Worker eligibility

• A worker generally becomes eligible for Social Security retirement benefits after earning 40 work credits--or 10 full years. Work credits are earned by working in “covered” employment (including self-employment) where Social Security taxes are paid.
• However, the amount of credits a worker must have accumulated for his dependents to receive survivor benefits depends on the age of the worker at death. The younger a worker is, the fewer credits are necessary for the family to be eligible for survivor benefits. For example, a worker under age 28 would only need 6 work credits, at age 34 it is 12 credits, and at 46 it is 24 credits. If the worker dies at age 62, 40 work credits are required--the same as for retirement benefits.
• Finally, there is a special rule allowing a deceased worker’s children and spouse caring for children to receive benefits even if the worker didn’t have the number of required credits. In this situation with dependent children, benefits are available as long as the worker simply had accumulated 6 credits (1.5 years of work) in the three years prior to death.

Planning tips

• While still alive, have the highest earner maximize their benefit. Although the majority of people choose to start their retirement benefits early, with married couples it is often wise to maximize the higher of the two benefits. This entails having the spouse with the highest earned benefit wait until 70, gaining delayed retirement credits. This maximized benefit will then be available across both spouses’ lifetimes. This is the most cost effective way to secure a healthy inflation adjusted lifetime income stream that will protect a couple from longevity risk. This strategy is most compelling when the higher earner is the older spouse, and has a shorter expected lifespan (often the male).
• Coordinate survivor and personal benefits wisely. If you are eligible for both a personal benefit off of your own work record and a survivor benefit off of a deceased spouse’s work record, you have an important opportunity maximize the long term value of the combined Social Security benefit stream. The general rule is to maximize the larger of the two benefits by waiting to start it at the most opportune time. Compare what your personal benefit will be if you wait until age 70 (maximized with delayed retirement credits) with the survivor benefit at your full retirement age (FRA—after which it will not grow). If your maximized personal benefit is the highest, delay taking it until age 70. In the meantime, start taking the survivor benefit as early as age 60 (usually as soon as you stop working), then switching to your own benefit at 70. If the survivor benefit at FRA will be the highest amount available to you, wait until FRA to start it. In the meantime, you can start your personal benefit at age 62. Using this strategy, you benefit from the largest possible retirement benefit for the longest possible time.
• Your survivor benefit may not be maximized at your FRA. If your deceased spouse started his or her benefit prior to their FRA (and many, many do), then are situations when it will not make sense to wait until FRA to start. (Remember the widow(er)’s limit provision mentioned in Part 1.) For example, if your spouse filed early enough, your benefit may never be larger than 82.5% of their PIA. Your survivor benefit may be maximized at this 82.5% a few years earlier than your FRA, and it may not make sense to wait any longer to start taking it. This is complex, so if your deceased spouse started taking retirement benefits early and you have yet to reach your FRA, contact the SSA and have them calculate when your survivor benefit will be maximized.
• Be mindful of the earnings test. In the years prior to hitting your FRA survivor benefits are subject to the earnings test. If you are still working, it may be counter-productive to start taking survivor benefits if you are going to lose $1 of benefits for every $2 you earn over the limit (in 2012 it is $14,640). Depending on the situation, it may, or may not, make sense to start receiving benefits if you are still working. It may be wise to delay starting and let your benefit get larger.
• Get married. Survivor benefits are available to married couples, not to those couples who have chosen not to tie-the-knot. Your decision not to encumber your relationship with the bonds of marriage may prove to be an expensive one, when you consider lost survivor and spousal benefits. Most unmarried couples (at least the ones I talk to) are oblivious to the availability and value of survivor and spousal Social Security benefits.
• Hold it…maybe you don’t want to get married until age 60. Make that remarried. Remarriage prior to age 60 will make you ineligible for survivor benefits off of a deceased spouse’s record. (If that remarriage ends, you will again be eligible for the survivor benefits.) If you are contemplating remarriage and you are getting close to age 60, it might just be worth waiting a few months…or years. It is possible that these survivor benefits may be more valuable than your personal benefit, or any spousal benefits available off of a new spouse’s record. The survivor benefits are also available earlier (age 60) than your personal or spousal benefits (age 62). Don’t underestimate the potential value of wisely coordinating a survivor benefit with your personal benefit.
• Keep track of your ex-spouse. If you were divorced after being married for at least 10 years, you may be eligible for a survivor benefit off of your ex-spouse’s work record, if he or she passes away. Your ex-spouse is dead, and money now starts appearing in your checking account! This may sound too good to be true, but hey, this is America. Again, remarriage prior to age 60 will make you ineligible (unless that marriage ends, also). Don’t count on the SSA to magically find you, though. You will need to contact them and prove your eligibility for a survivor benefit.
• Survivor benefits are listed on your Social Security statement. Although these are not mailed out annually like they used to be, you can always get an updated statement here. Your statement tells you what your spouse and children would be eligible for if you were to die this year.

Rules concerning survivor benefits

• A surviving spouse is entitled to a survivor benefit based off the deceased worker's Social Security earnings record. These are often referred to as "widow's benefits", but they also are available to widowers.
  • The two must have been married for at least nine months prior to the death, unless the death is due to an accident.
  • Remarriage before age 60 disqualifies a widow for survivor benefits. However, if that marriage ends (e.g. a divorce, death of the second spouse) the surviving spouse is again eligible for benefits off the deceased spouse's record.
  • Remarriage after 60 does not cause a person to lose eligibility for survivor benefits. That person could continue to receive the survivor benefit, but may also choose to switch to their personal benefit and/or spousal benefits based off of their new spouse's earnings record.
  • There is no double-dipping--a person cannot take a survivor benefit and their personal and/or spousal benefit. For example, John dies at age 70 with a $2,500/month benefit, while his 70 year old wife Mary was receiving own benefit of $1,000/month. She would drop her personal benefit and start receiving her survivor benefit of $2,500. She would not get to receive both benefits totaling $3,500.
  • If a person is unlucky enough to be widowed multiple times, they are eligible for the highest of the available survivor benefits.
  • There are potentially survival benefits available for divorced spouses.
• The size of the survivor benefit is determined by 1) the amount of the deceased worker's retirement benefit, and 2) the age at which the surviving spouse starts the benefits. However, there are some important adjustments and limitations that can make calculating the survivor's benefit pretty complex.
  • The survivor benefit is calculated off the prmary insurance amount (PIA), which is the monthly benefit the deceased worker would have received at full retirement age (FRA). If the deceased worker's benefit had been increased with  delayed retirement credits (DRCs), then this higher amount (or "deemed life PIA") is used. (This includes the situation where a worker dies past FRA without having started to receive benefits--the deemed life PIA is adjusted upward for DRCs that had been earned up to point-of-death.) What this means is that if a worker delays starting their retirement benefits and earns DRCs, the surviving spouse will ultimately be eligible for a higher survivor benefit.
    
  • When a worker dies after receiving reduced benefits (i.e. retirement benefits were reduced for starting prior to FRA), the deceased worker's PIA is still the base for calculating the survivor benefit. However, the deceased worker's actual reduced benefit will be a limiting factor on the ultimate benefit available to the surviving spouse. This is because of an obscure, but very important rule called the widow(er)'s limit provision. The survivor benefit will never be higher than the larger of the deceased worker's actual benefit or 82.5% of the deceased's PIA. (This is meant to prevent, or at least limit, situations where the survivor benefit is higher than the actual benefit the deceased worker was receiving.) What this means is a worker's decision to take early benefits will reduce the potential survivor benefits available to their spouse.
    
  • If the surviving spouse waits until their own FRA*, they will receive the full survivor benefit--i.e. 100% of the deceased spouse's PIA (adjusted upward for any DRCs). However, in the situation where the worker had taken early reduced benefits, the widow(er)'s limit provision basically reduces the full survivor benefit to the level of the deceased worker's actual benefit, but not below 82.5% of the PIA. (Got that?) Important to note is that unlike a person's personal benefit, there is no advantage to waiting longer--the survivor benefit will not continue to grow past one's FRA (i.e. there are no delayed retirement credits with survivor benefits).
  • A surviving spouse can generally start receiving benefits as early as age 60. If a surviving spouse chooses to start receiving survivor benefits prior to FRA, the benefit is reduced up to 28.5% (to 71.5% of the full survivor benefit), depending upon how early they choose to start. (See this chart for details on the exact monthly reductions by birth year.) Even if the deceased worker had started reduced benefits at the earliest age (62), and the surviving spouse starts survivor benefits at the earliest possible age (60), the survivor benefit is never lower than 71.5% of the worker's PIA.
    
• There are some special rules that allow surviving spouses to receive benefits prior to age 60.
  • If the surviving spouse is disabled, they can start receiving benefits as early as age 50. Any benefit prior to age 60 would generally be 71.5% of the PIA.
  • If the surviving spouse who is not yet age 60 is still caring for the children of the deceased spouse, he or she is eligible for 75% of the deceased's PIA until the child reaches the age of 16. (Or any age if the child becomes disabled prior to age 22.)
• Surviving spouses are not the only ones entitled to benefits off a deceased person's Social Security earnings record. The deceased's children and dependent parents may also receive benefits.
  • Children of the deceased worker who are under age 18 (age 19 if still in high school) are eligible for a benefit equal to 75% of the deceased worker's PIA . (The child must also be unmarried.)
  • A disabled child may receive the same 75% benefit at any age, as long as he or she became disabled prior to age 22 and remains disabled.
  • Believe it or not, some parents may receive benefits off of their children's earnings records. If the deceased worker was providing greater than 50% of the support for a parent over age 62, then that parent may receive a benefit of 82.5% of the worker's PIA. If both parents were supported by the deceased worker, each is entitled to a benefit of 75% of the worker's PIA. Of course, if the parents were entitled to larger benefits off of their personal records, they would continue to receive them instead. They would not be able to receive a survivor benefit and their personal or spousal benefits at the same time.
  • A special one- time lump sum death payment of $255 is also available to surviving spouses who were living in the same household with the deceased worker at the time of death. If there is no spouse eligible for this benefit, it may be paid to a child (or children) eligible to receive benefits off the deceased's record.

Some limiting factors

As you can see, a number of people might be eligible to receive survivor benefits off of a deceased person's Social Security earnings record. These survivor benefits, when added together, could far exceed the benefits the deceased person would have received if they remained alive. However, there are a couple of important rules that limit the amount of benefits available to survivors.

