Keeping up with the Joneses

If there is one stage of life in which competing demands for income are most intense, it is when couples first start out. It is a time when they typically make the biggest purchase of their lives — a home — as well as when they begin the most expensive long-term project of all: raising a family. And let’s not forget getting an early start on retirement planning. Precisely because of these many demands, planners advise young couples to get into the saving and investing habit. To demonstrate the challenges facing such couples — and possible courses of action — InvestmentNews created a hypothetical young family and asked two seasoned financial planners, Janet Stanzak and Thomas J. Henske, to review their finances and come up with some solutions.


The Jones family: John, 35, and Jenny, 34, have two children — Jenna, 9, and James, 6.

Income: John, assistant director of human resources at a computer software company, earns $135,000.

Jenny, an accountant at a midsize regional firm, earns $70,000.

Major assets: Residence: single-family house purchased in 2005 for $425,000; now worth $375,000

Retirement funds: John’s 401(k) account, $40,000

Jenny’s 401(k) account, $3,000

College savings: $25,000

Emergency savings: $10,000

Major liabilities: Mortgage balance:
$380,000 (30-year fixed), at 6.5%; monthly payment (plus taxes and insurance), $2,951

Credit cards: Payments of $300 a month on total debt of $15,000

Insurance: John has a term life policy through work with a death benefit of $675,000, for which he contributes $1,200 a year; Jenny has a term life policy (also through work) with a death benefit of $350,000, for which she pays $600 a year.

Concerns:
College and retirement saving. Now that Jenny has returned to work after a five-year hiatus, the Joneses would like to ramp up saving for college and retirement. But the couple is not sure where to invest after the 2008 market crash erased $20,000 from John’s 401(k) account. The market rebound last year has restored about $10,000 of that.

Credit card debt. To landscape and furnish their new home, the Joneses ran up $15,000 in credit card debt. They don’t know whether they are making a sufficient monthly payment on the balance.

Inheritance. Jenny expects to receive a $50,000 inheritance following the death of her grandmother. They don’t know what to do with that money.

Mortgage debt. The couple is also concerned about owing more on their mortgage than their home is worth. They don’t want to move, but have heard about people walking away from “underwater” mortgages.

Ms. Stanzak’s solutions

COLLEGE SAVING
Using a college savings calculator, I ran one scenario for James, assuming that half, or $12,500, of the current college funding dollars are designated for him. To fund 100% of a four-year college — $220,065 — would require monthly contributions of $653 (assuming college costs rising at 6% per year and a 7% return on investment). That’s just for James, and does not include the calculation for Jenna. Funding 100% may not be realistic. As for specific investments, consider Section 529 plans. After-tax contributions to a 529 plan grow tax-deferred, and distributions to pay for the beneficiary’s college costs come out federal-tax- free. Some states offer tax incentives to investors as well.
RETIREMENT SAVING
A good goal would be to maximize their 401(k) contributions — the maximum deferral is $16,500 in 2010 — or to make annual contributions of 10% to 15% of income. The Joneses should consider completing a retirement analysis to determine the appropriate amount to save and invest each year. Also, a complete risk tolerance assessment is needed to determine an asset allocation with which they can be comfortable and which also helps them meet their goals. Their current portfolio provides no diversification. Typically, a diversified portfolio includes cash, fixed income (bonds, CDs), large-cap stocks, small- and mid-cap stocks, international stocks, and often real estate and commodities as a hedge. The couple’s uncertainty after the losses in John’s 401(k) plan suggests that more than 25% should be allocated to cash and fixed income to give the portfolio a more conservative allocation, thus potentially reducing volatility.
CREDIT CARD DEBT
It appears that the $300 a month is the minimum payment. At 12% interest, it would take 368 months — over 30 years — to pay off the cards, and it would cost $14,545 in interest. If they double the payment to $600 a month, it would take 29 months — about 2½ years — to pay off the debt, and it would cost $2,347 in interest. But a better option is to use part of Jenny’s $50,000 inheritance to wipe out all credit card debt. In the future, they should use credit cards only for purchases they know they can pay off each month.
INSURANCE
The Joneses should complete a capital-needs analysis to see exactly how the premature death of either spouse would affect the family’s ability to meet expenses. In addition, the analysis would take into account paying off debts such as their mortgage, credit cards and auto loans, as well as college and retirement funding. This needs analysis would determine how much insurance they actually require. At their age, lower-cost term insurance makes sense, but in addition to the group coverage provided to John, he should consider a policy of his own. The group coverage will end if he changes jobs and a personally owned policy can be maintained, regardless of insurability in the future.
EMERGENCY FUND
They Joneses should build up their cash reserves to equal six to 12 months of income. This can be saved in a money market or in short-term CDs.
MORTGAGE DEBT
They would have trouble refinancing, because they owe more than the home’s value. They could pay down some of the loan balance with the inheritance and try refinancing at that time. They’d have to pay $42,500, plus closing costs, to obtain a $337,500 mortgage with 10% in equity in the house. This would use most of the inheritance and is unrealistic in their current situation.

