Personal Finance – Week 3 Reading

Saving and the Automatic Investment Plan (AIP)

By Dr. Mark Skousen, Grantham University
Copyright 2011, Grantham University

“Two of the hardest things is to save when you’re young and spend when you are old.” --Anon.

“Any fool can waste, any fool can muddle, but it takes something of a man to save, and the more he saves the more of a man does it make of him.” -- Rudyard Kipling

In order to get your financial house in order which of the following actions should come first?

· Decide to have more tomorrow than you do today

· Start saving at least 10% of your income.

· Pay off your mortgage.

· Paying off your credit card and other debts.

· Get a pay increase.

· Start a new business.

· Sell off assets and use the proceeds to pay off loans.

· Other (specify)

I will argue that the most correct answer to “A” in conjunction with "B". They go together...the cause and the effect.

Putting savings first, ahead of paying off your debts, getting a raise, or starting a business, is the key to financial success. You must learn from Day 1 that living within your budget and saving regularly is the key to financial success.

If you were to ask the average persons on the street what they needed to solve their financial problems, the overwhelming response would be “more money.”

A Gallup poll taken several years ago concluded that a majority of Americans felt certain that they could solve their money problems if they just had ten percent more income. Interestingly, even high-income earners agreed. Ironically, however, people have been getting ten percent more income for years, but they still face serious financial challenges. Why doesn’t the extra income help?

First, it instills responsibility and self-discipline in your life. You need to master money, rather than let it master you. If money controls your behavior, you will forever be in debt and financial worry. But if you control money, it can work for you and give you financial happiness and independence. Also, by mastering your financial desires, you will be able to avoid the greed that allows so many people to be tempted by get-rich-quick schemes.

Second, it is the key to achieving personal goals. If you want a new home, a better education, a retirement income, influence in the community, or other good things in life, you must have the funds to attain these goals. As you build a long-term saving plan, you will slowly but surely fulfill your desires.

Third, it is a proven method for attaining financial independence. There are many roads to riches, but all are not suitable. Most financial books have one overriding message: They way to financial success is by earning a lot more money. They tell you how to get another job, start your own business, or invest in the stock market or real estate. But, as we have emphasized, earning more money is no sure way to financial security because, no matter how great your income, if you over spend, you will have little to show for it. Besides, not everyone wants to be an entrepreneur, salesman, or real-estate speculator. Most people end up working for others as salaried employees, wage-earners, or company executives.

What’s the safest, most secure, way to be financially success? Always spend less than you earn -- year after year -- just like Arkad in “The Richest Man in Babylon.”

Two Roads to Saving Money

Okay, you need to save. What’s the best way to go about it?

There are two roads to personal wealth. One is to earn more money, and then set aside 10% toward savings and investing. Another is to save 10% or more out of your current income by cutting back on wasteful expenditures.

I recommend the second approach, so that you start saving immediately, without looking for ways to cut back to make room for savings. Put savings first. Reward yourself immediately by putting savings ahead of all else -- before your bills, before clothing, before the rent, and even before food on the table. This may seem like a drastic measure if you owe a lot of debts, but it will reap enormous benefits over the years. Putting savings first is a critical first step. If you don’t follow it, you will never have “enough.”

You do this by paying yourself at the beginning of the month, rather than the last of the month. If you wait until the end of the month to pay yourself, usually nothing is left over -- except maybe last night’s vegetables (as my wife says).

I will show you in a moment what the best ways are for saving money automatically at the beginning of each month. This is particularly true for military service members who have unusual opportunities to accumulate wealth while in the service of their country.

Consider the following reasons:

First, persons with additional income may wish to increase their standard of living, particularly if they feel they can enhance their social status with friends and colleagues. They may want to move into a nicer, larger home which will result in higher monthly housing expenses. They may want to eat out more, buy more expensive clothes, or purchase a new appliance or a new car. People’s perception of their “needs” can expand rapidly when their means (income) increases. Desires are insatiable; there is always one more thing that would be nice to have.

