Tim Maurer in Forbes on parent student loans.
Tim Maurer, Director of Personal Finance, The BAM Alliance
Parents have sacrificed their financial futures on the altar of their children’s education. Fueled by easy federal money and self-interested colleges, the result is a student loan crisis that appears already to be eclipsing the catastrophic proportions of mortgage indebtedness leading up to the financial collapse of 2008.
I’m not anti-education. In fact, I valued my college education so much that I went back to teach at my alma mater, Towson University, for seven years.
Please allow me to disclaim a few things:
I’m also not a conspiracy theorist, but the facts, according to a new Wall Street Journal article, are indisputable:
Parent Plus loans, by the way, are those that parents take out to cover tuition and living expenses typically after kids have maxed out their student debt allowance, ensuring that both the apple and the tree are sufficiently indebted.
Interestingly enough, all the way back in 2011, the Obama administration placed tighter restrictions on Parent Plus loans due to concern that unqualified borrowers were loading up on unsecured debt. But schools put up a fight (successfully), suggesting that such limits impaired students’ ability to get an education.
And this is where we get a glimpse of the fundamental problem: Education has been deemed invaluable—at any price.
Yes, college can be very expensive. The cost of college education has risen well above inflation for decades, resulting in apparent absurdity. (Really, you’re telling me that the collective benefits of any college experience are worth $65,000—per year? Really?)
BUT, college doesn’t have to be outrageously expensive.
A student who commutes to a community college for two years and then transfers to State U for the final two years can get an undergraduate degree from a reputable university for the same cost as a single semester on campus at an elite private school.
With $1.3 trillion in school loan debt, a lot of water has already flowed under the collegiate bridge, but I’ll speak to those parents and students who’ve yet to burden themselves:
To parents:
Sacrificing yourself financially for the sake of writing your children a blank check for education isn’t generous—it’s actually selfish. It would be much less expensive for a young adult to pay off a reasonable college loan than to bail out his or her parents who’ve run out of money in retirement and have health care bills piling up.
As they instruct on the airplane, you have to take care of yourself before you can take care of those who depend on you. Your long-term financial security (including your retirement) is a priority over your children’s education—for both of your sakes. And there are few opportunities more ripe for teaching our children financial and life wisdom than the discussions regarding college.
(If you’re looking for some guidance, here’s my “Non-Conformist’s 4-Step Education Savings Plan.”)
To students:
Please don’t take advantage of your parents. They love you, and they desperately want to see you succeed in life. But if you let them take on loans so you can party your way to a diploma, it could literally ruin them financially.
And if you’re like many who are navigating this decision on your own, please realize that the mystique of the college experience loses its luster very quickly if you’re buried in student loan debt. College truly is a value proposition, so try to restrict your total student loan debt to no more than you expect to make in your first year’s salary.
Then you'll be able to enjoy employing your education without being stalked by its cost.
This commentary originally appeared April 29 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
A sound investment plan isn’t the only way to find financial security.
Earlier this week, we looked at the importance of incorporating different types of risk—specifically, human capital risk—into an overall financial plan. Today I will focus on mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.
Mortality Risk
For those families whose human capital makes up a substantial portion of their total assets, protecting that capital via the purchase of life insurance should be part of the overall financial plan. Life insurance is the perfect hedge for mortality risk because its return is 100% negatively correlated with the human capital asset.
The younger the investor (the higher the human capital), the greater the need for life insurance. The amount of insurance required can be determined through what’s called a “needs analysis.” It can also be related to bequeathal motivations.
It’s important to note that life insurance can be used for purposes other than to hedge mortality risk. For example, it may be the most effective way to pay estate taxes. It can also be useful in terms of business continuity risks. Thus, while the individual’s need for insurance to hedge the risks of human capital falls as he or she ages, the need for life insurance might actually increase.
Longevity Risk
Longevity risk is the risk that you will outlive the ability of your portfolio to support your desired lifestyle. This risk has increased for much of the population with the decline of defined benefit plans (which, like social security, pay out for a lifetime) in favor of defined contribution plans. Also, advances in medical science continue to expand life expectancy. Longevity risk can be addressed by the purchase of lifetime payout annuities.
