Walking on Nest Egg
Caution has been both an asset and an obstacle in John and Christine Murray’s effort to build a financial nest egg.
On one hand, the Pomona couple’s net worth has grown to a respectable $126,000 through thrifty habits. They shop at Target, Mervyn’s and other discount stores, skip such luxuries as dining out and pay off their credit cards each month.
On the other hand, their fear of investments with even a hint of risk has left their savings growing slowly.
For years, Christine, 38, and John, 41, chose the safest options for their retirement savings plans and put their spare cash into low-interest bank accounts. While the stock market was advancing at double-digit percentages for more than a decade, the Murrays’ savings were earning skimpy returns of less than 5% a year.
“We’re both very afraid of losing money,” said Christine, who works as a production scheduler for a company that produces eyeglasses.
Both of the Murrays grew up in homes in which money was often tight. Also fueling their risk aversion is the fact that Christine has been laid off from jobs twice in the last five years.
“We’ve always liked things that guarantee that we’ll get out of it at least what we put in,” Christine explained.
The couple, whose combined gross annual income is about $110,000, began to have doubts about their financial strategy late last year when they started to consider long-range concerns such as college educations for their daughters, now 2 and 4 years old, and their own retirement.
“We looked at the numbers and realized that we’re not going to make it if our money is earning only 4% or 5%,” said John, who is a network engineer for AirTouch Cellular.
With that in mind, the Murrays decided it was time to get a personal-finance education. They picked up financial writer Eric Tyson’s “Mutual Funds for Dummies” and a pair of books by David and Tom Gardner, the brothers behind the Motley Fool. They attended The Times’ Investment Strategies Conference and subscribed to financial magazines.
They learned that increasing an investment’s average annual return by even a few percentage points can make a huge difference in the long run: For example, $10,000 growing at an average of 5% annually will become about $43,000 in 30 years. At 8%, that same $10,000 would mushroom to about $100,000.
Three months into their studies, the Murrays decided to put their new knowledge to work. They had nearly $100,000 in bank savings or other ultra-safe instruments, both in tax-favored retirement accounts and outside. They put roughly $30,000 of that into stock mutual funds, mainly index funds.
“We realized we needed to get into the stock market to get higher returns,” Christine said. After hearing a speech by index-fund proponent and Vanguard Group founder John Bogle about index funds’ advantages, they decided that “index funds seemed safer than trying to pick individual stocks or going with more volatile mutual funds.”
After reading several articles about the tax advantages of the new Roth individual retirement accounts, they opened one of those, too, and invested it in a mutual fund that tracks the Standard & Poor’s 500 stock index.
Before making further alterations, however, they decided to consult a financial planner to review their strategy. They also wanted to get advice on what else they should be doing.
Judith Martindale, a fee-only certified financial planner in San Luis Obispo, applauded the couple’s decision to get serious about their financial future and gave a thumbs-up to most of their initial moves. “I’m very impressed--you’re on your way to being millionaires,” Martindale told the surprised couple.
Martindale told them they need to finish the job by investing the rest of their tax-favored retirement money and about half their other funds more aggressively, mostly in a selection of domestic and international equity mutual funds.
But first, Martindale said, the Murrays should consider two things people with young children should never overlook: a will and adequate life insurance coverage.
Martindale urged the couple to increase their insurance coverage by getting $250,0000 each of term life insurance. “You want to be in a position that, if something happens to one of you, the surviving spouse won’t have to make major lifestyle changes for at least three years,” Martindale said. “You don’t want to be in a situation where you have to immediately sell your house or start thinking about getting a second job.”
And a will, of course, can make for a smooth transfer of assets and designate guardians and financial custodians for their children.
Martindale then turned to more immediate issues--starting with the $52,000 the couple has in various non-retirement savings accounts. About $38,000 is in a bank CD, and the rest is in bank savings and checking accounts--and includes about $8,000 the couple have put in their children’s names as college savings.
“Getting laid off really shocks you when you don’t expect it to happen,” Christine said by way of explaining the large amount held in cash savings.
Martindale agreed that an emergency fund is necessary, but she said that three months’ worth of living expenses--about $13,000 for the Murrays--should be sufficient. That amount should remain in a readily accessible bank account.