• There is a maximum family benefit--the maximum monthly amount that can be paid on a particular worker's earnings record. This applies not only to survivor benefits, but also when a beneficiary is alive and receiving benefits. (There is a different maximum family benefit payable to a family of a disabled worker.) This is an excessively complicated formula, but the gist of it is that the family maximums range from 150% to about 180% of the deceased workers PIA.
  • For example, consider a deceased worker with a PIA of $2,000/month, who leaves a surviving spouse below the age of 60, and three children under the age of 16.
  • Each would be eligible for a benefit equal to 75% of $2,000, or $1,500/month. Combined these four benefits would equal $6,000/month, or 300% of the deceased's PIA.
  • However, the family maximum benefit in this situation would be about 175% of the deceased worker's PIA, or $3,500/month. In such situations, each benefit is adjusted proportionately to bring the total within the limits.
• There is the earnings test--which can mean lower benefits if a beneficiary works and earns too much in a year. Just as regular retirement benefits are subject to the earnings test, so are survivor benefits. This means that if the recipient is below their FRA and they earn over the earnings limit, they would lose some (or all) of their survivor benefits. In 2012 the earnings limit is $14,640 for benefit recipients who are below FRA for the entire year. For every $2 earned above $14,640, there will be $1 of Social Security benefits deducted.
  • For example, consider a person receiving $1,000/month ($12,000/year) in survivor benefits. As long as the person earns below $14,640 then there is no impact on their full $1,000/month survivor benefits. If they earn $24,640 for the year, then $5,000 of benefits will be deducted. (This is half of the $10,000 above the limit). If the person earns $24,000 or more above the limit (i.e. $38,640 or more) then their survivor benefit would be entirely lost.
  • If the recipient of benefits is past their FRA, then there are no earnings limits. They can earn as much as they want and still receive 100% of the benefits to which they are entitled.
  • There are special rules for the year in which a beneficiary hits their FRA.
  • Only earnings from work (i.e. wages or self-employment income) count toward the earnings test. Investment earnings, pensions, and other government benefits are not counted toward the limit.
  • The earnings test is on an individual, not a household level. As a result, if a surviving spouse earns above the limit it does not impact the benefits of any children also receiving benefits. Also, a person earning above the limit does not impact the Social Security benefits of their spouse.

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*As if this isn't complicated enough, your full retirement age as a survivor may be different than your FRA for regular retirement benefits. For example, a person born in 1956 will have a survivor FRA of age 66, but a regular FRA of 66 and 4 months. This is because the birth years for the gradual FRA shifts from age 65 to 66 started in 1943 for regular benefits and in 1945 for survivor benefits. Also, the gradual FRA shift from age 66 to age 67 starts two years later-birth years 1954 for retirement benefits and 1956 for survivor benefits. (Was anyone paying attention when these rules are made?)

I used to joke that helmets messed up my hair. That was before the brain surgeons shaved my head and then closed up the suture with stainless steel staples. -- Comment on blog discussing the bicycle helmet debate

Considering both the penalty of failure and the probability of failure is important in personal financial planning. If they are severe enough, the consequences of our potential failures are often more important than the probability of our success or failure. This is why we buy fire insurance for our homes, and life insurance while we are young, healthy and raising children. Although we know we will likely never cash in on the policies, the downside is just too much to risk.

Retirement planning is a key area where we should be concerned not only with the probability, but the penalty of failure. We don't just want to know what will happen if things go well, but how will we fare if things go bad. Your financial projections may look great, assuming you get reasonable returns on a consistent basis, and you don't live much beyond your life expectancy. However, what happens if market returns are significantly lower for an extended period of time, or you simply have the back luck of encountering a bear market right when you start to take large withdrawals from your retirement accounts? What happens if you (or your spouse, or both) happen to live long beyond your average life expectancy--say to age 95 or 100? In addition, what are the consequences if one of you (or both) needs expensive long term care services?

We can't eliminate all of the risk in our lives or financial plans. However, we can often mitigate the consequences of failure or bad luck. We can lessen the potential penalty of failure by implementing different strategies to secure a healthy, guaranteed minimum floor of retirement income that will last for a lifetime. For example:

• Maximize your Social Security benefits, which will give you (and your spouse) inflation adjusted benefits for across both your lifetimes.
• Consider forgoing the lump sum benefit, and take your employer pension (if you are fortunate enough to have one) as a monthly annuity with survivor benefits.
• Use some of your retirement savings to purchase low cost immediate annuities to create your own lifetime income stream--a do-it-yourself pension. Although it adds to the cost, consider buying these with inflation protection.

Even if you think the probability of needing expensive long term care is low, consider the penalty of failure. Will you have sufficient income and assets to pay for care, even if the markets don't cooperate? If the penalty of failure is simply a smaller inheritance for your children, this is an acceptable risk for most of us. However, if the penalty of failure is leaving your spouse financially insecure or destitute, than the risk is simply unacceptable. If the penalty of failure is relying on government assistance (Medicaid) you should strive to avoid it by proper planning. Although we may not eliminate this risk, we can mitigate the consequences by purchasing a reasonable level of long term care insurance, or by dedicating sufficient assets to pay for any necessary care.

If you study enough financial planning literature, you are bound to come across references to Pascal's Wager. Blaise Pascal was 17th century French philosopher, who reasoned that although it was impossible to prove the existence of God, it was a smart wager to believe in Him when a person considers the consequences of the decision. When you weigh the costs, benefits, risks and rewards, it is certainly a much better bet to put faith in God than to join with the non-believers. Although I suspect that financial writers have taken considerable license in adapting Pascal's reasoning to modern day risk management, that isn't critical for our purposes. The key point is that in making decisions, avoiding unacceptable outcomes (e.g. eternity in hell or moving in with your in-laws) should be a top priority.

When making our personal plans, we would all be wise to consider the sage advice of respected author, investment advisor, and former Oregon neurologist William Bernstein: "Always consider Pascal's Wager: What happens to my portfolio--and my future--if my assumptions are wrong?" You can count on him for a consistent reminder that, "The name of the game with retirement planning is not to get rich. Instead, the goal is to not be poor."

You can also bet he has a strong opinion on wearing bike helmets.

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 *Miles lived to ride another day. See him after the crash.

Below are six more singles and couples, these with "high" incomes of $100,000 to $125,000 per year. Again, two of the examples are single workers, while the other four examples are married couples. Two of the married couples have only one working spouse (couples #8 and #11), while the remaining two couples are comprised of dual earners paying into the Social Security system. (The examples assume all are retiring in 2012 at their full retirement age of 66, and they have not yet consulted with Table Rock Financial Planning on ways to make the most of their Social Security benefits.)

• Compare the single individual and the married couple, both making $100K/year (#7 and #8). Assuming their earnings have been the same over their working life, they have paid the same amount of taxes into the Social Security system. However, due to the availability of a spousal benefit, the married couple stands to receive a 50% higher combined benefit. The high earning single person will receive a benefit that replaces about 29% of his or her pre-retirement income, but the married couple will receive combined benefits amounting to a 44% replacement rate. Again, we see that the married wage earner potentially receives a significantly larger return on his or her contributions to the Social Security system. Fair or not, it is how the system is designed. And, if you understand the somewhat complex rules of the system, there are many perfectly legal and ethical opportunities for a married couple to further maximize the potential value of their combined Social Security benefits.
• Next, check out the situation with married couples #8 and #9. Only spouse A worked in couple #8, earning a healthy $100K/year. Couple #9 has an even higher combined income since each spouse worked, earning $100K and $25K respectively. As a result of these work histories, couple #8 has only one spouse with their own earned retirement benefit, but with couple #9 both spouses have earned benefits. Remarkably, even though couple #8 earned less money and paid less into the system, they will have the same combined Social Security benefit as the higher earning couple who both worked and paid more taxes. (Not to be critical, but who designed this system? Could it have been Congress?) Both couples' dollar benefits are equal, but the lower earning couple #8 is receiving benefits that replace 44% of their pre-retirement income, but the higher earning couple #9 is receiving only 35%. What this means is that, all things being equal, couple #9 will need to save more money to maintain a comparable post-retirement lifestyle. Couple #9 appears to get a raw deal here...but, isn't it always that way with entitlements? The other guy always seems to get a better deal from The System. Get used to it. Couple #9 can console themselves and improve their situation by going to a fee-only financial planner that understands the Social Security system.They have some opportunities to increase their income by coordinating their spousal benefits.
• Like couple #9, couples #10 and #11 also earned $125K, but taking different paths to that end. With couple #10, both spouses worked and contributed to the combined income equally. (I'm sure they hyphenated their names and shared the chores equally, also.) In couple #11, the income was earned the old fashioned way--entirely by spouse A. After seeing the previous examples, including the average earners in Part 1, you probably assume these three couples will have wildly different combined Social Security benefits. Not so--they are all pretty close, with replacement rates between 35% and 38% of their pre-retirement incomes. In Part 1, we saw how having the earnings concentrated with one spouse can lead to higher earning replacement rates. However, high earning couple #11 didn't find that to be true. The reason is that high earning spouse A earned over the Social Security maximum taxable earnings over their career, limiting both their Social Security tax liability and their eventual benefit.
• Finally, let's compare the two single individuals (#7 and #12). Even though #12 earned on average 25% more than #7, their retirement benefits are very close to the same. This is fair, since they both probably paid about the same amount of taxes into the system. The higher paid #12 likely earned over the Social Security maximum taxable earnings for entirety of their career, where #7 probably earned close to, but slightly below the limit. However, when you compare their replacement rates, the lower earning #7 fares somewhat better than the higher earning #12--29% versus 24%. The key point here is that both of these high earning single people receive a much lower replacement income from Social Security than their married counterparts (#8-#11), whose combined benefits replace 35% to 45% of the couples' similar incomes. Also, the Social Security retirement benefits these high earning singles receive provide them with a much lower replacement income than the lower (or average) earning singles we saw in Part 1. Higher earners need to save more to replace their pre-retirement incomes than lower earners. And, if you are single, count on having to save even more to replace your income in retirement than your married friends. Otherwise, don't fret about not having a companion to dine out or vacation with--you won't be able to afford it anyway.

If you haven't figured it out yet, the Social Security system is much more complicated than you first thought...if you ever bothered to give it a thought. And, this only scratches the surface. To sum up, here are a few key takeaways:

• If you are single person--save more for retirement.
• If you are a higher earner--save more for retirement.
• Everyone else--save more for retirement. (Just to be sure.)

Social Security benefits are a sizeable chunk of most American's retirement incomes. Before you make the important decisions regarding when to start your benefits, or how to coordinate your benefits with your spouse, make sure you have an adequate understanding of your options. This is a great time to consult with a fee-only financial planner who understands the system, in order to make sure you are doing the most to maximize your personal long term financial security.

Below are six different situations with workers making an "average" income of $40,000 to $50,000 per year. In two of the examples the workers are unmarried, with the other four comprised of married couples. In two of the married couples, one spouse does not work. In the other two married couples, both spouses have earnings covered by Social Security. (It is assumed all are retiring in 2012 at their full retirement age of 66. None of the individuals have been reading financial planning blogs suggesting they wait until 70.)