While the academic literature demonstrates that many investors would benefit greatly from the purchase of immediate annuities or deferred income annuities (because of “mortality credits” built into the product—in effect, people who die earlier than expected subsidize those who live longer than expected), very few are purchased.
The main reason seems to be that people are risk averse, in the sense that they don’t want to risk giving up their assets and then dying soon. The fear is that the assets would no longer be available for their heirs. But this is only true if they live a shorter-than-average life span. By definition, half will live longer. And for them, buying a payout annuity preserves any remaining assets for the estate.
The academic literature suggests that deferred income annuities are superior to immediate annuities for the purpose of protecting against longevity risk. Deferred income annuities can be purchased in an investor’s mid-60’s, with income beginning at age 85. Investors should begin to consider purchasing immediate annuities during their mid-70’s and buy them before they reach age 85.
Since the payouts from annuities are dependent on the level of interest rates (among other things), a recommended strategy is to diversify the interest rate risk by purchasing various annuity contracts over time instead of all at once. This strategy also preserves liquidity for some period. Monte Carlo simulations help analyze the benefits of annuitization. It's also important to understand that delaying social security benefits as long as possible provides longevity insurance.
Another risk is also related to longevity. As we age, the risk of needing some form of long-term health care increases. It’s estimated that at least 60% of people over age 65 will require some long-term care services at some point in their lives. And contrary to what many people believe, Medicare and private health insurance programs do not pay for the majority of long-term care services most people need—help with activities of daily living, such as dressing or using the bathroom.
Thus, when investors develop an overall financial plan, they should consider the purchase of long-term care insurance. Again, the use of Monte Carlo simulations can help analyze how the purchase of long-term health insurance impacts the odds of achieving one’s goals.
These examples demonstrate why having a well-developed investment plan isn’t sufficient for financial planning purposes. Other important risks also exist. We need to consider another broad category called wealth protection.
Wealth Protection Insurance
Financial plans can fail in several ways because we don’t have sufficient insurance. A well-developed plan covers not only longevity and mortality risks, but disability.
Sufficient coverage should also be in place for all types of property and casualty risks, as well as the all-too-often overlooked personal liability risks covered by umbrella policies that protect against claims from lawsuits. Because needs change over time, incorporating a regular, thorough review of your overall insurance needs is an important part of the financial planning process.
In addition to integrating into an overall financial plan the management of the risks we have discussed, integration of strategies that add “tax alpha” can significantly improve the odds of achieving your financial goals.
Tax Alpha
Tax Alpha refers to the additional performance benefit gained from your investments through tax savings. Following are just two ways tax alpha can improve results:
Summary
Having a well-thought-out investment plan is a critical part of the financial planning process. However, it’s only the necessary condition for likely success. The sufficient condition is to integrate the investment plan into an overall financial plan that also addresses the risk management issues discussed above. Even then, other issues may need to be considered.
For example, for those with charitable intent, there are more, and less, efficient ways to make donations. The same is true for the transfer of wealth, whether through lifetime gifts, leaving a legacy or both. A well-thought-out financial plan helps to ensure that transfers to loved ones or to charity are made in the most tax-efficient manner, in a way that maintains the donors' financial independence during their lifetime and meets their nonmonetary objectives.
If your planning doesn’t address each of these issues, I hope this serves as a wakeup call. It’s not too late to act—until it is.
This commentary originally appeared April 14 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Larry Swedroe on the importance of integrating all risks (not only the investment kind) into an overall financial plan.
Larry Swedroe, Director of Research, The BAM ALLIANCE
Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.
Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.
Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).
Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.
Managing Financial, Not Just Investment, Risks
When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.
Human Capital Risk
We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?
The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.
The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.
For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).
This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.
A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.
Correlation, Health And Mortality
The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.
This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.
The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).
There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.
Risk Tolerance And Adaptability
Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.
Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.
Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.
Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.
We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.
This commentary originally appeared April 12 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE