Saturday, February 27, 2010


Inflation is another one of the things that can go wrong with needs based planning. Inflation is when the general price of goods and services goes up over time. When the price of goods or services goes up it means that each unit of currency can buy less. Inflation erodes the purchasing power of money and any return on investments. For example, if you are able to earn 10% interest, but inflation is 4%, your inflation adjusted rate of return is 6%. Underestimating inflation can cause a person to think they need less money for retirement than you actually do. If someone is using needs based planning and they underestimate inflation, their expenses during retirement will be more than they expected. Even if they meet their original retirement goal, they still will not have enough for retirement.

In recent history inflation has been pretty stable, but looking back only 30 years you can tell that inflation is anything but stable. Between 1979 and 1981 (3 years) annual inflation was above 10% peeking at 13.58%. In 1947 it was 14.65%, and between 1917 and 1920 (4 years) it was above 15% peeking at 17.5%. So as you can see inflation can creep up out of nowhere.

There are a few different things that can cause inflation, but one of the major factors involved is the amount of money in circulation and the rate at which that amount increases. Since the late 1960’s the money supply of the United States has been growing very significantly. In the last few years we have more than doubled the money suppy. I can’t imagine how we are not going to have inflation problems in the near future. The only reason why we haven’t experienced the full effect of the increased money supply is because it hasn’t all gotten to the public yet. I’m not a doomsday kind of person, so I won’t go as far to say that we will have hyperinflation, which destroys almost all value of your money. However, I have a hard time figuring out any other scenario than at least 10% inflation in the next 5-10 years.

Monday, February 15, 2010

Rate of Return - Bench Mark

First I would like to thank everyone that comments. Second I would like to encourage people that are new to this blog to read previous post in order to catch up. For example, this post is a direct lead off of the post "Needs Based Planning." If you read that post this one will make a little more sense.

When it comes to needs based planning, one of the variables most likely to be off is rate of return. Rate of return (R.O.R.) is the gain or loss from an investment over a period of time expressed as a percentage of the original amount invested. So, if I invest $100 and in a few months I sell my investment for a total of $125, then my gain or loss (return on investment) is $25, and if expressed as a rate of return is 25% ($25/$100). Investors use rate of return to gage their investment and know how well it is doing. The ultimate bench mark, and what most investors try and beet is the Standard and Poor’s 500 (S&P 500). The S&P 500 is an index comprised from the stocks of 500 companies selected as a representation of their specific industries. The goal of the S&P 500 is to reflect how good or bad the U.S. economy is doing.

It is said that the S&P 500 index averages a 10% annual rate of return. That means that year to year the S&P’s average annual return is 10%. Even though most people accept the average rate of return as 10%, between 1971 and 2009 it is actually 10.59%. This means that when investors are trying to beat or match the S&P 500 as a bench mark they usually expect about a 10% return. However, average and actual returns are two different things, and averages can be very tricky. I’ll give you an example of what I mean. Let’s say that we invest $100 in the stock market. In Year 1 we receive a return of 100%. So after Year 1 we have $200. In Year 2 we lose 50% (return of -50%). We now have $100 again. Then in Year 3 we gain 100% again. In Year 4 we lose 50%. In Year 5 we gain 100%, and in Year 6 we again lose 50%. After 6 years we now have $100. This is demonstrated by the chart below.

So, our average rate of return is 25%, but if we started with $100 and ended with $100, then our actual rate of return is 0%. Obviously this is as pretty extreme example, and I seriously doubt this would ever happen with any market index. However, it demonstrates the difference between the average and actual rate of return. If you would like to know the actual annualized (year over year) rate of return for the S&P 500 between 1871 and 2009 it is 8.89%. However, that comes with an average standard deviation of 18.94%. For those of you who are not statisticians, this means that any given year can have a return that varies at least18.94% in either direction. For example in 2008 the return of the S&P 500 was -37.22%. In 2009 it was 27.11%.  What does this mean to the average investor? It means that your actual return depends on your timing. If you put $100 into the market at the beginning of 2008 you would now have $79.80.