There is nothing wrong with satisfying some of these desires, as long as there is sufficient money to pay for them. But too often the extra money is spent and gone with nothing of lasting value to show for it.

Second, sometimes increased income can make it easier to go into debt, obtain “easy credit” with credit cards and bank loans. Many middle-class and higher-income families have seriously abused their credit on consumer purchases, thinking that a new raise will cover the monthly payments. We discuss debt and credit cards in the Module 4.

It’s easy to become overextended in the excitement of having additional money to spend, particularly if it’s an unexpected windfall. Don’t be like one family we know who received a small inheritance. The wife decided to redecorate the living room, the husband wanted to take the family on a first-class vacation; they both agreed that they needed a second car. In the end they decided to do all three -- even though the inheritance was only enough to pay for one of these choices.

Third, a person who lacks long-term financial goals may succumb to impulse buying. In one case, a single woman in her early twenties had no desire to save money, even though she had a high-paying job. She lived with her parents and had very few fixed expenses. Consequently she spent all her extra money on new clothing -- month after month. Eventually, when she decided to go to school and get a college degree, she had to borrow the money for tuition because she had spent everything she earned. The fact is that wealthy people often get into trouble, and even occasionally file for bankruptcy. Quite a few famous celebrities and multi-millionaires have ended up bankrupt because they handled their finances poorly or turned their money over to misguided advisors. Examples include the boxer Joe Lewis, the actor Mickey Rooney, and Las Vegas singer Wayne Newton.

How Much Should You Save?

Traditionally, the more income you earn, the easier it should be to save. Some people save 10%, while others save half their income. Americans are notorious low savers compared to Europeans and Asians. See the chart below.

Household Saving Rates (2011)

China	38.0%
India	34.7%
Spain	17.0%
France	15.2%
Switzerland	14.7%
Germany	11.4%
Italy	7.5%
Brazil	6.8%
UK	5.4%
USA	3.6%

Source: OECD

Japan used to have a high saving rate, exceeding 15% in the mid-1990s. Today it’s at 3.2%, the sharpest drop in saving rate among industrial nations.

We recommend a simple 10% saving rate as a minimum for all individuals. This is higher than the national average, but if you want to increase dramatically your financial independence and eliminate waste, 10% is a good place to start. Tithe yourself 10%!

John Barnes, a financial counselor, has written: “You must learn to pay yourself first….deduct this amount each month from your paycheck, or your profit if you are self-employed….It is surprising how soon your budget will adjust itself to our savings program. Within six months you won’t realize the difference…A good rule to follow would be to save a minimum of 10 percent of your gross income.” (emphasis added) The Money Book states: “If our income dropped by 10 percent tomorrow, we could quickly adjust to spending less money after going through an uncomfortable but brief adjustment period.” Why 10%?

First, it’s easy to figure. If you paycheck is $3,000 a month, you save $300 a month. If your retirement check is $2,000 a month, you put aside $200 each month. If you are a salesman working on commission, if you receive a bonus of $1,000, you save $100. And so forth.

Second, it’s reasonable and affordable. Everyone should be able to reduce spending sufficient to save 10%.

Third, it’s regular. The key to building wealth is to have a consistent savings program. Pay yourself 10% every time you are paid. It’s easy and convenient.

Fourth, it hedges against inflation. As your salary or wage climbs, the amount of money you save will automatically adjust upward. If you get a 15% raise, your savings should increase 15%. Some people wonder whether they should save 10% of gross income, or 10% of take-home pay. It’s up to you. You will save more if you set aside 10% of gross income, but 10% of take-home pay may be easier to figure.

Three Principles of Financial Success

Now that we have established the key principle of a 10% savings plan, how do we go about it?

There are three principles to keep in mind when it comes to maintaining a permanent savings plan.

· First, find your "lazy dollars"

· Secondly, make it easy to deposit your savings.

· Third, make it difficult to withdraw your savings.

· Fourth, invest your savings wisely.

Let’s see why each of these steps is essential.