• Compare the single individual and the married couple, both making $40K/year (#1 and #2). Even though earnings and taxes paid into the Social Security system are the same, the married couple stands to receive a considerable amount more from the system. Due to the availability of the spousal benefit (equal to 50% of the worker's primary insurance amount), the married couple will receive benefits replacing 66% of their pre-retirement income, compared to the single person replacing only 44%. Is this fair? I suppose it depends on whether you are the single person, or part of the married couple.This is a prime example of how Social Security is family oriented.
• Now compare married couple #2 with average earnings of $40K and married couple #3 with average earnings of $50K per year. Notice that spouse B of couple #3 contributed $10K/year of their earnings, and earned their own personal benefit of $700/month. However, spouse B's earned retirement benefit is lower than the $738/month spousal benefit they are eligible for. The Social Security Administration (SSA) will supplement spouse B's earned benefit to bring it up to the $738 spousal benefit. Note that the combined benefits of couples #2 and #3 are equal, even though couple #3 made 25% more money, and presumably paid 25% more into the system. The earnings replacement rate of the lower earning couple #2 is 66%, but drops to only 53% for couple #3. Unfortunately, that part time job for couple #3 didn't contribute as much to their retirement as they had anticipated. Hopefully, they saved a good part of spouse B's earnings.
• Similar to couple #3, couples #4 and #5 also earned $50K, but did so in different ways. In couple #5, only spouse A worked and earned a benefit. In couple #4, both spouses contributed equally to the family finances, both earning $25K/year. Both earn an equal benefit from Social Security, which is higher than the spousal benefit they would be eligible for off the other spouse's record. Note that couple #4, where both spouses worked, has an earnings replacement rate of 52%--slightly lower than couple #3. Couple #5, where only one spouse worked, has a remarkably higher combined earnings replacement rate of 62%--about $400/month more than couples #3 and #4 where both spouses worked. How earnings are split between spouses makes a surprising difference. For these average earning couples, having the earnings concentrated with one spouse leads to higher earnings replacement rates. However, having earnings concentrated with one spouse does not necessarily lead to higher benefits as incomes rise, as you'll see in Part 2.
• Finally, compare the two single individuals (#1 and #6). As expected, the one making $50K/year has earned a higher retirement benefit than the one making $40K/year. However, notice that the earnings replacement rate is a bit lower for the higher earning worker as compared to the lower earning worker (42% versus 44%). Even though Social Security retirement benefits increase with higher average lifetime earnings, the amount of pre-retirement income that is replaced by Social Security significantly declines. As you'll see in Part 2, the replacement rate for a single worker averaging $125K/year drops to under 25%. This is just one way that Social Security benefits are already "means tested"--where higher earning people pay more and/or receive less from the system. Most will agree this is somewhat appropriate, but it is important to consider how much "means testing" is currently in the system before calling for more.

These examples give you an idea of how different factors determine the amount of replacement income people can expect from Social Security. Obviously, it makes a big difference for an individual or couple whether their Social Security benefits will replace 20% or 60% of their pre-retirement income. After all, they need a plan to cover the rest or else face a severe drop in lifestyle in retirement. Next, we will look at a similar set of examples covering higher earning workers and spouses.

When the Social Security Act was passed back in 1935, the initial provision of monthly benefits for retirees was set to begin in 1942. This allowed at least a small number of years for payroll taxes to build up a reserve. However, in 1939 the system was amended to pull in the start of monthly payments to 1940, and also added benefits for wives, widows, and dependent children of covered workers. In one fell swoop, Congress set the tone for the next several decades and established two important Social Security trends:

1. It is easier to add additional Social Security benefits first, and let others worry about paying for them later. But, hey, before we complain about too much about Congress doing this, we should admit that this simply reflects the will and the behavior of the "average" American.
2. The Social Security System is about enhancing the economic security of families, not just individuals. Since the common family model of that time was a working father and a stay-at-home mother, it was important to also ensure the economic well-being of the non-working spouse and children. Interestingly, spousal benefits were initially provided only for women, not for men. (This was changed after Ozzie Nelson organized a massive march on Washington by stay-at-home dads in the mid 1950s.) As a result of spousal and dependent benefits, married workers and their families generally stand to receive more out of the Social Security System than single workers.

Here are the key rules regarding Social Security spousal benefits:

• The spousal benefit is calculated off the retired workers primary insurance amount (PIA), which is the worker's earned retirement benefit at full retirement age (FRA). Full retirement age is 66 for workers born between 1943 and 1954, but transitions to age 67 for younger workers.
• A spouse is eligible for up to 50% of the retired worker's PIA, but the exact amount depends on when the spouse (not the retired worker) files for monthly benefits. At the spouse's full retirement age, the benefit is 50% of their husband or wife's PIA. However, if benefits are taken earlier than FRA they are reduced by 25/36 of one percent for each of the first 36 months. After 36 months, the reduction is only 15/36 of one percent per month. The table below shows the percentage of the worker's PIA spouses can expect, depending on when they start benefits, and whether their own FRA is at age 66 or age 67.

• Waiting beyond FRA does not increase the spousal benefit. This is in contrast to a worker's own benefit that can grow considerably from FRA to age 70 with delayed retirement credits. Even if the worker delays until age 70, maximizing his or her personal benefit with delayed credits, the spousal benefit will not increase--it is always calculated off the worker's PIA. Conversely, the spousal benefit is not reduced if the worker chooses to claim a reduced benefit as early as age 62.
• Age 62 is the earliest a person can apply for spousal benefits, unless they are caring for a "qualifying child"--i.e. a dependent child under the age of 16, or one receiving Social Security disability benefits. Unlike normal spousal benefits, if the spouse is caring for a qualifying child the benefit is not reduced for early receipt.
• Generally, a spouse must be married to the worker for at least one continuous year prior to applying for benefits. This requirement is waived if the spouse is already receiving survivor benefits or spousal benefits off an ex-spouse's work record.
• The spouse cannot claim benefits until the worker is "entitled" to benefits. In other words, the worker with the earned benefit must either be receiving benefits, or have filed for, but suspended receipt of his or her benefit. (More on why someone would the "claim and suspend" later.)
• If the spouse is working and has not yet hit their FRA, any spousal benefits they receive may be reduced if they exceed Social Security earnings limitations ($14,640 for 2012.)

In the next post we will look at some of the implications of the spousal benefits, along with how cultural trends will impact the amount of "replacement income" that Social Security will likely provide future individuals and families. And, if you are wondering about how retirement benefits work for divorced spouses and widows (and widowers), these will also be examined in coming weeks. Finally, we will look at some of the planning opportunities provided by the very thoughtful, but very complex Social Security retirement system.

We know the BCS is complicated. We know the BCS is crooked. We've almost learned to live with that. But, could it possibly be that measuring inflation is even more complicated than the BCS...and just as crooked?

"There are three kinds of lies: lies, damned lies, and statistics." - Mark Twain (attributed to Benjamin Disraeli)

Unless you are into anti-government conspiracy theories--after all this is Idaho, and we do love to hate the Feds--you may never have given much thought to the possibility that the official inflation numbers published by the Bureau of Labor Statistics (BLS) have been manipulated to your detriment. Over the last few decades the BLS has made important changes to how it calculates the CPI that significantly lower the reported inflation numbers. This is no secret, and the methodology and impact of these changes is well documented. There is considerable controversy, however, as to whether these changes were appropriate, or part of a complex plot to lower the official CPI estimates to order to minimize inflation's apparent impact. And, more importantly, minimize the on-going increases of government expenditures linked to the CPI.

First, a quick summary of the controversial changes in CPI measurement:

• In 1983 the way the changes to cost of owner-occupied housing is measured was significantly modified. A new measurement called owner's equivalent of rent (OER) was substituted for the change in actual housing prices. OER measures the amount a homeowner would have to pay to rent their home, or alternatively would earn by renting their house out in a competitive market. The reasoning behind using OER instead of house prices is that owner-occupied housing consists of both a consumption element and an investment element, and the CPI is designed to exclude investments (e.g. stocks, bonds, real estate.) This is certainly reasonable when you consider that contrary to other price increases, homeowners are usually very happy when the values of their homes rise. There is no arguing that using OER instead of house price changes has resulted in a much more stable index. For example, since 2000 housing prices changes as measured by the Case-Shiller Index have swung wildly between +20% and -20% per year, while OER has moved in a narrow range between 2% and 5%.
• In 1999 the BLS began using a geometric mean formula in the calculation of the CPI. This methodology seeks to reflect consumer substitution behavior, where people make trade-offs on the basis of both price and personal preferences in an effort to maximize their standard of living. Critics claim that if the price of filet mignon goes up, and consumers switch to hamburger, the BLS simply substitutes hamburger for steak and calls it even. The BLS adamantly denies this type of substitution is made, and makes a very reasonable defense. (For an understandable, but lengthy explanation of these changes and other see this 2008 BLS article--Addressing Misconceptions about the Consumer Price Index.)
• Starting in 1998 and phased in over time are hedonic (derived from the Greek word for pleasure) statistical models that adjust for quality changes. Using multiple regres­sion analysis the value of new features or quality changes is estimated by comparing the prices of items with and with­out that feature. Basically, the BLS is trying to estimate what portion of a price increase (or decrease) is due to quality changes, and whether the consumer is left better or worse off. (Again, see the BLS article for a good explanation.)

On one side of the inflation controversy are economists that contend that the CPI for years was systematically overstating price levels to the tune of 0.8% to 1.6% per year. These were the findings of the Boskin Commission, appointed by the Senate Finance Committee in 1995 to study the effectiveness of the CPI estimates, finally resulting in the late 90's changes mentioned above.

In the other camp are those that believe the pre-1982 methods of measuring inflation would give a truer picture of the debasing of the dollar and the impact of price changes on people's well-being. A well known, vocal proponent of this point of view is Walter J. "John" Williams and his work can be found on his Shadow Government Statistics website. Here is his 2006 take on the changes to CPI measurement:

The CPI was designed to help businesses, individuals and the government adjust their financial planning and considerations for the impact of inflation. The CPI worked reasonably well for those purposes into the early-1980s. In recent decades, however, the reporting system increasingly succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients, without ever taking the issue of reduced entitlement payments before the public or Congress for approval.

In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if you are making payments based on the CPI (i.e., the federal government), you are making out like a bandit.

According to Shadow Stats, the current annualized inflation rate, measured using older pre-1982 methodology is about 10.5%, compared to the official rate of a little over 2.9%--over 7% higher!

Ignoring the 1983 housing change, the cumulative impact of the other methodological changes is less dramatic, but still significantly large enough to be make a major dent in the COLA adjustments to your government check.

Are Williams and other critics right, and the federal government is manipulating statistics to hold the official inflation down? I'm not qualified to pass final judgment on the BLS statisics, but I have to say their methodology seems OK to me. For one thing, if the Shadow Stats' numbers were used and Social Security and government pensions were all about double today's level--does that even pass the smell test? It's not like wages and salaries have been rising at a screaming pace. Does it seem right that Social Security benefits and pensions should be rising at over 10% per year? I don't think so.

Just because inflation used to be calculated one way, doesn't mean that is the way it should be done in perpetuity. Just because cost-of-living increases were calculated in the 70's using the old way, doesn't mean it's a good idea for the new millennium. And, just because college football has always had a corrupt bowl system where elite colleges meet to crown a champion and divide the TV money, doesn't mean that is the way it always has to be.

Like the CPI, we should give economists a chance to redesign the college football post season and bring it into the 21st century. One thing for sure, it would certainly look different than the current BCS. Unfortunately for BSU, however, the championship will likely still require kicking a field goal.

Determining price levels and the rate of inflation is not as simple as measuring other things. For example, when you weigh yourself in the morning you just step on the scale and get a nice digital readout. There are, of course, some similarities between prices and our weight--a lot of short term ups and downs, but generally a small percentage movement up and to the right every year. But, think about it. If you are trying to measure price movements, the first question is the price of what? Each of us spends our money on so many different goods and services over the span of a year, and each of us spends our money different than the next guy. If gasoline goes up 5%, and bread goes down 5%, and milk stays even--what does that say about inflation? What if light beer goes down in price, but microbrews go up 5%? What if cable TV goes up so darn much you drop it altogether, saving $100/month?