Tuesday, February 9, 2010

Needs Based Planning

           Probably the most popular and naturally flawed form of financial planning is called needs based planning. This method is widely accepted and commonly practiced. 95% of financial planners and advisors would likely use this method. It very logically calculates what your monthly expenses will be at retirement by adjusting your current monthly expenses for inflation. Then, using your estimate of the time between retirement and death, it calculates how much money you will need at retirement in order to have income for the rest of your life. Then, again discounting for your planed rate of return, it calculates how much money you will have to invest every month in order to reach your goal. Below is an example of a needs based plan.

Current Monthly Expenses                                     $5000.00
Years Till Retirement                                                   30
Estimated Inflation                                                     4%
 Monthly Expenses at Retirement =                        $16,217
(This is how much your living expenses will be in 30 years when you retire)

Estimated Years in Retirement                                    20
Estimated Need for Retirement =                        $2,676,167
(This is a lump sum you will need in order to retire)

Estimated Rate of Return                                          10%
Monthly Investments Required =                            $1,176

            If you notice how many times estimates are included in the calculation (4 times) you will begin to see the first and most basic flaw.  It is all an estimate assuming that some very volatile things will remain consistent. If any one of these things is off in the slightest way it could mean disaster. In this case disaster means going back to work or moving in with your children during retirement. Neither of these things would be the end of the world, but neither are they ideal. Over the few weeks I plan to discuss a number of these variables, and other variables that aren't so obvious. I'll discuss where we have been and where we are headed. Email me with requests that you might have for topics that will be discussed first.

Tuesday, February 2, 2010

Backdoor Taxes to hit middle Class

This Article was ran by Reuters, and followed by a number of other media, but every article was quickly retracted after heated calls from the White House. The article was not retracted because of misinformation, but merely because the White House doesn't want you to know.

Backdoor taxes to hit middle class

By Terri Cullen Terri Cullen Mon Feb 1, 4:09 pm ET
NEW YORK ( –The Obama administration’s plan to cut more than $1 trillion from the deficit over the next decade relies heavily on so-called backdoor tax increases that will result in a bigger tax bill for middle-class families.
In the 2010 budget tabled by President Barack Obama on Monday, the White House wants to let billions of dollars in tax breaks expire by the end of the year — effectively a tax hike by stealth.
While the administration is focusing its proposal on eliminating tax breaks for individuals who earn $250,000 a year or more, middle-class families will face a slew of these backdoor increases.
The targeted tax provisions were enacted under the Bush administration’s Economic Growth and Tax Relief Reconciliation Act of 2001. Among other things, the law lowered individual tax rates, slashed taxes on capital gains and dividends, and steadily scaled back the estate tax to zero in 2010.
If the provisions are allowed to expire on December 31, the top-tier personal income tax rate will rise to 39.6 percent from 35 percent. But lower-income families will pay more as well: the 25 percent tax bracket will revert back to 28 percent; the 28 percent bracket will increase to 31 percent; and the 33 percent bracket will increase to 36 percent. The special 10 percent bracket is eliminated.
Investors will pay more on their earnings next year as well, with the tax on dividends jumping to 39.6 percent from 15 percent and the capital-gains tax increasing to 20 percent from 15 percent. The estate tax is eliminated this year, but it will return in 2011 — though there has been talk about reinstating the death tax sooner.
Millions of middle-class households already may be facing higher taxes in 2010 because Congress has failed to extend tax breaks that expired on January 1, most notably a “patch” that limited the impact of the alternative minimum tax. The AMT, initially designed to prevent the very rich from avoiding income taxes, was never indexed for inflation. Now the tax is affecting millions of middle-income households, but lawmakers have been reluctant to repeal it because it has become a key source of revenue.
Without annual legislation to renew the patch this year, the AMT could affect an estimated 25 million taxpayers with incomes as low as $33,750 (or $45,000 for joint filers). Even if the patch is extended to last year’s levels, the tax will hit American families that can hardly be considered wealthy — the AMT exemption for 2009 was $46,700 for singles and $70,950 for married couples filing jointly.
Middle-class families also will find fewer tax breaks available to them in 2010 if other popular tax provisions are allowed to expire. Among them:
* Taxpayers who itemize will lose the option to deduct state sales-tax payments instead of state and local income taxes;
* The $250 teacher tax credit for classroom supplies;
* The tax deduction for up to $4,000 of college tuition and expenses;
* Individuals who don’t itemize will no longer be able to increase their standard deduction by up to $1,000 for property taxes paid;
* The first $2,400 of unemployment benefits are taxable, in 2009 that amount was tax-free