Carlisle and Martha Lee Watson have been so preoccupied running their handbag business they haven't paid much attention to whether they're on track for retirement.
Like most entrepreneurs, their priority has been to keep their small business afloat. But now, as they reach their late 40s, they fear that their goal of retiring at 60 might be slipping out of reach.
The couple, who live in Los Angeles' Miracle Mile area on a combined annual income of about $120,000, have begun to realize that they can't live check-to-check forever. Their child-rearing expenses are almost finished--the younger of their two daughters recently graduated college--but their spending is still high.
"We make a good income, but we still seem to be treading water every year," said Martha, 47, who designs handbags, while Carlisle, 46, sells them. "We've been a little careless the last few years. We overdid the remodeling of our house, and we thought we'd make more money than we did. But we know how to make sacrifices. We just need to know what to do."
So far, the Watsons have $45,400 tucked away in separate IRAs. The funds are invested in two Morgan Stanley Dean Witter stock mutual funds, Treasury bonds and shares of Bristol-Myers Squibb, Dell Computer, Cheesecake Factory and Walt Disney.
They have about the same amount--$48,500--in a taxable brokerage account invested in eight stocks: Intel, Wal-Mart, Chevron, Deere, Cheesecake Factory, Schlumberger, Walt Disney and Hot Topic.
In addition, they have about $205,000 equity in their home and own inherited land worth $30,000. Subtracting debt, their net worth is about $300,000.
At this point they wonder if they'll be able to cut back to less stressful and lower-paying work when they hit their 60s.
Psychological as Well as Financial Challenges
Glenn Woody, a fee-only certified financial planner in Costa Mesa, responded bluntly: Not unless they start saving aggressively.
"The bottom line is that to get you retired, you'll simply have to tighten your belt and decrease your expenses," the planner said. More money can be found "in one of three ways: You earn more, spend less or a combination of the two."
He encouraged the couple to treat their finances as they do their business. Create a budget, then closely monitor their expenditures to identify areas to cut back.
"To me, wrestling with cash flow is like dieting," he said. "It isn't fun, but you're sacrificing for some later gain, which is intangible. It just gets down to motivation."
Self-employed people often have trouble finding time and the wherewithal to save for retirement, the planner said. While corporate employees often have 401(k) savings plans, people who are in business for themselves must set up their own retirement plans.
This can be particularly difficult when income varies from month to month, as the Watsons' income does. "It's hard to predict whether we're going to make $5,000 a month or $12,000," Carlisle said.
And saving for retirement can pose psychological challenges, of course. Although most people understand that they need to do it, it's easy to forgo saving and do things that provide immediate gratification. That's why the automatic paycheck deductions of 401(k)s and other work-based retirement programs are vital to many people's retirement planning.
Once self-employed people make a commitment to build a retirement fund, however, they have several good program options for tucking away money: a Keogh plan; a plan known as SIMPLE, which involves a savings incentive match for small-business employees; and a simplified employee pension, or SEP-IRA. The rules vary for each, but the central feature is tax-deferral on savings.
For the Watsons, Woody recommended that they each open a SEP-IRA and try to contribute the maximum to their plans. He selected that option because SEP-IRAs are easy to establish and have minimal reporting requirements and low costs.
Given their income, the Watsons would be allowed to set aside more than $8,000 a year each in investments within a SEP-IRA. (The basic SEP-IRA plan allows contributions of 13.04% of their net income, up to $24,000.) The plan can be started at any bank, brokerage or insurance company, sometimes for no charge.
After their SEP-IRAs are fully funded each year, Woody encouraged the couple to each contribute the maximum of $2,000 to a Roth IRA, the proceeds from which aren't taxed when withdrawn in retirement.
Any savings beyond that could go into a taxable account.
But even if the couple invest the maximum in their SEP-IRAs, Roth IRAs and $2,000 a month in their taxable account, they would barely be able to meet their retirement goals, assuming their investments return 10% annually, Woody said.
Although the U.S. stock market has returned more than 20% annually in the last three years, historical average returns for U.S. equities are 7% to 10%, depending on what longer-term period you consider.
Woody assumed that the couple would need 100% of their current annual living expenses in retirement, about 10% of which would be provided by Social Security. The couple could decide they need less income, but "few of my clients plan to live less well in retirement than they do now," Woody said. Delaying retirement also could help ensure that the couple will have enough to fund the rest of their lives.
Cash Flow Improving, but Watch Expenses
"We had to make some pretty aggressive assumptions to get you retired at all," the planner said. "If you work until age 60, then slow down and earn about half of your income until age 70, that would work. Or if you work full time until age 65, then it's possible."
The Watsons gross about $10,000 a month, spending about $2,400 on business expenses. (The bags are produced by a contract manufacturer.)
They spend $3,153 monthly on two mortgages on their home, $338 to pay off a $25,000 student loan for their younger daughter and $907 for health, auto, disability, life and homeowners insurance.