In order to get a handle on price changes the U.S. Bureau of Labor Statistics goes to great effort to construct two major categories of price indexes. The first set, which we will ignore for the purposes of this discussion, are the Producer Price Indexes which measure price changes from the perspective of producers along various points of the supply chain. The second set of indexes is the Consumer Price Index, which measures changes from the perspective of the end-use consumer. This is the most familiar, and has the most impact on most of our everyday lives. A quick scan of this document from the BLS tells you the first thing you need to know about inflation--it is an incredibly complex measurement that must take an army of economists and statisticians to pull together.

• Price data is collected every month from over 4,000 homes and 26,000 retail and service establishments of all kinds, in 87 different urban areas across the United States.
• Prices for goods and services are collected in 8 different major expenditure groups, and these are further divided into about 200 subgroups. Each subgroup has a representative market basket containing hundreds of specific items from specific retail establishments. In all, data on about 80,000 different items is collected in scores of different cities across the country. We're talking soup-to-nuts, mutton to motor oil, frankfurters to floor coverings, from Brockton to Bremerton and Saint Pete to San Fran.
• These representative market baskets were developed from major surveys of thousands of consumers--the last ones back in 2007 and 2008. Detailed diaries and interviews were used to determine the content and relative weighting of the over 200 subgroups. The relative weightings allow the BLS to get compute the index, which is a weighted average of all the items measured. This weighted average may be a good representation of the average consumer, but your individual market basket is undoubtedly very different. The current relative weightings of the eight major expenditure groups are shown below.

But wait, that's not all. You may not have realized there isn't just one CPI number--that would be too simple. There are actually a number of Consumer Price Indexes calculated. These indexes are calculated regionally, then averaged for the country. Also, the indexes are published in both seasonally adjusted and unadjusted form. If you are making any decisions from this data, you want to be careful to understand what you are looking at. Below are the key indexes you likely will see quoted in different contexts.

• CPI-W: The CPI for Urban Wage Earners and Clerical Workers, a collection of households that represent only about 32% of the population. This is an older index with a limited subset of households (wage earners and clerical workers), but is important because it is the one used by the government to adjust Social Security payments on an annual basis.
• CPI-U: The CPI for All Urban Consumers, which covers about 87% of the total US population. This is a superset of the CPI-W, adding many additional categories of workers (e.g. the self employed and professional, managerial, and technical workers), along with the unemployed and retirees. (It is interesting to note that SS payments are adjusted by an index that excludes retirees, the CPI-W. I'm sure this makes sense to someone in the government.)
• C-CPI-U: Chained CPI for All Urban Consumers which covers the same set of households as the CPI-U, but uses a different methodology that attempts to reflect substitutions and adjustments consumers make as prices change. There are serious discussions underway to use the C-CPI-U to base adjustments to Social Security benefits, government and military pensions, and tax brackets. The chained CPU approach results in a lower inflation adjustment, and thus would lower government payments over time, along with potentially securing more revenue through slow, stealthy tax increases. (Needless to say, not everyone is a fan of this idea. More on that later.)
• Core CPI: This is an inflation measure that removes the effect of the volatile food and energy components of the CPI. Since food and energy account for close to 25% of the CPI, and often have major short term swings, removing these items results in a major smoothing of the curve, and helps economists observe inflation over the remainder of the economy. The Federal Reserve pays close attention to this number in its role of keeping inflation within desired bounds. The core CPI is often contrasted with the "headline" CPI, or CPI-U. When you hear an inflation number that is totally out-of-sync with what you are experiencing, listen carefully. It is probably the Core CPI that is being quoted.
• CPI-E: This is a CPI measure the attempts to reflect the different "market basket" or spending habits of the elderly. It is an experimental BLS inflation statistic, and you probably haven't heard much about it. However, senior advocates would like the concept to catch on. The argument is that certain categories that older Americans spend more money on, especially healthcare, are underrepresented by the CPI-W. If Social Security was indexed to the CPI-E, cost-of-living increases would, in theory, better represent what seniors experience. And, more importantly, benefits would be presumably higher.

A couple of key points about inflation should be obvious by now. First, it is impossible to get an exact read on what inflation really is. The BLS goes to great effort, and probably does a superb job, but like most statistics about the economy it is an elaborate estimate that takes on the cloak of accuracy. Second, no CPI is going to measure your exact experience with price increases. You experience somewhat different inflation than your next door neighbor (the one drinking light beer while you sip your microbrew), not to mention the retiree in Florida, the oil worker in North Dakota, or the single mother in New Jersey.

What may not be obvious from all of this is the government conspiracy that is currently gaming the inflation numbers. (Yes, this is playing to the local crowd, but the best way to get Idaho readers to continue to the next post is to mention a government conspiracy or complain about the BCS. You get both in Part 3.)

Carl Richards is a Certified Financial Planner and investment manager in Park City, Utah (formerly located in Las Vegas, Nevada). He has developed quite a following for his "personal finance on a napkin" sketches and his personal finance blog posts at New York Times. (I truly look forward to seeing the latest sketch each week. But, really...who has time to read financial planning blogs?)

Experience is a hard teacher because she gives the test first, the lesson afterwards. -- Vern Law*

Richards' story is similar to millions of Americans'. He bought too much house in Las Vegas during the boom years. They borrowed too much off the equity to fund his business start-up, and live a bit better than they could really afford. After considerable soul searching, they stopped paying on the underwater home they could no longer afford, and eventually arranged for a short sale. You can hear Carl tell his story on a recent NPR Planet Money podcast.

Judging by the reader comments on the original article, Richard's struck a raw nerve for many people. Many cannot understand how a financial planner could make such mistakes, and still be an advisor. For example:

• "This article is incredible. The author isn't competent to manage his own financial affairs, and his job is advising other s how to manage theirs?"
• "The Times reaches a new low in the quality of its financial writers, and that's saying something. It's like it's a Times job requirement for them to manage their personal finances like a 7th grader."
• "The notion that Richards was, and still is, a financial advisor is an indictment of the entire industry. He is clearly incompetent. He made foolish choices based on avarice and now seeks to justify them."
• "My mechanic has more common sense about Finances. (No offense to my mechanic!) Wanna bet his next book and article is 'How I lost my Financial Business when I wrote about how stupid I was with my own Personal Finances in the NY Times'".

That is just a sampling of the negative comments fit to print. To be sure, there were also a number of readers who expressed positive sentiments. Many readers simply took the opportunity to tell a bit of their story of how the real estate downturn had affected them. And, a surprising number of humble folks took the time to explain how they were much better managers of their finances, much too wise, and much too moral to get caught in such a reckless fiasco.

Financial professionals have been debating the wisdom of Richard's mea culpa. Some believe he has harmed the profession and undermined the credibility of financial planners with the public. (Frankly, is that even possible?) Others see it as a breath of fresh air, and the start of number of useful conversations of how we all do stupid things with money, and how to avoid repeating them. I'm in the latter camp. The whole controversy has reminded me of the many mistakes I have made over the years, and how they have shaped the advice I give today. Just a few examples:

• I was in too big of a hurry to buy a house. I basically borrowed 100% at interest rates well above 10%. (It was the early ‘80s.) We should have been more patient, saved up a decent down payment, and waited for interest rates to drop to affordable levels.
• I didn't have the first house sold before starting to build the second house. It didn't sell, and we became accidental landlords. After a few years, we were able to finally sell, almost breaking even. Coming from California, I didn't realize you could lose money on real estate until then. Thankfully, my lesson was much less expensive than Carl's.
• While juggling two house payments, we had another child and I took a cut in pay due to the recession. We found out those house payments don't necessarily become easier over time. I discovered the wisdom of sufficient margin between your house payment and your income.
• Even though we had two children depending on us, we never had a will in place until much too late. We had plenty of excuses, but in retrospect this was really irresponsible.
• Too little life insurance. Too little emergency savings. Too much company stock. Too much stock in general.
• And, yes, even though I advise my younger clients not to do it--I borrowed money to buy cars. (It would have been easier to save up for them if I hadn't been paying on two houses. One mistake begets another.)

"Experience is a brutal teacher, but you learn. My God, do you learn." - C.S. Lewis

It just could be that our ability to learn from our own mistakes, and the mistakes of others, is the best thing financial planners have going for them. I thank Carl for encouraging me to reflect upon my past experiences, and reminding me to not be so darn smug and self-righteous about the "right way" to handle personal finances. Hopefully, financial advice delivered with a little more humility and a lot more understanding will be more acceptable, and ultimately more effective at improving the lives of clients.

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*Yes, the Vern Law from Meridian, Idaho. The Cy Young Award winning pitcher with the Pittsburg Pirates is also credited with saying, "A winner never quits and a quitter never wins." Who knew? I thought Coach Manship at Ladera Vista Junior High made that up.

Here is a quick example of money illusion. Nick gets a 3% raise during a year when inflation is at 3.8% (as in 2008). Nora gets only a 1% raise during a year when inflation was actually a bit negative, such as in 2009. Who got the better deal? Most people would say Nick, whose nominal raise was three times that of Nora's. However, the real purchasing power of Nora's salary increased over 1%, while Nick's actually declined almost 1%. Despite getting a smaller nominal raise, Nora actually got a much better deal than Nick--it probably didn't feel that way.

People are just not very good at factoring in inflation as they think about their money over time. Gary Belsky and Thomas Gilovich give a couple of reasons for this in Why Smart People Make Big Money Mistakes: "First, accounting for inflation involves the application of arithmetic, which is often annoying and downright impossible for many people. Second, inflation today, at least in the United States, is an incremental affair--2 percent to 4 percent, on average, over the last decade and a half...little numbers are easy to discount or ignore."

Although it might be somewhat difficult, and the impact may seem small, accurate thinking about inflation is crucial in avoiding some big financial planning mistakes. Here are three areas where people commonly fail to consider the impact of inflation on their future:

• Projecting investments and salary forward at a nominal growth rate, but failing to adequately consider that expenses will also be going up with inflation. For example, a 50 year old couple anticipates having $2.5M saved by age 65, considering their current savings rate, anticipated raises, and portfolio growth of 7% per year. Assuming a safe 4% withdrawal rate, that means $100K of income in retirement, to be combined with Social Security of about $36K per year. Wow, that's considerably more money than they make today! Maybe they can cut back on the savings a bit, and enjoy life a bit more. What they don't understand that these anticipated investment returns factor in an expected inflation rate of about 3%. What costs $100 today will on average cost over $150 in fifteen years at that rate. With 50% higher expenses, that $2.5M nest egg doesn't seem quite so adequate.
• Investing so conservatively, that a portfolio does not grow at a sufficient pace to offset inflation. Many people cannot bear the daily ups and downs of the stock market. Instead they choose an ultra conservative portfolio of CDs, money market and other fixed income investments that will provide a lower, but steady return. Even though the nominal return may be steadily positive, the real return of such a portfolio is anything but steady and positive. At its best the ultra conservative portfolio will barely outpace inflation. At its worst, this combination of investments will leave the investor with less and less purchasing power over time. As Larry Swedroe points out: "The lesson we take from the historical evidence is that those seeking to avoid investment risk may incur the even greater risk of the loss of their purchasing power over the long term. The bottom line is that in terms of achieving financial goals, the return from riskless instruments may likely to prove insufficient." The only ways a person can effectively compensate for the lack of real growth in their portfolio is to lower their expectations for the future, or save more--generally a lot more. Unfortunately, not many people are willing to do either of these.
• Not understanding the significance of cost-of-living-adjustments (COLAs) on pensions, annuities, and Social Security. Imagine two friends retiring the same year from two different employers. Ed considers himself very lucky, and will get a $4,000 per month pension from a private sector employer. Like most private sector pension plans, Ed's pension does not include any inflation adjustments. His neighbor, Ralph will also be receiving a $4,000 per month pension from a public sector employer, and it will have annual COLA adjustments. In year one the two friends feel equally happy, have a similar lifestyle, and they enjoy the same purchasing power from their healthy pensions. However, after twenty years averaging just 3% inflation, Ralph will be receiving about $7,200 per month, but Ed will still be receiving $4,000. Those two pensions, which seemed so equal at the beginning, are anything but equal. A pension or annuity that does not have any provision for inflation adjustment is worth much less than one that does. If inflation is low, the difference will take a while to show up. However, just a few years of extremely high inflation, such as experienced in the 70's and early 80's, will wreak havoc on the fixed pension. The impact of inflation on a fixed pension should be anticipated from the start, but a lack of planning for the inevitable decline in purchasing power is a common mistake.

