[Editor's Note: This is a guest post from an endowment fund investment manager and a blogger who blogs at Our Family Fortune. We have no financial relationship. Today he walks us through the various decades of our lives and where we should be focusing. He wanted to run this disclaimer with it, which you can also apply to every other blog post on this site: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not. Do your own due diligence before making an investment decision. It’s your money; you’re the best person to judge what is best to do with it.]
Few of us are handed a large chunk of cash early in our career to invest for our future. Instead, we have to build our wealth slowly. Like many of you, I started my professional life with student loan debt, a near-empty checking account, and a savings account with a few hundred dollars. For most of my college years, I worked full-time to pay for tuition and living expenses. Working full-time through college allowed me to start my professional life with a close to zero financial balance; something not as easily accomplished today.
Building wealth is intimidating. The basics are straightforward: live like a college student for as long after college as possible, sign up for your retirement benefits at work, focus on increasing your earnings potential, minimize fixed expenses, and save like crazy. It’s acceptable to live in a dumpy apartment when you’re 25; it’s not so acceptable to live in a dumpy apartment with a spouse and kids in your 30s. While the basics are easy to know, doing the actual work is another story. Beyond that, what do you do after you’ve done the basics?
What specific steps can you take to build out your investment portfolio and your family fortune through time? Most advice starts and stops at signing up for your retirement plan at work, allocating to a target dated mutual fund, and hoping for the best. Instead, I’ll walk through the work needed and what I consider to be the best way to allocate amongst asset types and account types at different stages of your career. This advice will be tailored for “normal” market environments, where there is a reasonable expectation that stocks will perform within their historic distribution, bonds will have a positive real expected return, and other asset classes have a reasonable return expectation relative to risk. That time is not necessarily now (2nd half of 2017), as the stock market is historically expensive, bond yields are low, and any moderately interesting alternative investment is priced at high levels. However, this time will pass; it always does. Expensive stocks and low yields are part of any market cycle.
Building Wealth in Your 20's
Your 20s: bad clothes, 9/11, Remember the Titans, Britney Spears and Eminem. Okay, those were my 20s; yours were probably different. Your 20s are a time when you are just starting out in your career, earning the smallest paycheck you’ll ever receive (hopefully), and have some debt and few assets. How do you begin to build wealth and invest your money for the future?
# 1 Focus on Skills, Contacts, and Getting in the Right Company and Industry
The amount of wealth generated by a good career in a growing industry cannot and should not be underestimated. Frugality only gets you so far, but high earnings make saving and investing while still enjoying life possible. Your 20's is the time to take a lower paying job if there is a greater upside for your earning prospects. Your career path should be on the revenue generating side of the business, not the expense side. If you’re an engineer, work in an engineering firm. If you’re a marketer, work in an advertising firm. If you’re an accountant, work in an accounting firm. Picking the right company and the right industry will put you on a path to above average earnings potential. Scratch, claw, and fight to get those positions.
# 2 Build the Foundation of Your Financial Fortress
Build the processes needed to save a good size chunk of your paycheck. Begin to eliminate debt. Low balance debt should be the first priority, even if you have higher interest debt elsewhere. It’s better to build momentum and eliminate a monthly bill than to worry about which debt has a higher interest rate. Sign up for your company’s 401k plan, especially if they have a match. Start building an emergency fund.
# 3 Find Something Entrepreneurial or Focus Hard on Your Career
I’m always a bit torn about whether there is greater wealth potential in starting a new business or becoming a higher-up in your chosen profession. On the one hand, wealth is generated by owning equity in a growing company. Even better if you founded it and most of the equity is yours. On the other hand, most people don’t have the natural inclination to be an entrepreneur and most start-ups fail. If you have a great idea and want to start something new, do it! If you’re like most people and don’t, then focus like crazy on getting better and better in your career. Follow Steve Martin’s advice and “Be so good, they can’t ignore you.”
# 4 Contribute to Roth Accounts Over Traditional, if Available
Roth accounts (401ks and IRAs) have both advantages and disadvantages. Roth accounts allow for the contribution of after-tax dollars, with tax-free growth and tax-free distributions later. Traditional accounts contribute pre-tax dollars, thereby reducing your current tax bill. They also allow for tax-free growth, but with taxable distributions later. When you choose Roth over Traditional, you give up a known tax break now for an unknown tax break later. There is always a possibility of Congress changing the tax code. If you expect that your tax rate is lower today than it will be in the future, invest through a Roth. If not, invest through a Traditional account. Since young professionals tend to be in the lower marginal tax brackets, investing in a Roth now makes sense.
# 5 Favor Equities and Equity-Like Investments
With the caveat that the market environment matters a lot, I would still recommend that young professionals favor equity and equity-like investments across the board. While time is of course on their side, time on your side can be deceiving. Life tends to get in the way of well-laid plans. However, what young professionals do have is the expectation for higher pay and more working years. This is a huge benefit. A 28 year old has the ability to lose 80% of their portfolio and not be too severely impacted. The portfolio was likely small to begin with and they also have decades to make it up with both new contributions and better market returns.
