Friday, November 30, 2007

Metrics to evaluate Personal Finance Progress

I noticed on some other PFblogs several PF related ratios that are posted on the sidebar. Ratios are helpful as metrics or benchmarks – something to help measure your progress. It’s a great motivator and I can’t wait to run the numbers.

Savings to Income = S/I
If your interested in PF, you have probably calculated your net worth. If not, get out a spread sheet and start tallying up everything you own (exclude your home) and subtract all debt. Now take that number and divide by your total before tax income. For example, if you have a net worth of 500K and income of 100k, the ratio is 5. For reference, a rule of thumb often touted by Certified FPs is a S/I goal of 12 to begin retirement. The number 12 is based on a 5% withdrawal rate that would equate to an income that is 60% of your final salary. Add Social Security and/or pension benefits to that and you retire with approximately 80% of your final income. My S/I = 9.9. Lets try another one.

Debt/Income = D/I
I like this one, because I have no debt. My credit card is paid off every month, my truck is free and clear and I have paid off my mortgage ( we can argue the pros and cons about that later). So D/I = 0.

Savings Rate to Income = SR/I
This is a little bit sketchy because only pre-tax savings are to be included. For instance, add up any contributions to an IRA or 401(k) plus any company matching and divide by income.
IMHO, I think all savings should be included, even after tax savings. In fact, after tax or non sheltered savings are the key to early retirement. Having an over funded 401(k) that can not be utilized without penalty until you are age 59.5 is not going to help you retire in your 40’s. Including all savings increases my SR/I substantially to 59%.

Another useful ratio, Passive Income/Expenses = PI/E
Passive income includes income only from capital gain distributions and dividends. It excludes salary, capital appreciation, one time sales, etc. My PI/E = 95%.
My goal is to live off of passive income, only. Some margin is necessary to allow for variations in capital gains that are distributed based on fund performance, turnover, and other fund manager controlled activities.

And finally some Wealth accumulation ratios
A Wealth Accumulator or WA from the Millionaire Next Door is defined as a net worth that is equivalent to or greater than 10% of your salary * age. While PAW or prodigious accumulator of wealth is quantified as two * WA. Let’s calculate the WA value and then divide by net worth to get a WA or PAW ratio. When I first started tracking this metric 6 or 7 years ago, I was not quite to the PAW level. It gave me something to shoot for - a rabbit to chase. My current PAW ratio = 115%

I plan to incorporate these ratio calculations into my net worth spreadsheet. The spreadsheet is used to track my assets and their performances and is updated on a monthly basis.

Thursday, November 29, 2007

Admiral shares Conversion

I have another fund at Vanguard that has recently qualified for conversion from Investor shares to Admiral. The Admiral shares are a lower-cost version of the same fund that is limited to investors with $100,000 or more in an account that has been held at VG for a minimum of 3 years. It’s a wonderful thing and once again the spoils are given to the clients with the most money. It goes to reason that clients with 100k or more are less likely to jump in and out of a fund, so its easier for VG to manage. Its easier meaning its less costly because the fund does not have to sell shares to meet the demands of traders. Managing an index fund is most efficient with a steady money pool.

Key points of the conversion
1. The conversion is free, there are no tax implications
2. The ticker symbol changes
3. Expenses drop by 33%!!!! VG is well known for its low cost, low fee index funds. The average expense for a fund in the same category is over 10 times that of VG!

What about ETFs, aren’t their expenses even lower?
Yes, they can be. I found a comparable ETF with an expense ratio of 0.12, that’s 0.02 cheaper than the VG Admiral fund. They also do not have the 100k minimum requirement. The downside is that ETFs require a commission to buy and sell and the commission makes dollar cost averaging very inefficient. If you don’t have the 100k, buying an ETF through Zecco (free trades) is an attractive option. However, with such a large sum I am definitely more comfortable investing through a proven and trusted institution such as VG.

Wednesday, November 28, 2007

Tips to Avoid Late Fees and Bill Collectors

I have never been very aware of when certain recurring bills are due. I just pay them as they come in. The problem with that is what if you miss a statement? For instance it gets lost in the mail, or you inadvertently shuffle it in to the discard mail, or the biller mishandles your payment. You probably won't catch the problem until your next statement arrives with penalties, fees and/or threats to cut off services. Unbelievably, this can happen when you are overdue just a single day.

Simple Bill tracking tools
There are many services out there, typically packaged with e-mail programs like Yahoo or Outlook, that will track recurring events and remind you when they are due. These are helpful tools, but can be rather annoying as I already have enough e-mail reminders and pop-ups in my life.

Calendar Bill
I prefer to build a simple calendar in a word document using the table tool. I locate the date for each bill and place the name of the service and the method of payment in the square. “Calendar Bill” resides on my desktop for easy reference. Many of my bills are automatically paid with credit card, but I still want to track and verify that everything is getting paid on time. A couple of the bills, my city water bill and my credit card require interaction on my part. I pay these online using a billpayer service from my bank. I make note of when I sent payment, but I also watch for the transaction to clear my checking or credit card acct before I highlight it as paid.

