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Retirement Strategies REdux: Old School v. My Way April 21, 2008

Posted by shaferfinancial in Uncategorized.
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Mary and Joe are typical folks, they have about twenty years to retirement with two kids fast approaching needing money to attend college.  Joe has been fortunate and has had the same job for over 15 years, while Mary works part-time for a local business and still does the majority of taking care of the kids.  They have accumulated around $100,000 in a 401K and owe $100,000 on a home that is worth $300,000 by aggressively paying off the mortgage and owning the home for 15 years.  Their emergency fund is meager at $8,000.  They know they need to figure out a way to get more money for retirement, but frankly, are at a loss how.  They make an appointment with John, the financial planner.  Mary pulls up in a 7 year old Honda minivan and waits for her husband.  Joe running a few minutes late pulls up in a 4 year old Chrysler 300.  Joe parks next to a new Lexus and admires it as they go into the office.  John meets them at the door and acknowledges Joe looking at the Lexus and mentions he has just leased it a few weeks ago.  Joe is impressed.

John, takes all their information and runs the numbers.  He looks them in the eye and delivers the bad news.  At their present rate they will not have enough to retire on.  They need to do something now!  Mary and Joe are a little embarassed about their situation, but they thought they were doing the right thing, paying off their mortgage and putting 8% of Joe’s salary in to the 401K.  Frankly, Mary knows because the wives talk about this, that they are better off than most of their friends.  So she is a little peeved at John’s rather cavalier attitude toward their retirement savings.  Then John throws in the kicker.  He can help them achieve success.  He starts to talk about asset allocation mentioning that they have all their money in one mutual fund.  He pulls out a prospectus that is for an international mutual fund that returned 28% last year.  Joe is impresses as he knows his fund returned a meager 3% last year.  Then Joe pulls out another prospectus for a Precious Metals Mutual Fund that returned 85% last year.  Joe is fully impressed now.  John suggests he take control of the $100,000 in the 401K to manage it.  He tells the couple to keep up the good work paying off the mortgage, but they need to put away more, much more if they want to retire comfortably.  John also suggests they need some life insurance so he suggests a $250,000 10 year term insurance which he says is dirt cheap now.  Joe and Mary look at each other with the same thought.  They are already pretty thrifty, but there goes the one night a week they eat out together and maybe Mary could work more hours after all the kids are old enough that they don’t need Mary to be there when they get home from school.  But, if that is what they need to do, then they will figure it out.

On the way home Joe is sold but Mary has some doubt about John.  She remembers reading “The Millionaire Next Door” in her book club a few years back, so she is not impressed with John’s car.  Her intuition also tells her that the returns that he showed them for those two funds were a little high, they must be risky she thought.  She thinks  they should talk to someone else.

Can you spot the mistakes?

1.  The assumption that leasing a nice car means that you know what you are doing financially is incorrect and probably the exact opposite.

2.  Mutual funds as a class underperform the market and specialized mutual funds have even more variability which means that those two mutual funds will probably underperform for many years to come to make up for their amazing performance last year.

3.  They use little leverage on their finances and are decreasing it by paying off their mortgage.

4. The majority of their net worth is home equity which gets a 0% rate of return.

5.  Suggesting to a frugal couple that they need to be more frugal is like throwing gasoline onto a fire.  They drive older cars, eat out only once a week and work 1 1/2 jobs between them while caring for two kids.  Life shouldn’t be this onerous for this couple.

My Way:

Move their 401K money to a discount brokerage account and buy $100,000 of Berkshire Hathaway B’s.  Warren Buffett’s returns 21% over 43 years and 18% over  the last 10 years.

Re-finance their home with a $250,000 mortgage now available at 5.75%.  This gives them $150,000 cash.

Take $25,000 and purchase a $200,000 duplex in Dallas, Texas that is cash  flow positive (See my Friend Jeff www.bawldguy.com for details)

Purchase a $450,000 equity index life insurance contract.  Fund it with $25,000 year for five payments.

Reduce the 401K amount to the 3% company match to cover the extra expense of the larger mortgage.

Place the $100,000 left over into a money market fund or high paying savings account to act as an emergency fund and reserve fund for the real estate.

As each year goes by make the $25,000 life insurance premium payment. 

Taxable income goes down as the mortgage interest goes up substantially and the real estate investment throws off tax advantages.

Let’s look down the road five years.  The real estate investment has a cash flow of +$3,000, +$3,000, +$4,000, +$5,000, +$6,000 as rent could be increased.  This $21,000 is held as reserves for deferred maintenance and is not counted for assets.  College aid was applied for the kids and this amount was not counted!

The insurance contract has a cash surrender value of $110,000 since the front loaded fee’s have been paid.  But this works as the couple’s emergency fund available to them with no tax consequences.  The big positive is that this is not counted toward income or assets for college aid.  So they have moved over $100,000 off the college aid books allowing the kids to qualify for more aid.

The Brokerage 401K is worth $228,776 with Warren Buffett continuing the 18% he got the last decade.

The duplex is worth $250,000 getting slightly less than 5% return. They have around $80,000 in equity.

Their home is worth $380,000 getting the same 5% return.  They have over $150,000 is equity.

Their taxes have gone down due to the mortgage interest deduction and the investment real estate.

Their passive income from the real estate is 500/month.

Their kids received large amounts of student aid for college.

They have a emergency fund/reserves over $130,000 so they sleep well at night.

The costs to do this was $5,000 for the refinance, $5,000 to buy the duplex, $12 to buy the stock, and the commission and fee’s for the insurance contract.

There are no ongoing fee’s (other than the insurance contract) payable to a financial planner.

No reduction in life style needed.  In fact as the couples net worth rose, they started to take a nice vacation once a year and Mary will stop working  as soon as the kids are out of college.

Old School V. My Way:  You make the choice!

PS  I used conservative numbers all the way through my way!

PSS  As usual this should not be construed as financial advice with respect to any particular stock or any general investment advice that might come under the auspice of the SEC.  It is only the ramblings of a derelect and a individual that does not have a license to issue stock or mutual fund or real estate advice.  Please see an “expert” for all tax issues.