Personal Finance Hacks to Revive the US Economy

Published on 22 Feb, 2019

The net worth of an average American in the retirement age group of 65+ currently stands at ~$244,450; it drops to ~$94,450 if home equity is excluded1. Even if one were to assume that all the equity tied up in home ownership can be tapped into by means of a reverse mortgage, an optimistic spending rule of 5% would yield an annual payout of ~$12,223, substantially short of the estimated requirement of ~$22,500 per year per person2.

Establishment of welfare programs such as Social Security and Medicare and obsession with consumerism have truly created an environment of moral hazard where very little incentive was placed on retirement budgeting. With fiscal burden piling up rapidly, majority of the welfare schemes could verge near insolvency in the coming years. The onus, thus, lies entirely with the current generation to accumulate savings that would fund their golden years with minimal support programs from the government. This article, therefore, evaluates how the American economy can be revived based on classic personal finance habits and provides guidelines in this regard for an average American.

The sheer size of the problem and its inertia would mean that there is no instant fix and the change has to be instilled at the very grass root level to have a system-wide effect. This would entail a transition from the current consumer-centric economy to one centered on financial stability and sustainability. To achieve this, basic financial literacy should be made mandatory as part of school curriculum and the learnings should be made easy to understand and implement. A step-wise guide that can be used to revive personal financial health is given below.

Step 1: Analyze three months of expenditure to evaluate personal spending pattern. Bucket expenses in certain pre-defined categories.

Here is how an average household in the US spent its annual paychecks in 2017:

Source: Bureau of Labor Statistics Consumer Expenditures 2017


For an average American household, before tax income totaled $73,573, of which $60,060 was spent annually in 2017. Approximately 6% of the expenditure was on food away from home and 5% on entertainment, two segments where expenses can be reduced. An estimated 7% went on vehicle purchases, where the scope for reduction is also significant.

Step 2: Distinguish between assets and liabilities. An asset is something that has a relatively high probability of appreciating in value and providing capital protection, or generates cash flows with high degree of reliability. Anything that does not meet this definition is a liability. Calculate current personal net worth and keep a track of this number on a monthly basis. Any number that is not monitored is difficult to improve on and, hence, must be evaluated periodically.

The table below shows the median net worth for an average American by age:

Age

Median Net Worth

Under 35

$11,100

35 – 44

$59,800

45 – 54

$124,200

55 – 65

$187,300

65 – 74

$224,100

Above 75

$264,800

Source: The Street “Average Net Worth by Age: Mean, Median and How to Calculate”

The amounts are significantly short of what a retiree would need to live on and as the age dependency ratio increases, greater tax burden would be placed on the earning population to fund the already burdened welfare schemes.

Step 3: Set up a monthly budget amount that clearly demarcates between necessities and luxuries and helps determine the surplus cash available. Follow the decision tree below to evaluate monthly spending patterns:


The table below outlines the recommended spending rules of monthly after tax income in percentage terms based on the debt levels (debt excluding mortgage):

 

Basic Expenses – Should account for roughly 75% of total income

Surplus cash can be allocated to either of these three categories (roughly 25%)

Debt Burden

Mortgage + Housing

Necessities

Luxuries

Debt Repayments

Savings

Avg. American

33%

46%

15%

0%

6%

High

35%

40%

5%

20%

0%

Mid

35%

40%

8%

10%

7%

Low

35%

40%

10%

0%

15%

Source: Bureau of Labor Statistics Consumer Expenditures 2017, Aranca Analysis

Step 4: Use the surplus cash available to first set up an emergency fund that meets at least six months of basic necessary monthly expenses.

So, for an average American household that spends $60,060 annually, or $5,005 monthly, this would translate to 75% of total as basic expenses * 6 months * $5,005 monthly expenses which would provide a cash reserve requirement of $22,523. Contrast this with an average American household’s savings account balance of $4,830. Furthermore, nearly 29% of American households have less than $1,000 in savings, which renders them highly vulnerable to personal financial emergencies.

Step 5: Sort all debts excluding mortgage in descending order of interest rates. Pay off the mandatory minimum payment amount needed on all debts outstanding, starting with the highest interest rate debt.