Social Security is an inflation adjusted pension or annuity that most Americans will benefit from in retirement. Discussions are underway about the right methodology for determining future Social Security COLAs, and these changes will likely result in somewhat lower future inflation adjustments. However, even with some tweaks to the calculation, people should continue to receive tremendous value in having a basic foundation of inflation adjusted retirement income through the system.

Of course, we don't know exactly what inflation rates will be in the future, but we hopefully know enough to plan. Investors need to realize that there is a certain level of inflation expectations implicitly or explicitly built into the prices of stocks, bonds, and other investments. It is important to always consider the difference between the nominal return to investments, and the real return. Higher nominal rates of return may sound better, but real rates of return will determine your future lifestyle. The big risk to our financial plans is if inflation rates deviate significantly (up or down) from the somewhat low inflation expectations built into current stock and bond prices. Protecting yourself from both expected and unexpected inflation is a key objective of portfolio construction.

In later posts we will look at the Consumer Price Index--some of the controversy around it, and why your personal inflation rate may look very different from the averages.

Let our advance worrying become advance thinking and planning--Winston Churchill

A critical first step of your planning is to understand what coverage you may already have for long term care expenses. Although many people are mistaken (or deluded) that Medicare will cover most of their nursing or home care costs, this isn't really the case. Medicare will cover 100% of the first 20 days in a nursing home, along with an additional 80 days subject to a significant copayment. This is has proven to be substantial benefit for a great many people, but it isn't a long term long term care financing solution. Medicare's coverage of home care is more open-ended, but has definite restrictions. For example, the patient must have a need for "skilled care", not simply assistance with the activities of daily living. Your private health insurance and Medigap supplemental policies may also provide limited coverage in the early days, but also are not long term solutions.

That's it--after the first few months of care you need a plan for paying for any potential long term care needs that may arise. If you are single, planning is fairly straight forward, although not necessarily easy. Ignoring for a moment the possibility of families providing care for one another (i.e. the old fashioned way), the financial resources most people can call upon are limited to the following:

• Monthly income from Social Security, pensions, and lifetime income annuities
• Investment assets, including your home equity
• Veterans long term care benefits
• Private long term care insurance

Look closely at your available resources, and consider whether they will be sufficient to provide adequate care for you, should you need it at age 70, 80, or even 90. For example, your retirement income may not be able to cover the entire cost of assisted living or nursing home care, but it will cover a percentage. Next, you may want to set aside a portion of your investment assets specifically to cover any potential long term care--promising not to spend it on vacations, new cars, or whatever. Alternatively, a reasonable plan may be to sell your (presumably paid off) house, using the equity to pay for your care. Finally, you should at least consider the purchase of long term care insurance, allowing you to transfer the risk of future LTC needs to an insurance company, at the cost of a predictable annual premium.

Planning for couples, however, is more complicated. Although couples have the distinct advantage of providing care for each other in many situations, they face the added risk of a surviving spouse being left financially insecure after an expensive long term care episode. When outside caregivers are eventually required, whether at home or in an assisted living or skilled nursing facility, a couple's financial assets can become quickly depleted. Whereas a single individual can plan to use the entirety of their retirement income and financial assets to pay long term care, a couple cannot afford to do this. The person not receiving care still has income needs, still has housing needs, and will still need to draw upon the financial assets for what could be many years into the future.

We are naturally concerned about our spouse's welfare should we predecease them. Besides leaving a spouse emotionally and physically exhausted, the possibility of leaving our spouse financially destitute after paying for long term care is a risk none of us should willingly take. For this reason, it is all the more critical for couples to either set aside dedicated financial assets for long term care contingencies (i.e. self insure), or to purchase sufficient long term care insurance.

Besides relying on your retirement income, financial assets, and insurance to deal with long term care contingencies, there are at least two other potential options--family members and government assistance. If there are family members willing and able to care for you as you require, this is may be a viable solution. Caring for an aged parent is an undertaking deserving of much honor and respect. However, if you are counting on children to step up to this task, please discuss this possibility with them long beforehand. Your children need to be aware, and possibly plan for this potential. Also, consider the possibility that circumstances (e.g. divorce, health, finances, etc) may preclude the option of your children providing care.

Finally, there is a backstop of government assistance for long term care. Medicaid now pays for over 40% the nation's nursing home expenditures, and over 30% of home care. With federal and state budgets stretched to their limits, Medicaid simply cannot continue to be the long term care financing solution for the middle class. If you care about keeping your taxes low, and are disturbed about government spending and debt, Medicaid should not be your long term care plan. And, if you are concerned about the best quality care you or your loved ones, Medicaid should not be your preferred long term financing solution.

Instead of worrying about the future and possible long term care, do something constructive--make a plan. Discuss the alternatives with your spouse and other family. If you need assistance, consider consulting a fee-only financial planner--someone who will objectively assist you to evaluate your options, not sell you a product. Facing these issues may not be pleasant and may take some effort, but hopefully this preparation will result in less unproductive worrying, and more peace of mind.

Why a 4% safe withdrawal rate may be too optimistic

Most safe or sustainable withdrawal rate studies are based on historical data, and the general assumption is that future returns will be similar to the past. Two issues with this approach are identified by a number of researchers.

First, many (but, not all) safe withdrawal rate studies ignore the impact of that investment costs have on investor returns. On average, investors will not earn the gross return to stock market index, but rather a net return after costs. Between mutual transaction costs, mutual fund expenses, and potentially investment management fees, it is easy to imagine a drag of at least 1% to 2%. William Reichenstein of Baylor University calculates that if you assume investment returns are 2% lower than the historical gross (i.e. before investment costs) returns, then sustainable withdrawal rates over 25 to 30 year periods are about 1% lower. In other words, your 4% to 4.5% safe withdrawal rate becomes 3% to 3.5%.

Second, there is no guarantee that future market returns will be as generous as the past hundred or so years of data. In fact, many influential investment managers and economists expect lower market returns over the next ten to twenty years. They point to historically low dividend yields, high stock market valuations (i.e. price to earnings ratios, or the amount investors are paying for a dollar of corporate earnings), low interest rates, and concerns over future economic growth as harbingers of lower future stock and bond market returns. Here is a sample of prominent voices on this subject:

• John Bogle, founder of Vanguard, expects future stock market returns to be around 7%, compared to historical returns or 9% to 10%. In a 2009 Morningstar video he stated: "I think we give far more credence to past returns in the stock market than they even remotely deserve. The past is not prologue. The stock market is not an actuarial table." Rather than looking at past returns, Bogle says we need to focus on the sources* of past and future stock market returns. We can, and should, have reasonable and rational expectations of these sources of returns.
• Ed Easterling of Crestmont Holdings points to relatively high stock market valuations, the current low interest rate environment, and uncertainty of future economic growth as reasons to be very cautious with future expectations. In a recent Wall Street Journal article he says, "Retirees, especially those that started in the recent past, have a relatively long period ahead of them. Over-assumed returns can empty savings more quickly than many expect." With the conditions of the past few years, he believes a safe withdrawal rate is 3% or less. (If you have access to the AAII Journal, see Easterling's September, 2011 contribution: "Historical Performance and Future Stock Market Return Uncertainties.")
• Rob Arnott and John West of Research Affiliates also don't believe future returns will match expectations set blindly on historical data. In "Hope is Not a Strategy" they derive baseline return assumptions for large U.S. stocks of only 5.2% (or a 3.2% real return after inflation). For bonds, they have a baseline assumption of only 2.5%. "The only way today's expected returns can match tomorrow's targeted returns is through remarkable good fortune in the years ahead. We're relying on hope. But hope is not a strategy; hope will not fund secure retirements. We're planning for the best and denying that worse can happen. It makes far more sense to hope for the best, with plans for realistic outcomes-and contingency plans for worse ones."
• Bill Gross of PIMCO has been talking about a "new normal" period of slower economic growth and lower market returns for both stocks and bonds. "Instead of 10% returns for stocks, look for five or so. And instead of the past 20 years' returns on bonds, which are actually better than stocks -- close to double digits -- it's 4% going forward. So that's what the new normal is. And it's based upon the primary assumptions of a deleveraging of the private sector and the public sector being limited in what it can spend."

This just brings home the fact that future market returns are not some sort of entitlement. We don't know what the next 10 to 20 years has in store in regards to market returns, but it is probably unwise to presume that the future will deliver historically healthy results. Although the concept of a safe withdrawal rates is a tool to deal with these risks and uncertainties, there may be reason to be a bit more cautious. (For one such cautious approach, see this video where Ken French of Dartmouth discusses establishing a safe withdrawal rate starting with Treasury Inflation Protected Securities, or TIPs.)

As discussed in Part 2, it is unrealistic for someone to set a withdrawal rate and leave it untouched for 30 years. For a successful outcome (i.e. one that doesn't involve moving in with your children or becoming a regular at the food bank), it is important to be attentive and flexible. If the markets are not delivering adequate returns over the first critical 10 to 15 years of retirement, you will certainly be getting real time feedback on your account statements. If that doesn't alert you to cut back a bit on spending, take the hint when your financial advisor suggests you look into jobs at Walmart.

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*Bogle breaks the the sources of stock market return into:

• Investment return, which comes from initial dividend yield and future earnings growth.
• Speculative return, which comes from the change in the public's valuation of stocks, measured by the price/earnings ratio--basically how much investors are willing to pay for each dollar of corporate earnings.

In Part 1 a popular rule of thumb for sustainable portfolio withdrawals, the 4% rule, was discussed. Now calling the 4% rule "popular" is a bit misleading. It is popular in the same vein that other often repeated rules like "floss daily" and "stay within 5 MPH of the speed limit" are popular. People don't like the 4% rule because it seems very conservative, very restricting, and a major obstacle to enjoying retirement. When they realize that the 4% rule implies you need a portfolio 25 times the beginning portfolio withdrawal-people exclaim, "No way, that is just not going to happen!"