Your 30's are a time of substantial transition. This is the stage where I find myself. While in your 30's, you likely have a healthy amount of capital, although probably not huge, as well as a healthy number of growing responsibilities. You may be married with children, find yourself moving up the food chain at work (along with the stress that brings), have a mortgage, and a lot less time than in the past. Also, you’ll (hopefully) be making a much larger income that puts you in a higher tax bracket and allows you to both maximize your retirement contributions and begin building capital outside of retirement accounts. This changes the math on where to allocate and what assets to buy in what account.
Your 20's set a strong foundation for your financial fortress, but now is the time to switch to building up the walls and growing your kingdom.
# 1 Funnel New Retirement Contributions into Traditional Retirement Plans
First, you should be at a stage where you can fully max out your retirement accounts. Do this, but due to a higher tax bracket, funnel new contributions to a traditional 401k instead of a Roth (keep the Roth IRA/401k that you started in your 20s). If your expected tax bracket in retirement is lower than your current marginal tax bracket, a traditional 401k is the way to go.
The below example illustrates this well. It assumes a 28% marginal tax rate while working, a 15% tax rate while in retirement, a real rate of return (after inflation) on investments of 4%, an increase in contribution and income growth of real 2%, and a tax-free vs. taxable equivalent contribution during work and distribution during retirement (max out contributions pre-retirement and distribute an after-tax $50,000 per year in today’s dollars during retirement). Note that traditional 401k contributions and distributions are larger in both cases due to taxes.
As you can see, the Roth runs out while the Traditional account still has over $300,000 (again, in real terms or today’s dollars). The difference is due to the difference in tax rates (28% while working vs. 15% in retirement). As long as your retirement tax rate is lower, you’re better off in the traditional. Plus, you can at least take the tax break today knowing that Congress can’t screw that up later!
# 2 Network, Get Promoted, and Put Your Career into Overdrive
Very few people make a name for themselves in their 20's. Those that do, we are sure to hear about because they are so rare. Instead, your 30's is the time to really begin to leave your mark on your chosen profession. Build your network, be so good at your job that you get promoted, and turn up your earnings power. Given the level of transition in your life and the added expenses that come with it, now is the best time to start earning well into six figures. Higher incomes lead to a larger safety net when life inevitably goes wrong.
# 3 Build up Assets in Taxable Accounts
Your 30's are a chance to begin to build real wealth outside of retirement accounts. Even if you’ve been contributing before, you can really turn your F-You account into something with size. Focus on equity and equity-like investments, including option-like strategies, in this account. The tax code strongly favors equity and dividend investments as opposed to interest-bearing investments. Which means:
# 4 Begin to Add Interest-Bearing Investments to Your Retirement Accounts
Now that you’ve actually got some money, downside protection becomes more important. It’s tough, both from a mental well-being and a financial well-being standpoint, to lose a big chunk of your wealth in a bear market. Begin to gather some downside protection and diversify out of equity-like risk. If you purchase interest-bearing investments (e.g. bonds), put these in your retirement accounts. You’ll both protect some level of your future consumption, as well as minimize your tax bill as much as you can.
# 5 Build the Foundation of a Great Family
Your kids will probably still be young when you’re in your 30's, but now is the time to start teaching them how to build character, how to find answers for themselves, the value of social capital, and the benefits of spiritual strength. Teaching basic cash flow management and introducing early saving and investing lessons can begin around this time as well.
Your 40's & 50's
By the time you’re into your 40s and 50s, you’ve been through some tough transition years, and hopefully have generated, grown, and preserved a decent level of wealth. A net worth of $2-10 million is a reasonable goal in your 40s for anyone making six figures in their 30s. Along with generating more wealth, you now have a second, part-time job managing that wealth. Managing your wealth well starts to have a large impact; the difference between a 6% and 10% annual return on a $4 million portfolio is $160,000.
You built the walls of your fortress in your 30's. Now focus on digging the moat and training your army to protect your empire.
# 1 Hit Your F-You N
A conservative F-You goal is $2.5million with no debt. This amount will safely, and for the long term, distribute ~$65,000 per year in income and should cover anyone’s reasonable expenses (assuming you are not living in NYC or SF!). With your career paying you the highest amounts you’ve ever made, saving generously gets easier. You’ll be able to loosen the purse strings and enjoy a few of life’s luxuries as well.
# 2 Start Investing in Your “Get Rich” Account
Recall that the proper distribution of savings should be the basics first (get out of debt, maximize retirement savings, have an emergency fund), fully funding your F-You account second, and then put money in investments with the possibility of generating large returns third. These are the investments that return three times, five times, ten times, or more of your initial investment. Plant those seeds and begin to take some risk. Most will fail; that is the nature of high risk, high reward investments. But given your solid base, you can handle the losses and hold on for the gains.