Principle #1: Find your lazy dollars

We all have lazy dollars. What are they and where are they? They are dollars not working for you and working in all likelihood for someone else, perhaps Mr. VISA, Mr. AMEX etc. High interest credit cards are prime sources of lazy dollars. Another source is taxes. Many overpay throughout the year and like to get that big refund in the spring. Question: Why let anyone hold your money without paying interest all year when you just might be able to earn some yourself in it. Example: let’s say your income tax return was $240. That is $20 a month. If you just took that $20 every month for thirty years would it be significant. You bet. It would be worth $16,830 if you got just five percent. Where are you going to get five percent? We will discuss this later in the course. Just suppose you got eight percent. The answer is now $26,540. The longer you do it the better it gets or as the old saying goes …”the luckier you get.”

Principle #2: Make it easy to save regularly.

In order to save on a consistent basis you need to make saving convenient and painless.

You could decide to write a check every time you get paid, or once a month. If you adopt this formula, I can guarantee you that within a year you will no longer have a regular savings program. Why? Because if you get paid every two weeks, that means you make the decision to save 26 times a year! On many occasions, you will be strongly tempted to delay or miss a payment to your bank or investment account. Perhaps you have an unexpected emergency, or it’s the Christmas season, or August, when back-to-school purchases quickly add up. It’s all too easy to give up on your savings plan when sudden immediate needs seem to be pressing on you.

If you are in the military service you have others who will do the work for you. It is called a military government allotment. It is your passport to financial independence.

Automatic Investment Plan (AIP)

For easy investing, I recommend you open up an investment account with your favorite discount broker (such as Charles Schwab & Co., E-Trade, or Fidelity). Have them institute an “Automatic Investment Plan” (AIP), where you instruct them to withhold a certain dollar amount from your checking account at the first of the month and invest it in a designated investment or money market account. Almost all banks, brokerage firms, and insurance companies offer these services.

All investment companies, financial planners, financial advisors, insurance companies and even banks and credit unions are familiar with the AIP through either the electronic funds transfer program, the automated clearing house system or direct deposits from employers to accounts of your choosing.

Automatic Deposits

Another way to increase significantly your saving and investing is to have your pension or retirement checks, including Social Security checks, automatically deposited directly into your investment or bank account. I recommend this approach for retirees who don’t need all their monthly payments or pension funds to live on.

Join an Investment Club

You might also want to join an investment club. Thousands of clubs have been established over the years through the National Association of Investment Clubs (NAIC). A group of like-minded individuals get together in a town and establish a low-cost investment plan. Investment clubs generally have three principles:

1. Invest a set sum of money regularly. Most clubs require members to contribute at least $50 a month.

2. Reinvest all dividends from stocks and bonds.

3. Invest in growth stocks, companies that promise to be more valuable in the future.

Joining an investment club has many benefits -- making it easy to save and a great way to get to know people and develop new friendships.

Advantages of Automatic Saving and Investing

The advantages are tremendous of “automatic” saving and investing.

First, you make only one decision to save, not 12 or 26.

Automatic payroll deductions or monthly AIPs by your brokerage firm, bank or insurance company take human nature into account. We noted that if you have your own savings plan, you will have to make 26 decisions to save or not to save each year, assuming you get paid twice a month. Or 12 times if you have a monthly savings plan. However, using payroll deduction or AIP plans, you only need to make one decision -- when you set up the withholding or the account. Once you have made this single decision, you will be reluctant or even too lazy to discontinue it, even though at times you may be running short of cash. Payroll deduction programs are very popular among employees of major corporations and government. Studies have shown that those who use an automatic deduction plan tend to save more than those who don’t.

Second, automatic deduction is a painless way to save.

There’s an old saying in the finance industry, “You don’t spend money you don’t see.” If you savings are withheld from your paycheck, you won’t miss the money so readily. It is much more difficult to save if you are given the full amount first, and then asked to put aside cash for savings.