Source: USA Today “A Foolish Take: Here's how much debt the average U.S. household owes”

Below is the debt profile by age:

Age

Median Debt

Under 35

$67,400

35–44

$133,100

45–54

$134,600

55–64

$108,300

65–74

$66,000

Above 75

$34,500

Source: Money.com “This Is How Much Debt the Average American Has Now—at Every Age”

The debt profile varies greatly by age. Households under 35 years of age carry a high proportion of student debt due to the escalating tuition fees and financing costs in recent times, something their predecessors did not face. The average millennial household owes $14,800 in student loans; this robs them of the prime saving years where the compounding returns are most likely to multiply.

Another alarming finding was for the 65–74 household category—their second highest source of debt was related to vacation homes or investment properties which wouldn’t generate a stable source of income in their retirement years.

Although debt levels decline drastically for households above 75 years of age, the number is still shockingly high.

Step 6: Attack the highest interest rate debt with any surplus cash pending every month to accelerate principal payment. Target to use 25% of income that is left after meeting basic expenses and channelize it wisely to knock out highest interest burden.

Credit card debt carries the highest interest rates and is driven greatly by impulse as indicated in the chart below. The highest proportion of respondents (who answered that they opted for a higher amount than anticipated earlier) is for this kind of debt. Nearly 41% of the credit usage is for dining, clothing, personal care and hobbies, categories that can be cut down on3. Analyzing where credit card expenses arise can provide insights that will help in getting finances in shape.

Source: NerdWallet

The second crucial debt to avoid is student loans as this forces an individual to start their adult life with a negative compounding engine. A good rule of thumb would be to evaluate the return-on-investment of the college and ensure that the debt can be paid off in thrice the graduation tenure with a 15% pay off rate.

Step 7: Once the debts outstanding, apart from house mortgage, have been paid off, max out the tax saving investment opportunities available. Budget for this and make a payment every month religiously.

Nearly two-thirds of Americans are not even saving any money in a 401(k). Just 4% of people earning below $50,000 a year max out their 401(k), while just 11% of Americans who earn between $50,000 and $100,000 a year do the same. The number only rises to a meagre 32% when Americans earning over $100,000 a year are considered.

Maxing out Roth IRAs or 401(k)s can help individuals reach their retirement goals, if implemented diligently. The table below shows the future value at the age 67 of $5,500 invested every year and earning 7% annually on average.

Age when investing was started

IRA Balance at age 67

30

$881,855

35

$606,199

40

$409,661

45

$369,531

55

$98,386

Source: USA Today “Are you among 70% of households missing out on this important tax break?”

Actively-managed mutual funds have underperformed the broad market index consistently over the past few decades. Hence, invest in Exchange Traded Funds (ETFs) which would generate similar returns if not better than actively managed alternatives. Apart from the obvious diversification benefits that ETFs offer, they also save on management fees which can add up to a significant amount over years.

Step 8: Aim to save 15% of funds for retirement every month. A rule of thumb would be that if you are targeting a spending rate of 4%, you would need 25x your annual expenses upon retiring.

So for a household with $60,060 in annual expenditure, the retirement annual expenses would be close to 75% of that amount (basic expenses), which is $45,045. To meet this annual expenditure, a household would need $1,126,125, which is 25x (1/4%) that amount. This holds true for a household and, as seen from the table above, can be achieved through systematic and diligent saving.

Eliminate market timing risk and follow a systematic investment plan (SIP) during your investment years. When you are approaching retirement age use the last five to ten years prior to retirement to implement a systematic transfer plan (STP) and transfer the funds to safer mutual funds. During retirement years, use systematic withdrawal plan (SWP) to meet monthly expenses.

Step 9: Save 5% for child’s education which would ensure that the debt spiral is broken and the next generation gets a head start.

Currently, an average student loan borrower in the US has a debt balance of $37,172, which is nearly $20,000 higher than 13 years ago4. Student loan is anticipated to have a negative impact on the overall financial situation, with a vast majority of borrowers delaying major life decisions, including buying a home and starting a family.

Co-signing student loans for your children is another way to quickly wind up back in debt and should be avoided.

Step 10: Use any surplus cash pending to pay off the house mortgage. Opt for a 15-year tenure mortgage which reduces the cumulative amount paid out as interest to financial institutions.

1The Street “Average Net Worth by Age: Mean, Median and How to Calculate”
2Bureau of Labor Statistics Consumer Expenditures 2017
3CNBC “Here's how much debt Americans have at every age”
4CNBC “Here's how much the average student loan borrower owes when they graduate”






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