They also must set aside funds to pay state and federal taxes, which last year amounted to $22,600, or $1,883 per month. After normal living expenses, that doesn't leave a lot to pay off their credit card debt, which is about $10,000.
"If I'm short one month, I'll have to take advances on the credit cards," Carlisle said.
But the couple's situation is not bleak. Their younger daughter's graduation means they no longer will contribute to her $25,000 annual college costs.
They're also selling more bags this year, so they have hiked their income estimate to $150,000.
"If you make $150,000 this year, it seems like there's room for the type of savings I'm suggesting," Woody said. "But you have to watch the outflow. Don't let the extra income go out the door."
Before the Watsons start building their retirement savings, the planner stressed that they should get rid of their card debt.
"Borrowing money on credit cards is the most expensive way to borrow," Woody said. "I think credit limits can be a wonderful safety net for unexpected emergencies. But you need to make a point to pay your balance off every month."
Relying on Stocks' Long-Term Strength
Once their debt is paid off, the couple can concentrate on retirement planning. First, Woody suggested they compare costs between brokers and consider transferring their IRAs and taxable brokerage account at Morgan Stanley Dean Witter to a discount brokerage such as Charles Schwab to reduce commission costs.
The couple made their stock investments on the advice of their broker and ideas they garnered from friends. They've enjoyed the thrill of making quick profits in the bull market, but they admit that they haven't been studying the companies carefully or thinking about basic investment principles such as diversification.
Because the Watsons enjoy stock picking but admit they fear taking on a lot of risk, Woody suggested they shift the bulk of their stock assets to mutual funds, while earmarking a small portion of their taxable account as stock market "play money."
If they get more interested in following the market, they could always invest more in individual stocks later, he said.
Although individual stocks can offer higher returns than mutual funds, a small number of stocks can be more volatile than a fund. Woody notes that investing in funds tends to be less risky because they cast a wider net.
"For serious money, which is your retirement funds, diversification is better done through mutual funds because they can better represent asset classes," he said.
There are no tax consequences if the Watsons sell the individual stocks in their IRAs and replace them with mutual funds. But Woody agreed the couple might want to hold onto some of the stocks in their taxable accounts.
Gains on stocks held for more than a year would be taxed up to a combined federal capital-gains and state income tax rate of 29.3%, Woody noted. By contrast, shorter-term holdings, if sold at a gain, would be taxed at the Watsons' marginal federal/state tax rate of 37%.
"So for those stocks that you've had for under a year that have had a big gain, you might want to pause a bit" before selling, Woody said--although that also entails "market" risk that the stocks could decline.
Woody recommended that the couple's overall portfolio, and all future investments, be held 80% in stocks (including mutual funds and any individual shares the couple choose to keep) and 20% in bonds. Given that retirement is more than a decade away, stocks should outperform other investments in that time frame, but the bond investment offers a buffer.
The bond portion could be held in a basic fund such as the Vanguard Total Bond Market Index fund (three-year average annual return: 7.5%), he said.
Once they make their bond allocation, Woody recommended that the money allocated to stock funds be divided about 38% in an index fund, such as the Vanguard Index 500 (three-year average annual return: 33.3%), which focuses on the biggest U.S. stocks; 25% in Harbor International Growth (three-year average annual return: 13.4%), and 12% or so each in three funds: Vanguard Small Cap Index (three-year average annual return: 17.3%), Harbor Capital Appreciation (three-year average annual return: 39.9%) and Dodge & Cox Stock (three-year average annual return: 25.8%).
Harbor International focuses on high-quality companies in developed countries. Harbor Capital Appreciation mixes both large U.S. stocks and mid-sized issues. Dodge & Cox targets large-company "value" stocks.
Woody's diversified yet aggressive approach earned the Watsons' approval. They didn't mind his stern message and agreed that they'll need to save more and perhaps work longer than they expected.
"I'm glad you're taking us in a different direction," Martha told Woody. "This is what we needed to hear."
Diane Seo is a regular contributor to The Times. To be considered for a published Money 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 or to email@example.com.
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This Week's Make-Over
* Investors: Carlisle Watson, 46, and Martha Lee Watson, 47, owners of a handbag business
* Gross annual income: About $120,000
* Goal: Devise a retirement plan
* Cash: $5,000
* Real estate: About $205,000 equity in home (after $270,000 remaining on two mortgages); land worth about $30,000
* Other debt: About $10,000 owed on credit cards; $25,000 owed on daughter's college loan
* Investments: $45,400 in IRAs, invested in mutual funds, Treasury bonds and individual stocks; $48,500 in individual stocks held in taxable accounts
* Track expenses to identify ways to save money.
* Pay off credit card debt as soon as possible, then pay off student loan.
* Maximize retirement contributions via small-business SEP-IRA.
* Shift investments mostly to a diversified mix of mutual funds, with an asset allocation of 80% stocks, 20% bonds.
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Meet the Planner
Glenn Woody is a fee-only certified financial planner and president of Glenn Woody Financial Consultants in Costa Mesa and La Quinta.