The government has applied this principle for years when it comes to income taxes. If taxes were not withheld automatically from our paychecks, very few of us would have the funds to pay the huge tax bill we would owe by April 15. The tax money would have been spent long before then. So the government cleverly started withholding during World War II as an “emergency” measure. Now it’s permanent and allows government to be far larger than it would be without withholding.

This reminds me of a story of a company president who was upset about the high amount of taxes he was paying. Yet he couldn’t get his employees to understand his plight. So the company president conducted an experiment. On the next payday, he arranged to have all his employees come into the payroll office and pick up their checks in person. But this time he paid all of them their gross pay in cash. At one table, he handed each worker his cash. Then he asked his employees to go to the next table, where they would have to pay back in cash their share of each item of withholding. This was a very long table. There were signs posted, one marked “Federal income tax,” another “state income tax,” another “Social Security” and “Medicare,” and finally “unemployment compensation.” Each employee had to shell out specific amounts for each category, all in cash.

When the workers completed their task, their reaction was unanimous. They were furious. Many of them previously had no idea how much they were paying in taxes. Until now the amounts withheld had just seemed like a lot of numbers that had nothing to do with real money. They had just looked at the net take-home pay, and little else. Now that they had the opportunity of holding their full earnings in cash and then having to give a large chunk back, they were away of how much they were paying -- and it hurt.

You don’t want your savings to hurt. You want it to be as painless as possible, like taxes. As you can see, an automatic payroll deduction can be a painless way to save….and, unfortunately, a painless way to tax as well.

Third, payroll deduction and AIPs do not require a big investment. 

There usually is no minimum investment to begin a payroll deduction plan, or an AIP with your financial institution. So there is no excuse for you not to start right away.

Fourth, payroll deduction and AIPs allow you to “dollar cost average” your investment. 

If you invest $100 a month in a market that fluctuates a great deal, such as the stock market or gold, you will end up buying different amounts of stocks or gold each time, as the price changes. Dollar-cost averaging allows you to average out those dips and rises in the market. As the market goes up you buy fewer shares, and as the market goes down you buy more. After they are bought they forget what you pay for them and they become just shares. Dollar cost averaging prevents you from buying too many high priced shares, and allows you to buy many low price shares. You don’t have to do anything it is automatic. Over time, inflation alone will drive up prices and you will enjoy a gain under those circumstances.

Fifth, a payroll deduction plan or AIP can help you get out of debt.

The same principle that makes it easy to save can make it easy to pay bills. Credit counselors often recommend using a payroll deduction program, particularly if the company credit union is handling the repayment of loans through debt consolidation. Fortunately, there are a number of alternatives that can make it easy to save and convenient for you to deposit your savings regularly. One of the best ways to begin a long-term savings plan is through an automatic payroll deduction program where you work. Virtually all employers offer payroll deduction programs, so that you can invest regularly in a savings program, or 401(k) investment plan. Companies already withhold money from your paycheck for taxes, Social Security, medical insurance, etc. In addition, almost all employers can withhold funds to buy company stock (often at a discount), US Savings Bonds, annuities, or mutual funds.

Hands On Activity: Review your employer’s withholding program and see if your company is withholding at least 10% of your income and investing it in a savings or retirement program, or a combination of the two.

Automatic Withdrawals from Your Checking Account

Payroll deductions are the most convenient way to save because you never see the money in the first place. But another possibility is to take advantage of “automatic withdrawals” from your bank.

Most banks allow automatic withdrawals to be made from your checking account. You can arrange with a brokerage firm, a mutual fund, insurance company or other financial institution to have a certain amount of money automatically taken out of your checking account and deposited into the investment of your choice. The arrangement is simple. You give them a voided check and tell them how much you want deducted every month from your checking account, and they do the rest.

I will show you in a moment what the best ways are for saving money automatically at the beginning of each month.

Our approach does not require you to get a raise, find another job, sell household products, buy real estate, or become self-employed. It works using your current income, whether you are working for someone else or for yourself. The key to success is to save part of your income, and then to invest it wisely. Remember, “a part of all you earn is yours to keep.”