Notes from the second part of Spend ‘Til The End. Here’s what this is all about, and last week’s notes. Read Kirk’s comments on last week’s post for some thoughts from a fee-only advisor, too.

Part 2: Financial Pathology

Here’s how I would summarize this section on Twitter:

“Wall Street has your worst interests at heart. Prepare to be swindled. But if its any consolation, everyone else is financially clueless, 2.”

140 characters on the nose. Now I will let everyone know what I just fed my cat.

Chapter 6: What, Me Worry?

Most of us dislike thinking about retirement, so we rarely do. It’s just easier that way. Besides, we borrow far too much, far too often and far too long to ever manage to save anything for our retirement. Gambling is the fastest growing industry in America.

Note: this book was written back in the salad days – when the economy was actual growing.

The size of U.S. consumer debt (inclusive of credit card balances, car loans and mortgages) is approximately $12 trillion-with-a-T, or about $108,000 of debt per household. The risk in being unable to pay off this debt is higher for two income households. If one or both partners lose their income, that debt can’t be serviced and things go bad quickly.

One of the major causes of poverty in America is premature death.

This sounded to me like the opening line of a Stephen Colbert joke, but, alas, it was not to be. It turns out that death is, well, another uncomfortable topic to think about. The result is insufficient insurance for the primary breadwinner. His death commonly leaves the family with little to no income.

Our list of mistakes doesn’t end there. We remain largely ignorant about our 401(k) contributions. Consider the dollar-for-dollar match. If an employee contributed $2,600 a year, he would effectively save $5,200 that year since his employer would contribute an equal amount. So he would double his savings at no extra cost and receive greater returns due to compounding. Only half of all workers save enough to capture that match, though. Or in other words, confronted with absolutely free money, one in two people simply ignore it.

In stark contrast to the overspenders are the oversavers. A 2005 Vanguard annual report on defined contribution plans showed that 16% of participants saved between 10% and 14.9%, while 8% saved 15% or more, which the authors consider to be irrationally saving too much. Those oversavers will go from a lower standard of living while they work to a higher living standard during retirement. They deprive their present and their youth to spend in a future which may or may not happen. Consumption smoothing is more ideal.

Other facts cited in this section:

– Roughly half of older households have never developed a financial plan.
– The average American has a credit card balance above $8,500 accruing 18 percent or more in interest.
– Fewer than two-fifths of Americans pay off their credit card balances monthly.
– Casino revenue surpasses annual 401(k) contributions.
– Some 20 percent of 401(k) assets are invested in employers’ stock.
– One-third of secondary-earning wives are severely underinsured against their spouse’s death.

Chapter 7: Understanding Financial Disease

We ape our parental preferences and behaviors. If your parents were spendthrifts, you tend to become a spendthrift; if they were savers, you will likely be, too. So don’t despair – if you’ve recently maxed out your credit cards, it may be your parents’ fault! (Sarcasm mine).

When it comes to personal finance, we tend to take advice from our parents and friends and/or rely on our personal judgment. The problem with relying on someone else’s experience is that it doesn’t necessarily reflect our own situation. The rich often rely on financial planners, software or even financial publications. But none of those help much, either.

(Note: I agree most online calculators are of limited value, and I tend to think of the financial media as peddling porn for investors. But the authors tend to lump all financial planners together with brokers, tax collectors and record company executives. You know, the real scum of the earth. I think this is shortsighted. My experience is that fee-only planners are a breed apart. I think everyone should use a fee-only planner to make sure the advice they receive is free of all conflicts. The authors whiff on making this distinction. Go to NAPFA.org to find a fee-only planner near you.)

Sometimes it’s just simpler to let others handle our financial decisions. It is certainly easier to let our employers and the government save for/invest for/insure us. And, naturally, they have our best interests at heart. Or do they?

Look back at Enron employees. When the company was on its way to bankruptcy, 11,000 employees collectively lost $1 billion in assets along with their jobs. This happened because they had invested almost two-thirds of their 401(k) assets in the company’s stock. To make matters worse, Enron prevented its employees from selling the stock when its prices were crashing.

Despite the Enron debacle, today over 5 million American workers still have three-fifths of their retirement assets invested in their own company’s stock.

This is bad.

Compulsive behaviors like shopping or gambling are also enemies of consumption smoothing. Just as there are compulsive spenders, however, there are also compulsive savers. In either case, no amount of persuasion can change old habits. One wife may save compulsively because she is unaware of her husband’s earnings. Another may overspend because she thinks she can afford it and her husband is too embarrassed to tell her otherwise. You’d be surprised how often a lack of communication between couples derails the goal of consumption smoothing.

Chapter 8: Financial Snake Oil

Core to the process of retirement planning is usually the concept of the retirement income replacement rate, or replacement rate for short. It says that most people, upon retirement, will need a certain percentage of the income they had earned immediately before retiring. So if you are earning $50,000 at age 65, a replacement rate of 70% to 85% means you’ll need $35,000 to $42,500 in your first year of retirement.

Replacement rates as used by Wall Street, however, typically assume that most of your pre-retirement expenses continue post-retirement. They assume continuation of mortgage payments and perpetual spending on children and college tuition. Most methods of determining replacement rates are made assuming no change is made in your household demographic composition, or that you never spend your accumulated assets. We know none of this is realistic, however. So what gives?

The authors believe “the con begins” with Wall Street convincing you that a replacement rate as high as 70% to 80% is absolutely essential to your retirement.

How do we save that high an amount? The simple solution is to buy any one of 23,000 mutual funds which attempt to provide higher than average returns. However, reality is a little different.

Most fund managers (80% of domestic actively managed stock mutual funds) fail to meet their benchmarks, but the funds they manage nonetheless increase their expenses over time. It’s a zero-sum game: the greater the expenses charged, the greater the losses to the investor.

Those losses, mind you, are in addition to the already high fees charged by the average mutual fund. Mutual fund investors in fact paid a handsome $39 billion in 2002 to brokers for selling mutual funds to them. That’s an extravagant sum to part with – especially for financial services that add no value.

The authors believe that financial planning as practiced on Wall Street offers most investors only two unattractive choices:

1 – Help financial planners make money for themselves while suppressing your consumption during your most vital years; or
2 – Spend your life in anxiety and fear that your retirement will be a disaster.

The best method of planning to the authors remains consumption smoothing. It looks at your entire personalized picture to come up with your lifetime spending power to help you have the smoothest living standard possible, without exceeding your ability or willingness to borrow.

Lastly, a note on annuities, which I mentioned here were a rotten deal for investors. The authors rip equity indexed annuities, too, on page 103:

While equity index annuity products don’t have explicit expenses as mutual funds do, financial economists have calculated that the cost of this safety [referring to the no-loss feature] is extraordinary. Economists have shown that investors would be better off in a simple portfolio of Treasury securities and large-cap stocks 97 percent of the time. They’ve also calculated that the typical equity index annuity purchase amounted to a transfer of 15 percent to 20 percent of wealth from the investor to insurance companies and their sales forces.

And with annual sales of equity indexed annuities reaching $30 billion a year, that’s a staggering loss for investors.

So keep your eyes wide open. At least until we get to Part 3 next week.