Saving for College, Part I

As requested by Luba, we will now delve into the complicated world of college savings. She asked about 529 plans, and is probably interested in an analysis of the different available tax shelters and investment products. We'll get into that, but first we need to discuss when you should be thinking about saving for you child's college education.

The sooner you can start putting money aside to help your children get a higher education, the better; for your children, that is. Certainly, if you plan to pay for the while bill anyway, then it probably also benefits you, but chances are you aren't planning on paying the whole bill by yourself. You also have other future expenses to think about: medical expenses as you get older, retirement, etc.

Here's where I might get a bit controversial: if you can't afford to save as I outlined in Saving and ALSO max out the amount you can put into a retirement tax shelter every year (IRA, 401k), then you have no business saving for your child's college education. Here's why:

-Your kid might not go to college. You will retire (or die, and then the account goes to your next of kin).
-Your child can get scholarships, subsidized loans, and other cheap financing for college. Let me know when you can get that sort of stuff for your expenses when you're 75.

This is like when you're flying and learning about using those oxygen masks: put your mask on first before assisting others. Like many finance decisions, it pays to think about the long-term.

Look for Saving for College Part II later...

Points are for Sports, Pay Attention to Percentage in Finance

The next time you are watching, listening, or reading the financial news, pay attention to how the stock market numbers are reported. Chances are, Carl Kasell will say something like "The Dow was up 80 points today to 7,752; the S&P 500 was up 17 points today to 835."

All right, Quiz Time! You have three seconds to answer the following questions (no calculators).
Which index did better today?
By how much?

Let's find the answer together. Imagine you had a little over $15,000 that you could invest in these two indexes. You invest about half in the Dow and the rest in the S&P 500. You bought one share of the Dow yesterday for $7672 and have $7,752 in that investment today; an $80 increase. You bought nine shares of the S&P 500 yesterday for $7362 ($818 each) and have $7515 today; a $153 increase. You invested less money in the S&P 500, but made almost twice as much! Answer the quiz question again.

The important measure for change in the value of an index (or any other security) is the percentage change, not the dollar or point change. A lower priced security going up 10% is better than a higher priced security going up 5%. You can just buy more shares of the lower priced security to gain the same numbers of dollars invested.

Understandably, a news anchor only has so many seconds to report on the markets. They should use this little amount of time to report the current price and the percentage change, but they could drop the point change. Someday I hope you will hear Carl say something like, "The Dow is currently at 8246, down 0.42%." Isn't that information more clear, and less sensational, than 35 points?

What is stock?

When I don't get questions from my readers, I write posts like this one. I'll describe a financial/economic theory, instrument, or idea. Many of you might already know this stuff, but I'm sure someone out there has no idea.

Today, I'll explain what stock is and how it is created. I'll try to follow up another day with how it is traded and changes in value.

Simply, a share of stock represents ownership of part of a company and the profits that company produces. I'll explain the details with an example.

As many of you know, before I started graduate school in Finance, I was working at a school running the Technology Department. I've continued to do some technology consulting at a couple different places to help pay the bills while I'm in school. For tax purposes, I created a business to do this work. Most of my income is earned actively doing consulting, but I also run a server at home that provides off-site data backup for clients.

So, right now, I own my company, all its assets (the server and other equipment, the cash in the checking account, the name, the license with my town, etc.), and future earnings the company may produce. Let's imagine, though, that the off-site backup services of my business grow significantly. Let's also assume that this is all the company does now; no more consulting. This would require buying more equipment to provide more space and faster service. If I (the company) have enough cash to make this investment without help, I'll just buy the equipment myself, but what do I do if I need to buy $20,000 of stuff and I only have $5,000. Well, I have a couple feasible options to get the extra $15,000 I need.

My first choice would be to go to my bank and get a loan, but let's say they turn me down because they think my expansion plan is too risky. My next option would be to look for an investor. I would ask someone, let's say my friend George (he's a technology guy too), to give me cash in exchange for ownership in the company. This would be a permanent relationship, as opposed to a bank loan where I pay it back eventually. George would own a part (or a share) of the company.

Let's say the non-cash assets of the company before this deal are worth $10,000. I'm also bringing $5,000 cash. George brings another $15,000 cash. So we each bring $15,000 to a deal that creates a business worth $30,000, meaning that we each own half the company. We could incorporate the business, create two shares of stock, and each of us get one share. No matter what happens to the total value of the company in the future, each of us owns half of it. We share good times and bad equally.

Now there is work to be done to keep this business going, and I'm the one who knows how it all works, so I'll probably still be doing that work. The company will need to pay me a salary for that work. After all the costs of running the business, including my salary, there will hopefully be profits. These profits will be shared equally between George and me, because we each own half the stock in the company. When these profits are paid out to us, they are called dividends. Also, decisions that involve spending these profits on the business (say, for future expansion) will need to be approved by both of us.