Another $13,000 should be set aside for contingencies such as car purchases or home repairs, but because those kinds of needs don’t require immediate access to cash, Martindale suggested putting this money into a tax-free bond fund, which would provide greater returns than a bank account yet be relatively safe. And, as the name implies, the couple would not pay state or federal taxes on the interest accumulated.
With no near-term needs for the remaining $26,000 in savings, Martindale suggested it be invested in several index-related stock mutual funds.
Fans of index funds--and Martindale is one--argue that over the long run, these passively managed funds will outperform their actively managed brethren, and that these kinds of funds are by nature low-expense. All of Martindale’s recommendations for the couple are for Vanguard funds, a family known for its low expenses.
Martindale said she’d like to see the couple gradually realign their investments so that about 55% are in domestic stocks, 12% are in international equities, and the rest in bond funds and cash equivalents.
Of the $26,000 in question then, $20,000 would be evenly divided between two index funds, one that tracks the Wilshire 5,000 index, a broad list of almost 7,500 U.S. stocks, and one that tracks the Wilshire 4,500 index, also known as the “extended index”, which is a list of the Wilshire 5,000 minus the 500 companies in the S&P; 500.
To save on taxes, Martindale recommended that the couple each put $2,000 a year into Roth IRAs, and have that money invested in a Wilshire 5,000 index fund too.
Martindale advised putting the final $2,000 into a mutual fund that tracks the Standard & Poor’s 500-stock index and that the couple think of it as college money for their daughters. The $100 a month the couple had been putting into the girls’ bank accounts should also be invested in this fund, Martindale said.
The Murrays, who had established their current college savings accounts in their daughters’ names, were surprised to hear that that may not be the best approach.
They had reasoned that interest earned in those accounts is taxed at a lower rate than the couple themselves pay, but Martindale pointed out that there are major drawbacks to saving in a child’s name. For one thing, the couple could find that the vagaries of college financial aid formulas could force the girls to pony up a higher percentage of their own assets toward college costs than would be true of the parents’ assets.
For another, she said, money saved in a child’s account belongs to that child. Once she turns 18, she could decide to skip college altogether and take a long Hawaiian vacation.
The couple know that what they’ll have set aside by the time their older daughter, Kaylin, is ready to start college won’t be nearly enough to pay her way at even a public school.
But, Martindale said, there’s no reason to panic. The girls may qualify for financial aid or be able to win scholarships. Other family savings may be available by then. And certain expenses the couple are now incurring--such as the $15,000 a year for a full-time baby-sitter, and the $450 monthly car payment that will end soon--will decrease in a few years and allow them to save more every month.
The Murrays’ home equity--now about $28,000 on a residence estimated to be worth $190,000--could also be tapped to pay for college.
Next, the planner turned to retirement savings strategies. The Murrays have no grandiose retirement plans, saying they’d like to conclude their careers sometime in their 60s and live on an income of about 80% of what they’re earning now.
“You guys are right on schedule with your plans,” Martindale told the Murrays, who have accumulated about $45,000 so far in various workplace and individual retirement accounts.
The planner agreed with nearly all of the couple’s recent mutual fund choices for their 401(k)s and IRAs, saying they’re helping to diversify their overall portfolio.
John, who recently boosted his 401(k) contributions to the maximum allowable 15% of his salary (something Martindale would have recommended had he not done so, to maximize the benefits of tax-deferred savings growth), puts half his contributions into a fund that tracks the S&P; 500, 25% into Fidelity Contrafund (five-year average annual return: 20.1%), and 25% into American Funds Euro Pacific Growth Fund (five-year average annual return: 15.9%).
Contrafund aims to pick stocks currently out of favor, and the Euro Pacific fund provides an element of diversity by investing in stocks overseas.
Christine’s plan is undergoing a management change. Martindale encouraged Christine to contribute the maximum allowable to her 401(k), and said the best choice among the options available to her would be to put all her contributions into Vanguard Institutional Index Fund (five-year average annual return: 23.3%), a fund that tracks the S&P; 500.
With the Murrays’ relatively generous employer-matching amounts included, the couple will be contributing about $20,000 a year to their retirement savings.
The Murrays also have $7,644 in a 401(k) plan with John’s previous employer (now invested in an equity-income fund and a small-cap fund), and $24,000 in a variety of IRAs.