Never fear, many respected financial planners agree that the 4% rule is a bit too cautious. Below is a brief rundown of some of the criticism.

Some reasons the 4% rule may be too conservative

First of all, the historical data shows with a beginning withdrawal rate of 4%, portfolios would have successfully sustained inflation adjusted withdrawals for 30 years 90%-95% of the time. As the following Vanguard tables show, 4.75% to 5.25% withdrawal rates (with moderate -- 50% stock/50% bond portfolios) were sustainable over 30 years with 75% or 85% success rates. (Not bullet-proof, but successful most of the time.) In fact, you'll often hear the 4% rule quoted as suggesting beginning withdrawals of 4.5%, or 4% to 5%.

Research Note: Revisiting the ‘4% Spending Rule'  (Portfolio allocation: Moderate portfolio = 50%/50% stock/bonds, Conservative portfolio=20%/80%, Aggressive=80%/20%)

A common, and valid, criticism of the whole "safe withdrawal rate" concept is that a static withdrawal rate over 20-40 years is simply unrealistic. Or, as Moshe Milevsky says, "...a simple rule that advises all retirees to spend x% of their nestegg, adjusted up or down in some ad hoc manner, is akin to the broken clock which tells time correctly only twice a day." Certainly, retirement expenses are not linear over time, and many argue that expenses are often higher in the early years of retirement when people are more active. Maybe rational retirees would prefer to have more spending early in retirement, and willingly accept lower spending budgets later in retirement, if necessary. To impose a 30 year linear budget is not only a bit rigid, but will more likely than not, result in a substantial surplus at the end of the plan.

If you are flexible and disciplined, you can do better than starting out with only a 4% portfolio withdrawal rate. You simply have to be willing and able to cut back if subpar portfolio performance demands it. Jonathan Guyton has done some of the best research defining relatively simple decision rules governing spending rates which, if followed, can significantly increase the beginning withdrawal rate. Guyton starts with a basic withdrawal rule that says withdrawals are modified upward for inflation, except following years where the portfolio return is negative. Any missed inflation adjustments are not "made-up", but he has two other decision rules (or "guardrails") that work to keep withdrawals from becoming too high or too conservative. The first guard rail is the capital preservation rule which calls for a 10% reduction from the previous year's withdrawal when the withdrawal rate gets too high (20% above the starting rate). In good times the prosperity rule kicks in, calling for a 10% increase in withdrawals when the current withdrawal rate drops too low (20% below the beginning rate). Guyton's research says that these decision rules will provide for 30 year withdrawal periods at beginning rates ranging from 4.6% to 6.5%, with the expectation that the capital preservation rule (i.e. 10% cuts) is triggered no more than 10% of the time. The lower starting withdrawal rate is for moderate portfolios (50% stock) and very high probability for success. The higher starting withdrawal rates require higher allocations to stock and/or somewhat lower probabilities of success (but still 90% or above).

Finally, another bit of research that points to potentially higher safe withdrawal rates was done by influential financial planner Michael Kitces in 2008. Kitces drew on research that has shown an "incredibly strong inverse relationship" between the starting price to earnings ratio of the S&P 500 and the following 15 year returns. Since it is sequence risk, or the risk of lousy market returns during the first 15 years of retirement, that deplete portfolios prematurely, P/E ratios could be an excellent predictor of potential failure. (The analysis uses a P/E ratio based on the 10 year average of real earnings, referred to as P/E10 or CAPE-the Cyclically Adjusted Price Earnings Ratio.) Indeed, Kitces found that "the only instances in history that a safe withdrawal rate below 4.5% was necessary all occurred in environments that had unusually high P/E 10 valuations (above 20). "When stocks markets have more normal valuations (P/E 10 between 12 and 20), Kitces recommended adding 0.5% to the beginning safe withdrawal rate, to 5.0%. When stocks are undervalued (P/E 10 less than 12), the beginning safe withdrawal rate could be bumped 1%, to 5.5%.

It is encouraging that if you are willing to be flexible and disciplined, and you are fortunate to be retiring when stocks are not highly overvalued, you may be able to take higher levels of income from your portfolio than the 4% rule demands. However, before you go rush out and buy that RV or lake house, see some of the reasons you may still want to remain a bit conservative. 

• How long are you going to live?
• How is your portfolio going to be invested over the rest of your life?
• What will your investment returns be, year-by-year, over the rest of your life?
• What will taxes be on your portfolio over the rest of your life?
• Do you wish to leave an inheritance, and if so, how much?
• How sensitive are you to the potential of running out of money in your old age?

You get the picture. Even though we crave a simple answer, life is complicated. And, even though we try our best to create reasonable plans for the future, we are reminded instead just how much is out of our control. In an attempt to create some order out of this chaos, financial planners and economists continue to research and write extensively on the subject of safe (or sustainable) withdrawal rates*.

A safe withdrawal rate is the maximum amount of money, expressed as a percentage of the initial portfolio, which can be withdrawn each year with a very high likelihood that the portfolio would not be completely exhausted within a specified timeframe. The safe withdrawal amount is generally incremented each year to account for inflation in order to maintain a constant purchasing power. The timeframe used is usually one that the individual (or couple) is unlikely to significantly outlive.

The 4% Rule

To illustrate the concept of a safe withdrawal rate let's look what has become known as the 4% rule. First of all it is important to note that the 4% rule is not an absolute like "don't run with scissors" or "time being equal to money". It is more of a rule of thumb, or good practice. You encounter these rules of thumb in many disciplines. Of course, the most famous is "Never get involved in a land war in Asia," but only slightly less well known is this: "Never go in against a Sicilian when death is on the line!"

The 4% rule (of thumb) is illustrated as follows:

• An investor retires at age 65 with a $1M portfolio.
• This portfolio is invested with a reasonable amount in stocks (e.g. 40-60%) and the remainder in safer bond investments.
• The investor can withdraw $40K (4% of the $1M) in year 1.
• The next year the retiree can withdraw another $40K, plus an inflation adjustment. If inflation was 3%, the withdrawal is adjusted to $41.2K.
• The next year the retiree can withdraw the $41.2K, plus an additional inflation adjustment. If inflation was 5%, the withdrawal becomes $43.26K
• If the future is reasonably similar to the past, the portfolio will be able to sustain these inflation adjusted withdrawals for at least 30 years (until age 95) with a high degree of probability.

The chart below illustrates the maximum sustainable 30 year withdrawal rates portfolios have supported from 1926 through 1979. (A retiree starting in 1979 would have completed his 30 years of withdrawals in 2009, about when this chart was created.) You will note how retirees starting in the 1960's and early 1970's could only sustain about 4% withdrawals. However, if they had the good fortune to start in the post war years or late 1970's, their portfolios could sustain withdrawals above 6% a year.

Source: Vanguard, "Does the 4% Rule Hold Up", August 2010

Why the difference in sustainable withdrawal rates, depending on the start date? The short answer is folks that face bad markets early in retirement as they start making large withdrawals will only be able to sustain lower withdrawal rates. Those lucky enough to have strong markets early in retirement will likely be able to sustain higher rates of withdrawal. Even if two retirees have identical average portfolio returns over their 30 year retirements, the one who has good years early will do better than the one who faces an early bear market. This is often referred to as sequence risk.

In a world where more of us will be relying on withdrawals from our IRAs and 401K plans, as opposed to guaranteed defined benefit pension plans, we need to understand how to manage our portfolios for long term sustainability. Accordingly, the concept of safe, sustainable withdrawal rates is an important one for retirees and pre-retirees to grasp. Rest assured the 4% rule is not the last word on managing your portfolio in retirement. In follow-on posts, we will discuss why the 4% rule is probably too conservative...or possibly not conservative enough.

* Some of the early, influential work in the arena of safe withdrawal rates, including the origins of the 4% rule are listed below:

Bengen, William. Determining Withdrawal Rates Using Historical Data. Journal of Financial Planning--October, 1994.

Cooley, Philip, Carl Hubbard, and Daniel Walz. Retirement Savings: Choosing a Withdrawal Rate That is Sustainable. AAII Journal--February, 1998.

Ameriks, John, Robert Veres, and Mark Warshawsky. Making Retirement Income Last a Lifetime. Journal of Financial Planning--December, 2001

Table Rock Financial Planning and other members of the Garrett Planning Network will also provide fee-only investment advice on an hourly or project basis. (Other advisory firms will also work on an hourly basis, but they are the exception, not the rule.) Under this model, the advisor works with the client to develop and document an asset allocation strategy, and recommends appropriate investments. However, the client is responsible to implement the plan--buying and selling the recommended securities and monitoring their own accounts. Usually the client returns to the advisor for regular check-ups where the plan is reviewed, accounts are rebalanced, and revisions to the plan are made. Other financial planning topics are usually discussed, and like the original engagement, these check-ups are billed on an hourly basis.

With an investment management relationship you will likely pay higher fees--compensation for the additional responsibilities the manager shoulders, often a higher level of value-added service and potentially a closer relationship. The hourly model, where you take more responsibility for implementation, will usually be lower cost. At Table Rock Financial Planning, you can receive competent, objective investment advice either way. You get to decide which model is a better fit, and establish a relationship that best meets your needs.

Four Key Reasons to Choose Investment Management

"The investor's chief problem-even his worst enemy-is likely to be himself."-Benjamin Graham

At Table Rock we believe that investors can be successful under both the hourly or investment management model. We recognize that the hourly model is clearly preferable and more affordable for many individuals. However, there are also people who would be better served with an investment management relationship, where they delegate day-to-day responsibility for their portfolio. Before you decide which is best for you, consider the following reasons where an investment management arrangement may be preferable:

• Implementation follow-through: You have taken the time to meet with your advisor and formulate an asset allocation and investment plan that is designed to help you meet your financial objectives. Under an investment management relationship, the investment advisor will immediately begin implementing the plan with an experienced hand--after all, this his or her full-time job. Alternatively, if you have retained the responsibility for implementation, will you get after it promptly? Or, will the plan get laid aside for implementation when you have more time, or the mood suits you. One of the biggest disappointments of hourly planners is working with clients to develop a sound investment plan, only to find out the individual waited months to implement it, or worse, never fully followed through. It is like a doctor diagnosing a patient and writing a prescription that is never filled.
• Your time is an investment: You have only so many hours in a day. Do you have the available time to execute your investment plan--recognizing that some effort is usually necessary during normal working hours? Whether it is work, play, education, service, or spending time with family, most of us have high value activities we would rather invest our time in. Because we recognize the value of our time, we routinely pay others to do tasks we could do ourselves (e.g. housekeeping, lawn care, and cooking to name a few). I could have built my fence recently, but chose instead to delegate that work to a qualified contractor. This freed up my time to work at my profession and mountain bike.
• Interest and capability: Do you have a reasonable level of interest in working on your investments? Do you feel confident you can implement the plan without significant errors or stress? Some people do feel empowered and capable implementing their investment strategy. It is OK if aren't one of them. However, if you lack the interest or confidence to do the job, it is time to consider delegating the responsibility to a capable investment manager.
• Emotional endurance: Market volatility can take its toll on our emotions. It takes resolve to stay with an investment strategy, and one of the key roles of an advisor is to maintain a clear head and steady hand. You are paying the advisor to follow the plan--to keep his wits when all around seem to be losing theirs. Without the advisor in the driver's seat, will you be tempted to deviate from your investment strategy? Will you sell out after market drops, or chase the latest investing fad? Will you have the steadfastness to rebalance your portfolio--selling high and buying low? Investor discipline and behavior are critical to long term portfolio performance. Many people behave much better, not to mention sleep much better, when they delegate the day-to-day management of their investments.

