds. The Vanguard Funds website provides a selection of funds that
range from pure stocks to pure bonds. Stocks are a share of ownership
in a business, and as such entitle the buyer to a share of the profits
(earnings) as well as maybe a periodic payment called a “dividend.” A
bond is a loan from the buyer to the business. Normally the business
pays interest on the loan to the buyer.
You should buy the stock fund if the S&P 500 earnings yield, ie
reported earnings divided by price, moves above (the CPI inflation rate
plus 2%). Conversely, you should buy the bond fund when the S&P
500 earnings yield moves below (CPI plus 1%). Always use trailing 12-month “reported” earnings and not “operating” earnings for this
calculation. Bond prices move inversely with yields (or interest). As inflation and interest rates (thence yields) go up, newly issued bonds are more valuable than existing bonds earning lower yields, so the prices for
existing bonds go down.
Insurance. Insurance is not a savings mechanism, so only buy “term”
insurance. It is a way to pay for an expensive, but unlikely, event. It
will be necessary to insure your car, your person, your home, and your
valuable personal property against possible but unlikely disasters such
as fire, flood (if applicable) and theft. Insurance is priced such that
many people pay in to a pool of funds that is then used to pay for losses
of the few who are actually affected. Most insurance policies pay off
after some minimum amount of cost has been accrued. This
“deductible” cost will by paid by you first, probably out of your
emergency funds. You can lower the insurance cost monthly premiums
by increasing your deductible, recognizing that insured events are, by
definition, unlikely to occur.
Car insurance will be more expensive when you are young. If you rent,
you will need renters’ insurance to cover your belongings. If you
marry, insure your own life, as well as that of your spouse, to help pay
for the potential loss of anticipated income. The need for parental life
insurance to protect the interests of young children is obvious. Health
care is increasingly expensive and those costs can be insured, if
possible by your employer, but if not, then by yourself. Other kinds of
insurance, such as travel insurance, etc are usually not cost-effective.
Insurance on your wages in the event of disability may or may not be
worth the money depending on your debts.
Managing Your Cash Flow – Banking. There are many financial
institutions available to help you manage your expenditures. The first
is a bank. You will need to write checks to pay bills, so it will be
necessary for you to open a checking account at a convenient local
bank. There are many banks available, and all provide electronic
access to your account. Automatic paycheck deposit into your account
is a good procedure since it is both safer and more convenient for you.
Your bank can also rent you a “safe deposit box,” which is a fire-proof
and theft-proof place to store important documents. As you write checks against your account, you must record each in an appropriate format, noting the date, the check number, to whom paid, and the amount. Your bank will send you a monthly listing of the checks they have cleared (paid out of your account). You must compare your records with the bank’s record each month to ensure that nothing irregular has occurred. They may return your paid check, or a photocopy of it, or maybe just a listing, but the totals must be reconciled. Review your bank statement monthly. Review your
financial condition quarterly. Your quarterly review should include
cash flow status, as well as projected availability of funds for upcoming
purchases such as furniture, more education, a vacation, and retirement
Do not permit any automatic withdrawal of money from your bank
account by any agency that can unilaterally raise the withdrawal
amount such as utility companies, phone or cable TV companies.
There is too much risk of ID theft and it is very easy to lose track of the
amount of money being moved, thereby complicating the process of
reconciling your checkbook. However, mortgage payments might be
charged automatically under specific contractual conditions. Your
bank will certainly provide you with access to automatic teller
machines (ATMs) as a convenient source of cash. There may or may
not be a transaction fee associated with use of other ATMs. You will
need your bank’s ATM card and a (usually 4-digit) personal
identification number (PIN). The machine provides cash from your
account up to some specified limit, so care must be taken only to use
such a machine in a protected space. Do not take a loan, sometimes
called a “cash advance” from an ATM because as with credit cards, the
interest rate on the advance is unreasonably high.
Credit and/or Debit Cards. Your bank, as well as many other financial institutions, will send you applications for credit or debit cards. A credit card allows you to charge purchases and to pay for them at the end of the month when they send you a bill. The credit card balance must be paid when due, because their interest and service charges are too high to be acceptable.