Again, this arrangement is permanent. There are ways for one or both of us to sell our ownership of the company, but an explanation of this process will be the topic of another post.

Notice how much I've used the word "share" in this post. Shares of stock are named as such for a reason.

AIG bonuses

This is my first post in response to a posted question. Does this mean my blog has grown from its infancy into toddler-hood?

In a comment to my posting about Capital Requirements, JD asked for my thoughts about employee salary structure and the public backlash to AIG paying bonuses with government bailout money.

This is a politically charged topic and the details of the AIG mess are still surfacing, so I'm wading into murky waters on this one. I'm going to start by describing how I think salaries should work, in general, and we'll see if I can answer JD's question without offending anyone.

In much of the private sector, an employee's main monetary compensation is based on three sources: salary (the weekly paycheck), profit sharing (the company does well and you get a piece), and an individual performance bonus (you do well as an individual and you get some extra). These should all be spelled out in an employment contract and have as many measurable benchmarks as possible to determine the amounts paid. Let's talk about each source.

Salary should be static and the company should pay it without issue as long as you don't violate your contract. Doing a crappy job doesn't merit docking this pay. In most cases, the only out a company has on this one is to fire you. This pay is usually transferred in the form of weekly, biweekly, semimonthly, or monthly pay checks.

Profit sharing is based on how the whole company is doing. As the name implies, the company is sharing some of the profits with you. This payment is not directly related to your performance. You could do a great job or a horrible job, but all that matters is how the whole company did. Imagine you are a salesperson at GE in the jet engine division. Your sales are way down, because the recession is hurting the airlines and that means the airlines don't want to buy new airplanes. Meanwhile, the microwave division has been doing really well as people eat in more to save money. If GE were just composed of those two divisions and microwave's successes outweighed jet engine's failures, GE would make a profit and ALL the employees would get a profit sharing check.

Individual performance bonuses are dependent upon your personal performance in your job. When designed and funded well, these are independent of company profits and other things you cannot directly control as an employee. How efficient you are, your sales numbers, how well you work with your colleagues, and finishing projects ahead of due dates are examples of qualities that may merit a bonus of this type. This bonus shouldn't have an automatic minimum, but there should be an amount awarded for just "doing your job." It doesn't need to be much, but having this base floor allows an employer to withhold money to punish you for screwing up without having to resort to drastic measures like firing you. Remember, they have to pay your salary and profit sharing, despite your performance, unless they want to fire you. If you do your assigned job (or better), you should get this bonus even if the company is doing horribly and getting taken over by the government.

That is how those terms are defined objectively, but companies often setup reimbursement practices that meld different aspects of those together and call them bonuses. Some companies always give their employees a "Holiday Bonus" except when the company is failing or a particular employee screws up. This is profit sharing with a withholding option for bad employees.

AIG claims to have contractually obligated Retention Bonuses that it had to pay to its employees, even the ones that caused all the trouble the company is dealing with. These aren't bonuses, they are salary. If the company is obligated to pay despite employee or company performance, then it must be salary. If that is the way the AIG contracts were written, we need to honor those contracts, but don't call them bonuses. It's a misnomer.

That said, AIG had more options than they often talk about. Again, these are Retention Bonuses. AIG was contractually obligated to pay them if they wanted to sign these employees on for another year of employment. These sorts of salary devices are used to keep your employees from quiting and going to work for a competitor. The question is, why would AIG think that they needed to do this? In this employment environment, there aren't any jobs for those employees to go take if they did quit AIG. AIG could have said, "We are happy to have you work here for another year, but we are going to renegotiate your contract to remove the Retention Bonus. Quit if you like." Plus, there are plenty of people willing to take the AIG jobs if the current employees did quit. I know a about 40 Boston College MSF students who are graduating this summer and looking for work in Finance. Call us.

Capital Requirements

I was driving home from class tonight and heard part of an episode of Fresh Air on NPR. Terry Gross was interviewing a journalist from The New York Times about AIG. They were going through the notable topics of the nice ride that AIG has given us around the block, how much they paid the drivers, how much change is falling out of our pockets into the back seat, and so on.

Anyway, the guest used the term "Capital Requirements" a number of times. Lots of other media folks use it too, but I'm not confident many people know what that means.

A little setup:
The US government lends money directly to private banks. Other countries do it too and it happens every day, not just in times like now. I'll explain how that all works another day. Banks generally take this money and lend it to other banks. Banks also borrow from other folks (your savings account) and lend it to others (your brother's car loan). This is a big way that banks make money: borrow money from someone at one rate and lend it out someone else at a higher rate.

Another setup point:
These banks are somewhat protected by the same government that lends cheap money to them. At the very least, their depositors (you and your checking/savings/CD account) are protected through the FDIC if the bank goes bankrupt. They might also be deemed "too big to fail," which has other protections that are harder to specify.