Financial planners are always encouraging our clients to be informed, disciplined consumers. The question isn't whether investment management will cost you more in annual fees. The question is whether you will be better off, financially and emotionally, if you delegate the day-to-day management of your portfolio. As noted behavioral finance professor Meir Statman said, "Paying someone 1% a year to keep you from making 1.5% worth of mistakes can make a lot of sense." Truth is you shouldn't have to pay 1% per year to manage even a moderately sized portfolio, and the opportunity for the DIY investor to underperform is very high.

You decide--will investment management provide a good value for you?

"A budget is telling your money where to go instead of wondering where it went."

In other words: Decide what you are going to do, write it down, do it, and know what you have done. This is the essence of the four fundamental elements of budgeting:

1. Prioritizing your needs and wants: Decide what you are (and are not) going to spend your money on.
2. Creating and documenting the plan: Write it down and agree on it.
3. Executing and living the plan: Do it...figure out how to live according to your plan.
4. Tracking your performance: Know what you've spent and how well you are following your plan.

The first two fundamentals have been discussed in previous articles. The final two are where the rubber hits the road and are examined below. There are also more helpful links for those looking to get started on their spending plans.

Executing and living your plan

"A budget tells us what we can't afford, but it doesn't keep us from buying it."-- William Feather

"Your money is like soap. The more you handle it, the less you'll have."--Eugene Fama

Once you have established your spending priorities, you need to live by them. If you are fortunate enough to have sufficient resources to cover most of your wants, this may not be so difficult. For most of us, though, this probably means following through with key decisions like cancelling cable TV, dumping your personal trainer, or selling that F-250 with the hefty payment. These one-time actions may be painful, but once you execute on them they are done and you start reaping the benefits. Often harder is following through on the recurring choices such as not going out to dinner, not buying those shoes, and not going on that unplanned weekend trip. However, if you have bought into a set of overall priorities, you are focused on attainable goals, and you are making shared sacrifices (assuming you have a partner in this endeavor), these behavior changes are achievable.

Key considerations and behaviors:

• Automate as much as possible: Automate your savings toward important goals and setting aside funds for irregular expenses. This can be done quickly and securely with today's on-line savings accounts. You can set up the amount and which day of the month you want money to be automatically moved from your checking account to your on-line savings account. This ensures that these high priority items get funded first. Experts in field of behavioral finance extol the virtues of this kind of automatic savings. David Laibson of Harvard says, "We need to exploit automaticity. We need to build in more of these commitment mechanisms, so we can live up to our intentions."
• Set up separate savings accounts for different goals: On-line banks make creating multiple named savings accounts easy. Consider multiple savings buckets for your emergency fund, new car or major purchase fund, a vacation fund--you name it. Putting a name on every dollar is powerful, especially when the goal is extremely important (e.g. college for your kids), or pleasurable (e.g. that vacation to Hawaii).
• Put aside money for irregular expenses: We all face significant expenses that do not occur on a regular monthly schedule. The effective way to manage these irregular expenses is to put adequate money aside on a monthly basis, in advance. Whether you use a single savings account (or even a cash envelope), or multiple ones (for insurance, clothing, presents, car repairs, etc.), it is up to you. However, if you simply leave this money "unprotected" in your checking account, much of it is likely to disappear and be unavailable when you need it.
• Identify areas for special control: If you are like most people, there are a few areas that are especially difficult for you to stay within budget. Consider using cash and the "envelope system" for those two or three areas that routinely get out of control. Groceries and going out to eat are prime suspects. Or, you might need a Home Depot or movie envelope. The point is, when the money is gone, you get immediate feedback and stop spending. People talk about some of the creative meals they've had after the grocery envelope got emptied.
• Will power may not be enough: If living according to a spending plan was easy, more people would be doing it. Besides the encouragement and teamwork of a spouse, you will likely benefit from the support and accountability of a like-minded community. Find others on the same journey, with the same goal of getting their spending under control and making progress in their financial lives. Likewise, you need to be aware of the kind of company that may derail your good intentions, and take appropriate precautions.

Tracking your performance

"Some couples go over their budgets very carefully every month; others just go over them."--Sally Poplin

"The person who doesn't know where his next dollar is coming from usually doesn't know where his last dollar went."--unknown

In many ways this last fundamental of budgeting should be getting easier for everyone. As more of your spending is moved from cash and check to on-line bill payments and credit and debit card transactions, the flow of our funds should be easier to track, even from your phone. (That is assuming you can still afford that iPhone after you have created your spending plan.)

Key considerations and behaviors:

• Pick a system to track your spending: Although there are many options for tracking your spending, you ultimately have to pick a system you can live with. If you are just starting out, you might want to do some experimentation with different methods to find what works best for you. This doesn't have to be fancy. Many people are still find manually consolidating expense data on an Excel spreadsheet, or with a calculator, a workable solution. However, now there are a number of more automated alternatives, many of them available for free. (See below.) Although an automated tracking system, with your accounts linked to a service like Mint, can save time and give more immediate feedback, you will still need to get things set up to work best for you.
• The right level of detail: Face it, you are not going to know exactly where every penny goes every month. Find the right balance between your time and effort and the level of information you track. If you are someone who balances their checkbook to the penny every month (which is certainly not a bad thing), resist the temptation to have the same level of accuracy tracking your budget.
• Feedback and adjustment: Simply knowing where you spent your money isn't enough. The goal is to track where you spent your money, compare it to your spending plan, and make necessary changes. Allot enough time to review and analyze your performance to determine if it is your spending behavior, or the spending targets that need to be adjusted.
• Communication and accountability: Finally, you need to use this information in a positive way, one that moves you forward toward your goals. Knowing how you are doing relative to your plan should result in meaningful communication and teamwork. You are constantly asking, "What are we doing right?" And, "What do we need to do to differently in order to meet our objectives?" Accountability for spending is generally a good thing, but if couples use the expense tracking to beat each other up, it can become counter-productive.

Tools and links:

• Mint.com--free on-line personal financial tracking system
• Mvelopes--on-line home budgeting system 
• Quicken--personal finance software
• YNAB (You Need a Budget)--budgeting system
• Check register (manual) budget tracking system--Montana State University Extension
• Excel home budget templates
• Budget software reviews, with additional links

Creating and following a spending plan may sound like a lot of sacrifice and hard work. Maybe it is. But, when you take active ownership and control over your spending it pays enormous financial and emotional rewards. In times of significant financial uncertainty--and, is there ever a time that is not uncertain--your spending decisions are the one thing you have control over. As Bill Schultheis of the Coffeehouse Investor encourages his readers: "We focus on the most important aspect of building financial wealth--how we save and spend our money."

I don't know who these people are, but they definitely had a plan and stuck with it. They did a lot of hard work as they could commit their time and money. I'm sure they got discouraged at times, and probably made a number changes along the way. But, wow, look where they are today.

You know where I'm going with this. With vision, planning, along with some hard work and sacrifice, these folks transformed a house no one could live in to one they can be exceedingly proud of. You can do the same with your financial house. Even if it is in as tough of shape as that old house, you can turn things around. Are you ready to get started?

Creating and documenting the plan

"He who fails to plan, plans to fail." -- Winston Churchill

"If you don't know where you are going, you might wind up someplace else." -- Yogi Berra

Many people say they have a budget, but it is in their heads, not on paper. Maybe your life is simple enough that this approach works for you, but for most of us it is not effective. If you are not making the progress toward your financial goals that you desire, it is difficult to imagine you are going to turn things around without a written spending plan. The fact is our financial lives are complex, and getting the numbers to add up right can take a while, especially in the beginning. Dave Ramsey, who has helped thousands get out of debt and make serious progress toward "financial peace" following his "baby steps", tells everyone to start each month with a written plan where every dollar has a name (i.e. purpose). This does take some work--but, then don't most things worth achieving?

Key considerations and behaviors:

• Set aside adequate time: Recognize that creating your spending plan is going to take some time and effort--more so to start, but also on an on-going basis. Like cleaning the bathroom or weeding the garden, this may not sound like fun. Hopefully, as you gain experience and control of your finances, it will become less of a burden. You will likely find it useful to break the task of creating the plan into two components--the budget decision meeting and documenting the detailed plan--and setting aside a dedicated time every month for each.
  • The budget decision meeting is where you work through hard task of deciding what you are and aren't going to spend your money on. If you are a couple, you both must show up and be engaged in this effort. Both of your interests and concerns must be heard, and no one should run roughshod over the other. It is critical you are both bought into the plan and are accountable. You both have to own it.
  • Documenting the detailed plan is where the numbers are put on paper (or on the screen) in a format you both can understand. However, one of you may better equipped or more inclined for this kind of analytical, detailed work. If fact, you may only get frustrated trying to do this together. The format isn't all that critical, but things need to add up correctly and make sense to both of you. (See below for some helpful tools for getting started.) Your goal is to create a working document you can use in the decision meeting to lay out the choices and decisions you are going to have to make. After you make the required trade-offs, they are then documented in the detailed plan. The end result is a written plan where both of you are know how exactly much money you intend to spend, and on what.
• Getting started: You should have a pretty good idea of what you currently spend your money on by looking at your checkbook or debit card transactions and credit card statements. Although a few months will capture most of your recurring expenses, it is helpful to look back over an entire year so you can capture those intermittent expenses that you will also need to be planning for. Remember, the goal here is not just figuring out what you have been spending your money on--it is deciding where you are going to spend your money in the future.
  • If you have difficulty accounting for a significant amount of your cash expenditures, you may find it helpful to track your cash (and possibly your credit and debit card expenditures) for a month or two. Keep a note card with you to write down everything you spend as you go through the week.
  • You want to break down your expenses into several key categories. How many is up to you--but, not too many, not too few. If you want help with this, check out some of the tools and forms below to get you started.
• Get help if you need it. If you are having trouble getting started, don't be afraid to seek out someone you feel is capable and trustworthy to give you a hand. Or, you might get assistance through community organizations, your church (or Crown Financial Ministries), or through Dave Ramsey's Financial Peace University.
• Plan for irregular income and expenses: If every month looked the same, budgeting would be much easier. For many, the income side of things is pretty stable, but for those on commission or self-employed it can be a roller coaster. Adapting can get a bit complex, but there are different strategies for dealing with this issue. For example, you may create a budget around a base level of income, and then prioritize how you will spend or save any additional income. Creating a savings bucket that enables you to smooth out the available funds each month is another strategy. Planning for irregular expenses (such as insurance payments, vacations, or back-to-school clothes) is a bit easier, but still takes foresight and planning. You basically want to smooth things out by purposely saving ahead of time, or you may be able to arrange for a vendor (e.g. utilities or insurance companies) to bill you a consistent, monthly amount.
• Forget the perfect plan: It will be remarkable if you get this plan perfect to start. You are going to miss things, and you are going to change your mind as you go along. Anyway, the goal isn't a perfect plan--the goal is to be in control of your spending. Forgive yourself, each other, and move forward. This is an on-going process where you seek to remain in agreement over time.
• Plan for some fun: Sure, if want to achieve your goals, you will likely have to sacrifice. However, this doesn't mean you can't enjoy life--you just want to be in control. Usually this is a combination of leaving some money in the budget for recreation and entertainment, plus identifying creative ways to have fun for free (or on a dime).
• Prioritize savings in your plan: Whether it is short term savings to account for irregular income and expenses, building an emergency fund, or longer term savings for college or retirement, savings has to be top-of-mind. Of course, you may have to get expenses under control and/or pay down significant debt first, but the objective is to become a consistent saver. Savings goals must have a prominent place in your documented plan, even if they are on-hold for a while.