Martindale suggested that John roll over that 401(k) into an IRA because his investment choices would be broadened from the 12 of that company’s 401(k) plan to the thousands in the marketplace. For now Martindale recommended that this money also be invested in an index fund tracking the Wilshire 4,500.
Christine recently converted a $9,000 IRA from a 2% savings account to Vanguard Index-Trust Growth Portfolio (five-year average annual return: 24.3%)--a smart move, Martindale said. This fund tracks the Standard & Poor’s/Barra growth index, an index consisting of stocks from the S&P; 500 with low dividends but high growth rates. The planner also has no problem with the Murrays’ recent decision to open a $2,000 Roth IRA in the relatively new Strong S&P; 500 fund.
Finally, the couple have a pair of $6,500 IRAs in CDs earning 5.27% a year. Martindale said fine to that, suggesting that the money could be a kind of supplemental emergency fund. Some financial planners might disagree, though, arguing that a CD is too conservative a place for an IRA for people more than 20 years from retirement, and that as an emergency fund the couple would face taxes and penalties should they need to tap the CDs before they mature.
But Martindale points out that an emergency--a job loss, for example--would probably put the Murrays in a lower tax bracket, reducing the tax sting. And with the rest of their retirement money invested in equities, she thinks it’s reasonable to have this relatively small portion of their funds in this fixed-income investment.
“Keep doing what you’re doing,” Martindale said of the Murrays and their propensity to save, “and you’ll know that you can relax and enjoy life” when it comes time to retire.
Graham Witherall is a regular contributor to The Times. To be considered for a publishedMoney Make-Over, send your name, age, phone number, income, assets and financial goals to Money Make-Over, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
The Situation:
* Investors: The Murrays, John, 41, and Christine, 38
* Annual gross income: About $110,000
* Financial goals: Adopt better strategies to finance retirement and college education for two children.
* The problem: Savings invested much too cautiously.
* The plan: Continue to stretch their comfort zone by moving a greater share of savings into stock mutual funds.
This Week’s Make-Over
* Investors: John and Christine Murray
* Ages: 41 and 38
* Occupations: Engineer and production scheduler
* Combined gross annual income: About $110,000
* Financial goals: Save for retirement and children’s educations
*
Current Portfolio
* Real estate: Estimated $28,000 equity in Pomona home
* Cash: About $38,000 in a certificate of deposit, $12,000 in savings accounts in the couple’s and their children’s names, $2,000 in a checking account
* Retirement accounts: In IRAs, the couple have a total of about $24,000 in four: $13,000 in CDs, $9,000 in Vanguard Index-Trust Growth Portfolio (five-year average annual return: 24.3%), and $2,000 in the newer Strong Index 500. In 401(k)s, John has $5,720 with his current employer, invested in American Euro Pacific Fund (five-year average annual return: 15.9%), Fidelity Contrafund (five-year average annual return: 20.1%) and a Fidelity S&P; 500 index fund, and $7,644 in a 401(k) with his previous employer, invested in T. Rowe Price Equity Income (five-year average annual return: 20.4%) and T. Rowe Price Small-Cap Value (five-year average annual return: 19.8%). Christine has $8,835 in her plan, which is undergoing a management change.
*
Recommendations
* Invest more savings more aggressively in stock mutual funds.
* Designate about three months’ worth of expenses in a bank account as an emergency fund. Further savings for certain other needs should be split between a bond fund and CDs.
* Prepare wills and buy term life insurance policies with $250,000 death benefits for each.
* To maximize children’s chances for college financial aid and to keep parental control of college savings, the planner recommends that money not be put in the children’s names.
*
Purchase Recommendations
Following are recommended mutual funds, with their five-year average annual return figures in parentheses:
Vanguard California Tax-Free Insured Long-Term Portfolio (6.5%)(800) 992-8845
Vanguard Index-Trust Total Stock Market (21.6%)
Vanguard Index-Trust Extended Market Portfolio (19.6%)
Vanguard Index-Trust 500 Portfolio (23%)
Vanguard International Equity Index European (23%)
Meet the Planner
Judith Martindale is a fee-only certified financial planner based in San Luis Obispo. She is the co-author of the books “Creating Your Own Future: A Woman’s Guide to Retirement Planning” and “52 Simple Ways to Manage Your Money.” She is a member of the National Assn. of Personal Financial Advisors and of the National Assn. of Tax Preparers.