It is good practice to have one Visa and one MasterCard. This provides
a safety factor in case of a problem with one of the cards. Be sure that
any credit or debit card you use is honored at your usual business sites.
A debit card can be set up to automatically withdraw payment from
your bank checking account to pay for purchases.
Credit cards are convenient for cash flow management because you see
all the bills again before you pay them. Debit cards can be abused
more easily since there is no immediate record of billing before
payment. Either is acceptable, depending on your discipline, although
a prepaid card (with a limited amount of funding) might be a good
starting point. Since each credit card number is an opportunity for
identity theft, only carry the minimum number actually needed. But
any credit card carrying an annual fee is unacceptable. There are plenty
of “no-fee” cards available. And keep the phone number to be called if
your card or number is stolen readily available in a safe place not on
Apply as many regular monthly bills such as household utilities, phone,
internet access, auto fuel, etc, as possible to a credit (not a debit) card.
Then pay the credit card bill when it is due. This will minimize the
number of checks written while providing a written record of your cash
flow management. Don’t have more than two credit cards (one to use
and one for backup).
“Opportunities”. Don’t waste your money. Anyone selling anything
is probably not looking out for you. He gets paid by selling you
something, whether you need it or not, especially insurance and stock
salesmen. And be especially suspicious of salespeople who say that an
investment will earn in the future what it earned in the past. After the
debt crisis of 2008, that is not true! It is almost impossible to find a
disinterested or impartial financial advisor, so learn about money
yourself. Family members are probably the only people you can really
Don’t respond to unsolicited mail or phone solicitations. You will get
thousands of offers by phone, mail, and email for charities, for magazines, for credit cards, for get-rich-quick schemes, for political
causes, and for various kinds of services. The most dangerous of these
“business opportunities” are really pyramid schemes that try to
convince you to enlist subordinate salespeople to get a percentage of
their “profits.” You end up buying a lot of “wholesale” junk that
nobody will buy. Most of them require you to spend some of your own
money up front and they never pay off. They are scams and confidence
games. The very fact that they are offered to everyone indicates that
they are not cost-effective and responding to one will just get you
thousands more “offers.” And never, never play a lottery, whether a “scratch-off” card or another format, nor play casino “gaming.” The chances of winning are too low and since the operators take expenses and profits out before the payoff, it is a losing game for the player. Every casino in Las Vegas was built with losers’ money.
III. Your Retirement
You will spend maybe 30 years in retirement. Your retirement will be
financed by some combination of your company’s retirement annuity
“pension,” your own individual investments and savings, and the gov’t
Social Security system and Medicare. Gov’t benefits will only be
available at some specified retirement age.
Company Pension. Your company may or may not provide you a
monthly “defined benefit” pension, the amount depending on your
working maximum salary and your service time. A “defined
contribution” plan provides the amount your and the company’s
matching contributions have earned over the years. Defined-benefit
plans typically would replace about 40% of your maximum salary. In a
defined- contribution plan the employer matches some percentage (58%?) of your wages that you contribute into the fund.
Savings and Investment Proceeds. Depending on the company
pension amount, it will almost certainly be necessary for you to provide
some of your own retirement funds through savings and investments.
Inflation must also be considered here, as well as some prediction of
your required living expenses. Analysis has shown that to fund your
own retirement it is necessary to have saved about 25 times the amount
of your retirement expenses not provided by a company pension and
Social Security. For example, if you estimate the need of $20,000 more
than your pension and Social Security in today’s money to live, you
should have a retirement pool of 25 times $20,000, or $500,000 (in today’s money) at retirement. This is simplified analysis, so see below
for a more detailed model to calculate your retirement finances.