# 3 Begin “Annuitizing” Part of Your Retirement Funds
I’m a big fan of ensuring that your basic expenses are covered, and taking large risks from there. Unfortunately, your 40's and 50's is a time to do some heavy math. Figure out what your basic expenses will be in retirement, and then add a 25% fudge factor to account for what you’ve missed. Determine how much your social security check will be, and subtract that from your expense number. The difference is what you need to generate from your investment portfolio. As you move through your 40's and 50's, slowly begin transferring retirement assets from risky assets to those that have low to no real growth potential but keep up with inflation and have low to no drawdown risk. Think US Treasury Inflation Protected Securities (TIPS) or short duration, investment grade corporate bonds. These are assets that should be bullet proof. As you move through your 40's and into your 50's, you should have enough of these assets that you’ll be able to purchase, at retirement, an immediate, lifetime annuity that’s inflation adjusted from an insurance company to cover what’s needed from your portfolio. You will not buy said annuity until retirement (if ever), but you should have the capital to do so. Immediate annuities, while expensive, are a fine choice for new retirees, as it takes the risk of running out of money off the table. And if you never purchase an annuity, ensuring that you have enough to do so will ensure that you have enough to last for the rest of your life.
# 4 Focus on Teaching Your Kids Hard Work and Smart Work
You began teaching your children about the basics of building wealth, character, and human capital in your 30's. Now is the time to get specific and prepare them for making it on their own. Teach them to work hard: get educated, continue to grow and to learn, network, and work their butt off so that they get paid well. Then teach them to work smartly: invest wisely, find a way to be an equity owner, build a business from scratch, and prepare their kids for the future. These are crucial times, but if done well, you can give your children a leg up over their peers.
Your 60's and Beyond
Now that you’ve made it to your 60's and beyond, you’ve done the hard work of life and can begin to enjoy the fruits of your labor. There’s still plenty to do, of course, but those tasks relate to educating your (now grown) family, covering your basics for the long term, and enjoying life.
You’ve built your fortress, dug your moat, and trained your army. Now is the time to hold off the barbarian hordes and prepare to hand over the keys of the castle.
# 1 Annuitize Your Basics
Now that you’re at or near traditional retirement age, you may be looking to wind down your full-time career. If so, now is the time to fully annuitize life’s basics. Follow the same math as above, but be more conservative, and consider buying an annuity. You can buy an annuity from a single insurer, or buy it from multiple insurers to spread the risk. If you do the latter, work to minimize fees (you can get to around 1-2% if you shop around and put insurance companies in competition) and find financially strong insurers. If you do not want to buy an annuity, develop a plan to invest in rock-solid assets that pay off through time. A US TIPS ladder strategy, where you have inflation-protected bonds maturing regularly, can provide a solid base. Beyond that, balancing out income growth with downside protection will be your primary concern.
# 2 Get Your Estate Plan in Order
If you’ve done well in your career, and believe in building a Great Family, then preserving assets for many generations will be a goal at this stage. Find ways to transfer money between generations while you’re alive if you have the financial wherewithal to do so. Multi-member LLCs, limited partnership investment vehicles, and equity ownership structures with earn-out structures (to be discussed in a later post) are all possibilities. Beyond that, setting up various types of trusts and ensuring the proper titling of assets will be part of the process. Consult a good lawyer, as the laws and requirements continually change.
# 3 Communicate With Your Family
Do not surprise your heirs when you die! Ensure that your family understands your estate plan, and practice radical transparency by giving them a look into your personal balance sheet. Let your family know how your assets are titled and structured, and what you plan to pass on and what you plan to give away. Have regular updates with the whole family, and don’t be afraid to have those awkward money conversations.
# 4 Plan Your Next Chapter
You’ve put in your time. Now it’s your turn to unwind and relax. Or maybe not. Start planning your next chapter. Maybe you want to fully retire and travel the world. If you’ve built up the assets, then go for it! On the other hand, maybe you still want to be impactful to those around you. Perhaps mentoring or working with a number of charities is in your future. Or perhaps you want to get right back to it and start a brand new company or switch careers. Try it, so long as you do it from a position of strength and don’t endanger your financial future.
# 5 Enjoy Life to the Fullest
Loosen the purse strings and enjoy life to its fullest. Hang out with your grandchildren and teach them like you taught your own children. Go to Tuscany for a month just because you read that book years ago. Plan for your future and your family’s future, but don’t forget to live life to the fullest.
The Path to Financial Freedom is Straight Forward but Difficult
Following the path outlined above is straightforward in concept, but incredibly difficult in practice. Life has a way of messing up the most carefully considered plans. Following these guidelines should allow you to build substantial wealth to be enjoyed in retirement as well as to be passed on to future generations. Only you can ensure that it happens, so get to it!
Keep building my friends.
What do you think? Agree? Disagree? What would you add to this advice? Comment below!