Bill Dating
Another approach that I used prior to automatic billpayer and electronic fund transfer options was “bill dating”. When I received a billing statement, I would write out the check, stuff it in the envelope and write the due date on the outside of the envelope. After stamping, I would stack the bills on the counter or desktop in order of due dates and mail each one 5-6 days before the due date. This simple routine helped tremendously in reducing bill mishandling problems.

Tuesday, November 27, 2007

Is Roth 401(k) better than tax deductible 401(k)?

About a year ago I sent an e-mail to my employer’s benefits office to inquire about when the company was going to provide a Roth 401(k) option. The response follows: “At this time the corporation is not planning any implementation as the Roth plan would only appeal to an extremely narrow part of the employee population, which does not justify the additional administrative cost”.

Extremely narrow population? That was worth a chuckle. Fast forward to today when the same employer announced with great fanfare that a Roth 401(k) option has been added to the company savings plan. Glad they came around to my narrow viewpoint.

Unfortunately, as I review the details I struggle to declare the best route. Too many unknowns in this equation: will tax rates increase, will my tax bracket change in retirement, will Uncle Sam eventually take away the Roth tax free distributions?? Yikes.

In a nutshell, the Roth means paying tax now, instead of later. IMHO, It’s a safe bet, based on the current financial state of America (see out of control national debt and growing entitlement programs) that taxes are going up. So paying now when I am young, healthy and bringing in a robust salary sounds intriguing.

What’s wrong with paying now?
Every dollar going to tax is one less dollar earning money. In other words, not only do we give up that tax dollar today but also all future earnings of that dollar. The old adage that a penny saved is a penny earned is an understatement.

What about that tax deduction?
Going with the Roth, means giving up a maximum of 15,500 tax deduction! Given a 28% tax bracket, that equates to $4340 in tax relief. Now that’s a tax deduction! Because of the tax expense, it will take many years for the Roth 401(k) to catch up to the traditional 401(k) (including the gains from dollars not paid in taxes). So going with a Roth is gonna hurt today, but feel good in 30 years. Ahhhh. Delayed gratification.

Tax Diversification
There is one other important feature that is seldom touted by the Certified FP community - the Roth provides tax diversification. Since distributions from 401(k) retirement funds will be taxed at your future income rate, it could prove to be very beneficial to have an additional revenue stream that is not taxed at all – the Roth 401(k). This strategy mitigates some of the risk and uncertainty over future tax rates.

The clincher
I already have a Roth IRA external to my 401(k) plan. Because of IRS income limitations, I can no longer contribute to my Roth IRA. So I have created a traditional IRA that I fund with after tax money. Given the current tax laws, in the year 2010, I will be allowed to convert my traditional IRA holdings to the Roth IRA without any income limitations. This approach results in the tax diversification benefit while still maintaining the 401(k) tax deduction.

Monday, November 26, 2007

Dollar Cost Averaging (DCA) gets beat by Value Averaging (VA)!

The results are in and DCA loses in the stretch. Ah darn, I love DCA. Its mindless, emotionless, and easy. Besides who ever heard of VA?

The VA approach sets a target growth rate and then adjusts new deposits based on the performance of the fund. Huh? Let's say you want a 12% return that equates to 1% growth per month. Okay, now you invest $1000 and it grows in one month to 1015 or 1.5%. This exceeds your target, so next month you adjust your monthly contribution down 0.5% to 995. Conversely, if the fund performance lags the 1% target, you increase your investment by the corresponding dollar amount.

So is it worth changing to VA?
5000 Monte Carlo simulations later and the answer is – “It is optimal to follow the 401(k) value-averaging strategy with a target annual growth rate between 8 percent and 12 percent.”

The table shows that 67% or a majority of the time (for 5000 simulations) the VA approach beats DCA. Given 30 years or 360 months using a target rate of 1% per month and monthly contributions of 1000, the mean final value of the DCA portfolio is 7.8% less than the VA portfolio. Who would have thought such a small change could make that much difference? I was skeptical about such a large differential. I created a spread sheet, ran a few test cases and although VA did have better returns than DCA, I did not see the differences of the magnitude shown in the table.

Whats so cool about VA?
It makes me feel like I am in control! I am the decider and after I finish my calculations every month I will direct a specific amount of money into my retirement account. I am no longer just standing by while the market whips my funds around. I am actively managing my finances!

Blinded by science
The data is staring right at you. A logical Personal Financier would change from DCA to VA, right? Ugh. Okay, I pledge that I will change at least one DCA account to VA this month.

Sunday, November 25, 2007

My First Blog Posting

Hello World! I stumbled upon the PFblog community several months ago, never imagining that I would write a blog someday. I got motivated when I realized that most of the PFbloggers are just beginning their journey or making a turnaround with the focus on paying off debt. Saving money and paying down debt is the foundation for PF, but the really interesting and exciting part is the accumulation stage that enables you to enter the distribution/retirement stage. I am on the verge of reaching my goal of financial freedom having experienced over 20 years of some of the most volatile markets in history! While some things like sound value investing remain unchanged with time, other aspects of the PF world are continually changing and expanding. There is always something new to learn in PF. Many consider PF to be boring, but like anything, learning and managing one’s finances can be fun when you have success. Lots of fun.