Individual Retirement Accounts and 401k Accounts. These
accounts belong to you so they can go with you when you change
employers. Your contributions and the investment proceeds are not
taxed until withdrawn, so they are “sheltered.” The Roth IRA is
funded with money on which taxes have already been paid, so there is
less to invest but the proceeds are not taxed upon withdrawal, also
sheltering the investment. The Roth IRA is preferable since the tax rate
on the withdrawn proceeds is likely to be higher than that on the
original investment. In a 401k, your employer matches part of your
pre-tax contribution. You should fully fund your 401k up to the limit
of employer matching. It would be good to start a Roth IRA when you
start working, but it is OK to wait a few years until you have an idea of
how employers are going to provide your pension, and you should be
making enough salary to afford savings without unduly restricting your
Social Security. The Social Security system was started in 1933 as a
“financial safety net” for older workers. Today’s payout is adjusted for
inflation as indicated by the CPI and it provides a substantial portion of
the income of many retirees. By the time you get to that point, the SS
system will likely pay out much less and it will be more highly taxed.
At your age, I would not count on a meaningful SS check from the
gov’t because it will probably only be available to the indigent and only
at a subsistence level. The actual amount received will almost surely
be means tested. Retirees who don’t actually need extra money won’t
Medicare. The gov’t provides some health insurance for seniors,
paying some doctor, medicine and hospital bills. It should still be
available to you when you reach the eligibility age, but it will likely not
be enough for adequate coverage so you should seriously consider
supplementing that coverage with health insurance of your own. There
will be many options by then. If you do not have medical coverage
from an employer before you are eligible for Medicare, you will need
some health care insurance for protection until you get Medicare.
Funds Available During Retirement. Most retirement calculators in
books or websites assume that when you retire, you will need about
70% of your pre-retirement income. That is not correct – it will
certainly be less than your pre-retirement salary, but not by some convenient percentage. By age 40 or so, you should begin to estimate
what your cost of living will be in retirement based on the checks you
write and the cash you spend, also considering those expenditures that
are likely to change after you retire. That is what your income and
savings must support. Your employer can provide an estimate of your
pension. The gov’t can provide an estimate of your Social Security
payments. You can estimate what your savings and federal and state
tax rates will likely be at retirement. And you will need to estimate the
length of your retirement period.
The model below assumes that a retiree can spend an increasing (by
age) fraction of regular after-tax income plus the after-tax investment
divided by the number of years the investment is to last. This assumes
the investments earn about the inflation rate, a surprisingly accurate
simplification. You need these numbers:
Your age at retirement: AGE
Cost-of-living at retirement: COL
Value of your investments at retirement: INV
Social Security: SS
Federal and state income tax rates: TAX
Retirement period: YRS
You can then calculate the money ($) you will likely have at retirement
to support your cost of living as follows:
$ =((AGE / 100)*(1-TAX)*(PEN+SS)) + (1-TAX)*INV / YRS
For example, let’s say you intend to retire at age 67, your COL will be
$30,000, your expected pension will be $30,000, your Social Security
will be $12,000, your combined tax rate (fed tax plus state tax over
adjusted gross income) is 20%, you will have saved $300,000 and you
want to support 30 years of retirement.
Then $ = (67/100)*(0.8)*($30,000 + $12,000) + (0.8)* $300,000 / 30)
= 22,500 + 8,000 = $30,500.
So if your COL is $30,000, the equation says you can retire safely at
age 67 and your money will outlast you. But $30,500 is only 2% above
your COL, which is not much of a safety margin. Personally I would
not be comfortable with a safety factor less than 10%, so I would want
$ to be at least 1.10* $30,000 = $33,000. That might mean working
and saving an extra year or two, thereby increasing your pension and
Social Security while reducing the years in retirement. This process also shows if any shortfall could be better corrected by saving more,
working longer, or consuming less. Obviously, if your employer
doesn’t provide a pension, your savings must be increased. (This
equation uses today’s numbers. You should use then-year numbers for
your equation, but you get the idea.)
IV. Grampa’s Money Rules
1. Maintain a positive cash flow.
2. Budget everything. Be sure that all your costs, including
savings for house, car, education, healthcare and retirement,
are included in your expenditures plan. And know the sources
of all these funds.
3. Don’t waste your money on get-rich quick schemes, fake
businesses or gambling.
4. Stay out of debt because credit is not free.
V. Personal Note
This little book summarizes some of the things I wish I had known
when I was young. I hope it is of some help to you as you start on your