Tools and links:

• Dave Ramsey's budget forms and Total Money Makeover
• Developing a Spending Plan and Schedule of Non-Monthly Family Living Expenses, from Montana State University Extension
• Elizabeth Warren's 50/30/20 budget, plus on-line tool
• National Foundation for Credit Counseling on-line budget worksheet
• You Need a Budget, 2011 About.com Readers' Choice for "Best Windows Personal Finance Software" with free trial

In case you missed them, you may wish to check out the initial article in this series, along with Budgeting Fundamental #1--Prioritizing Needs and Wants. Next in this series will cover the final two fundamental elements of budgeting--executing the plan, plus and tracking your performance. Then, I promise to move on to a topic that is less tedious and guilt-ridden. Maybe something on the Black-Scholes options pricing formula.

In this article the first of four fundamental elements of the budgeting process--prioritizing your needs and wants--will be covered. The remaining fundamentals will be covered in later posts.

Prioritizing your needs and wants

"It's not how much money you make that matters, but how you make do with what you have." - Big Mama (Michelle Singletary's grandmother)

"Plan for the future, because that's where you are going to spend the rest of your life." - Mark Twain

The first fundamental element of a successful spending plan is the prioritiziation of the many competing interests for your paycheck. Instead of just trying to figure out where you currently spend your money (although this is a good exercise), you need to decide where you should spend your money. There is no substitute for this critical exercise in family strategic planning. If you are single, this may be a lonely exercise, but it is generally much simpler. If you are married, this must be a team endeavor--usually involving a generous amount of negotiation and compromise.

Key considerations and behaviors:

• Setting goals: Creating your spending plan starts with setting goals. What do you want to accomplish with your life and money? Where do you want to be in a year, three years, five years, or twenty years? Listing, discussing, and agreeing upon goals is critical before you start making the important decisions on where you will spend your limited resources.
• Making trade-offs: Creating a spending plan is about prioritizing your needs and wants. It is about agreeing on what you will spend money on, and (maybe more importantly) what you will not spend money on. There is no getting around the fact this can be very difficult, especially if your resources are considerably less than your perceived requirements. As hard as this may be, you will be happier making a well considered spending decision up front, then an undisciplined one on-the-fly. It often takes a purposeful decision to sacrifice today, in order to win tomorrow.
• Agreeing on a core set of values: Spend some time discussing and agreeing on a core set of values for how you are going to manage and spend your money. This may come easy for some, but can be a real stretch for others. However, an agreement on these core values will guide you in the trade-offs you will inevitably have to make. Some the areas you may consider here are:
  • Debt--When is when it is acceptable to use debt? How high of a priority it is to get out of debt?
  • Financial security--How important is it for you to have financial margin in your life? For example, having a well funded emergency savings account, or plenty of "buffer" in your monthly budget for unforeseen expenses.
  • Giving--Will you give to the church or other charities on a regular basis? How will these commitments be prioritized relative to spending and saving?
  • Fun--How much importance will you place on fun experiences today relative to making progress on financial goals that are in the future? (Yes, you can budget in some fun!)
  • Work/life balance--The trade-off between career demands (and more money) and family time and less stress.
• Anticipating the future: Planning is a about preparing for the future. In creating your budget, you need to spend adequate time anticipating your future needs and wants. Some of these requirements are pretty easy to predict--e.g. the big auto insurance bill that comes every February and August. Others require you to consider what likely lies around the bend in the road--e.g. new tires, a repair bill, or even new shoes for your children. Of course, even further down the road may be a down payment for a house, college expenses, and eventually retirement. You don't exactly know when, but you know these things are out there. You may not be in a position to save for all of them today, but you want to keep them on the radar.
• Teamwork and communication: If you are single, prioritizing your spending may be difficult, but it is a fairly straight forward exercise--you make all the decisions. For couples, this is a major test of your commitment, teamwork, and communication skills. One member of the team cannot "opt out" and leave the responsibility to the other. Both must show up ready to work and compromise. Prioritizing your scarce resources often means sacrificing your needs for the needs of your partner. Learning to work together effectively as a team, is not only powerful in meeting your goals, but can really build your relationship.

Tools and links:

• Personal Budgeting: How to Set Financial Goals
• Setting Your Financial Goals with a Goals Worksheet
• Values and Personal Finance: Letting Values Determine Goals

The next in this series will cover the second fundamental element of budgeting--creating and documenting the plan.

"With very little effort or sacrifice, budgeting allows you to plan for your future, pay off your debts, and still enjoy life today."

Oh, if it was only so easy.

Let's be clear--budgeting is not about making your life easy, or hard for that matter. It's about being purposeful with your money so you can meet your life goals. Budgeting is also about looking down the road, imagining the life you want, and setting the financial course to get there. Generally, if you are serious about getting somewhere in life, you do some level of planning. Budgeting is simply creating and following a spending plan that supports your life objectives and values.

When you mention the word "budget", people think of several different things. They may associate a budget with a complicated spreadsheet or several labeled envelopes with their monthly cash allotments. The more digitally adept associate budgeting with having all their accounts set up and tracked in Mint.com or Quicken. More than likely, the term "budget" brings on visions of tedious sacrifices such as skipping your morning latte or taking your lunch to work. No wonder people hate budgeting--they see it as a spending diet. (And, unfortunately for many, it is often as ineffective as dieting.)

One of the reasons people struggle with creating and following an effective spending plan is they have an incomplete view of the process. They focus on just one facet of budgeting, but miss the big picture. You will likely find it helpful to organize your thinking about creating and following a spending plan into these four fundamental elements:

1. Prioritizing your needs and wants
2. Creating and documenting the plan
3. Executing and living the plan
4. Tracking your performance

A successful spending plan will incorporate all four of these elements, but each person may find it practical to invest more effort in a particular area. The first two elements focus on developing the plan and will be covered in the next post, and the next. The third and fourth elements are about living out the plan, and will be dealt with in the final article.

In the meantime, you may want to check out this short Dave Ramsey budgeting video, just to get into the mood.

At Table Rock Financial Planning we understand that your personal finances are not just about math, nor is maximizing your portfolio by age 60 your sole objective. You are managing your finances not only for wealth creation, but also to minimize your family's risks. You undoubtedly place a significant value on financial security and your family's peace-of-mind.

Advantages to paying off your mortgage

• Your highest risk-free rate of return: Except for paying off other, higher cost debt, paying off your mortgage almost always provides you with the highest available risk-free rate of return.* When you pay off your fixed-rate mortgage, you know exactly what your rate of return will be. It is more than likely going to be higher than FDIC insured savings accounts and CDs, money market funds, or Treasury bills and notes. Yes, you can possibly make a higher return elsewhere (see Part 2), but you will need to take some additional risk to do so.
• Lower overall portfolio risk: When you consider the risk of your family's complete portfolio of assets, paying off your mortgage will almost always lower your overall financial risk. If the alternative to paying off your home is to invest in even a conservative, diversified portfolio of stocks and bonds, you will still be exposed to a higher level of financial volatility. And, if the alternatives are to keep holding that concentrated position in your employer's stock, trying your hand at trading options, investing in your brother-in-law's start-up company, or maybe buying some rental property, you have will have vastly increased the risk you are taking with your family finances. And, please don't assume that holding gold or other precious metals will be a "safer" place for money earmarked to pay off your mortgage. It may work out well for you, but so can a trip to Jackpot or Vegas. (Thank you Carl Richards for another helpful illustration.)
• More spending discipline: When you have the assets to pay off your house (or the cash flow to accelerate your payments), but instead choose not to do so, you may feel a bit richer. Will those funds sitting in your brokerage or checking account tempt you to spend more on going out to dinner, a new boat, or possibly an expensive vacation? This isn't to say that spending on some of these luxuries is wrong, but will the available cash tempt you to spend more than you really want, or should? Will paying off the house help you to act smarter and make better decisions?
• More investing discipline: Helping you to control expenses may not be the only way that paying off your mortgage enables you to act smarter and make better decisions. Will a paid off mortgage give you the peace-of-mind and confidence to stay invested during down markets? Not panicking and bailing out of the market at bad times, and then missing the eventual rebound, is critical to capturing favorable long term returns.
• Reducing your cash flow needs in retirement: Having your house paid off will reduce your cash flow needs in retirement. This will enable you to have a lower, safer withdrawal rate from your portfolio, and result in a higher likelihood of not outliving your retirement assets. (Granted, your portfolio will assumedly be smaller, since you will have used funds to pay off your mortgage.)
• Reducing your cash flow needs prior to retirement: With no monthly mortgage payment, your lower monthly cash flow requirement will put you in a better position to weather a financial hardship, such as a job loss or short term disability. Yes, having the money you used to pay off the house sitting in investments would also be helpful. But, consider the possibility that in hard times these funds may be invested in assets that have lost considerable value, or be tied up in tax-deferred accounts. (Also, the assumption is you have established an adequate emergency fund prior to eliminating the mortgage.)
• Funding college expenses: If you can pull it off, eliminating the mortgage before your children hit college can be an effective strategy. First, and most obvious, you free up considerable monthly cash flow to put toward tuition and other expenses. Of course, you could have been investing the money you used to pay off the mortgage in accounts earmarked for college. Saving for college, especially in 529 plans or other tax advantaged accounts, is certainly to be encouraged. However, when it comes to qualifying for financial aid, you may be better off with a paid off house (and higher available monthly cash flow), than with a big 529 plan or non-retirement brokerage account. This is because federal financial aid formulas and the FAFSA form ignore your home equity, but do consider the investment assets in the 529 plan or brokerage account. Be aware, though, private colleges that use the institutional methodology and CSS profile may consider your home equity to some degree.
• Because it feels so good: As Dave Ramsey is fond of saying, "After you pay off the mortgage, take off your shoes, walk through the backyard--the grass feels different under your feet". And, that's different in a good way, let me tell you!

Maybe these reasons don't motivate you to pay off the mortgage earlier-than-later. Maybe you aren't one of us who gets a big emotional boost from completing such a huge objective. Ask your spouse, however. Usually, at least one of you would sleep much better at night knowing that the house was paid for. Have some serious discussions on how paying off the mortgage fits into your overall financial plan. And then, if it is right for you, get after it with a passion. Check it off the list and be done--it will feel great!

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*The only time this is not going to be the case is if you have an extremely low interest fixed-rate mortgage, and current interest rates have spiked up considerably higher. I'm not sure when the last time the stars were aligned like this, but I assume it was over 25 years ago.