Mr. Henske’s solutions

COLLEGE SAVING
They are behind in their college savings. To be on track, Jenna’s account should have at least $90,000, and James should have $60,000. They’ve got some work to do in adding regularly to these accounts. From an asset allocation perspective, I always like the age-based models, as they take the guesswork out of this important part of the planning process and help prevent taking an emotional approach to the investing process.
RETIREMENT SAVING
Both John and Jenny should max out their 401(k) contributions. If either of their employers has a Roth 401(k) option, they should take advantage of it. Wherever possible, they should convert any traditional IRAs or former employer 401(k) balances to Roth IRAs. Because the couple sustained losses in the ’08 crash and seem to be uncertain about equities, I would recommend a less aggressive portfolio to ease them back; they can always readjust the portfolio as their risk tolerance matures. Here’s my recommendation: 55% equities (half in emerging markets and half in developed markets), consisting of large-cap core (5%), large-cap growth (11%), large-cap value (11%), mid-cap (8%), small-cap (3%) and international (17%); 27% taxable fixed income, divided among Treasury inflation-protected securities (5%), high yield (4%), investment-grade corporate (14%) and international/ foreign fixed income (4%); and 18% alternatives, consisting of global real estate (2%), private equity (2%), commodities (4%) and absolute return (10%).
CREDIT CARD DEBT
It would seem logical for them to use their inheritance to pay off the debt. Clearly, from a rate-of-return standpoint, it makes sense. Another option would be to pay off a portion of the debt from the inheritance and then pay down the balance down at the rate of $500 a month. This would get them in the habit of putting money aside. When the debt is eventually paid off, they can switch these payments into a long-term dollar-cost-averaging investment strategy and make those payments into a balanced mutual fund portfolio.
INSURANCE
John is significantly underinsured. The rule of thumb is to protect 10 to 20 times your income. Based on an annual income of $135,000, there should be a minimum of $1.35 million of life insurance on John. The good news is that assuming he’s healthy, he could probably get a policy for the same cost — with double the amount of coverage — by going outside of his employer’s plan. This would also protect him, should he leave his current employer or if his company were to eliminate its life insurance benefits. Jenny’s coverage should also be doubled, at least. The same strategy of looking outside her company for a policy would let her do so for about the amount she’s paying for her present policy.
EMERGENCY FUND
They need to build adequate reserves of at least 12 months’ living expenses — about $72,000. They can use the $50,000 inheritance and existing $10,000 in emergency savings to get started.
MORTGAGE DEBT
The Jones’ current mortgage rate, 6.5%, is significantly higher than what’s available in the marketplace today. Unfortunately, the home value is currently less than the mortgage outstanding, which will make it highly unlikely that the lender will allow this borrower to refinance. They cannot just walk away from the house without significant consequences, such as having to declare personal bankruptcy, which would affect their ability to get any type of credit for years to come.