Now, imagine you decide to go start one of these banks. You set up shop, borrow money from the government, lend it out to your brother and his friends, and take a tidy profit home every night. Think about this for a minute and you will probably start doing it more and more. All you need is some cash to run the office and do marketing, and you can ride the borrow-lend-profit train all the way home. Not only that, but if things go badly for your bank (your brother's friends are deadbeats) you can just close up shop and let the government take on the losses. You lose the bit of cash you were using to pay your expenses, but you can go start another bank tomorrow with the rest of your money.

The government can see this plan as clearly as we can, so they protect against that. They require that banks put a few cents in the game for every dollar that is lent. The number of cents changes, depending on the bank, the type of lending it is doing, the economy, politics, etc. This helps to make the incentives right. If a bank has to put $10 million of its own money on the line to borrow $90 million from the government, the bank won't just lend out the $100 million willynilly. It will try to make good and profitable loans, because it knows that it will lose its $10 million if things go bad. In fact, that $10 million is supposed to be the first money that is lost when things go wrong.

Those cents are the "equity" and the dollar borrowed is a "liability." These are both parts of the capital structure of the bank, which is why these are called Capital Requirements.

If you've bought a house with a mortgage, this probably sounds familiar to you. Your down payment was a capital requirement. That hard earned cash in your house is one of many things that motivates you to keep the building and property in good shape, because if you sell the house for less than you bought it you will be the one to take the first loss.

Saving

For almost all topics of personal finance, I think that general advice given to a group of people is unwise. Every person has different financial needs, abilities, risk tolerances, etc. Successful finance requires individual thought, analysis, understanding of the system, and some work. Nothing worth having is free, right?

One exception to this rule, though, is my advice about saving. Everyone should save, all the time. Not only when you get a raise, not only when your grandmother gives you gift, not only when you get a tax refund, ALL THE TIME.

Saving is the best kind of insurance you can have. You give up a little bit every month to build a safety net when something goes wrong. Not only do you have that buffer from financial hardship, but if you are lucky enough to get through ten years of your life without having to use your savings, you have a nest egg that can help buy your first home or get transferred toward your retirement savings.

For those of us who do have something go wrong, savings allow us to weather the storm without relying on potentially hazardous (and more expensive) financial tools like credit cards, second mortgages, and loans from family or friends.

So how do you save easily? First, go get your last pay stub. Right now, go get it. Look for the number that represents your pay before taxes and other deductions. Multiply that number by 0.1 or 10%. You should save at least that much of every paycheck.

You should consider this as important as paying your rent or mortgage. Make the life changes necessary to make this work. If you can afford to save more than 10%, then do it. Your future self will thank you for it. I know it will be painful, but you'll get used to it. Imagine if you had just gotten paid 10% less for the last 5 years. I bet you would have made it work.

So why weren't you doing this already? Americans used to, and other cultures still do. I think the credit revolution of the 20th century allowed us to slack on this one, and we found that temptation too alluring. I'm not dissing credit, it is a very useful tool, but access to credit is not the same as having savings.

The saving habit starts early in life. When your parents gave you that first 50 cent allowance, you should have asked for it in nickles so you could put one of them in a steel-hardened piggy bank. Think about this with your kids, students, and self.

Basics Terms in Retirement Investment Planning

If you have spent any time thinking about investing or building a retirement savings, you've probably heard a lot of different terms related to the subjects. I notice that people often confuse the investment options with tax options involved with retirement investment.

This is a huge topic, and I'm not going to be able to describe it all in one posting. Instead, today I will explain the difference between an investment vehicle and a tax shelter (in relation to retirement planning). I plan to explain more details later; let me know if you want me to cover certain things sooner than others.

An investment vehicle or asset is an item you pay for with the hopes of getting more money later. Examples include stocks, bonds, CDs, options, futures, mutual funds, etc. If you don't know what those are, we'll talk about that later. In fact, I think we'll get into what stocks are soon.

A tax shelter is an account that is given specific tax breaks by the government. Retirment examples include IRA, Roth IRA, 401k, and 403b. Any number of investments can be inside one of these tax shelters.

The big take away here is that a tax shelter is NOT an investment. Just putting money into your IRA isn't enough. You also have to invest it in something, like a mutual fund or a CD.

The Two Flavors of Finance

There are two general areas of Finance: Asset Management and Corporate Finance.

Asset Management is named well. It involves the allocation and investment (management) of stocks, bonds, dollars, euros, gold, commodities, real estate, etc. (assets). People who work at brokerages, mutual funds, hedge funds, stock exchanges, endowments, etc. are doing Asset Management work. This is what I want to do with my career.

Corporate Finance is all about finding money for your company. This happens at all companies, not just financial firms. I'll explain with an example: SOL Inc. wants to build a new solar panel factory, but they don't have the cash to pay for it right now. Their Corporate Finance folks will figure out the best way to get the money to build the factory. They might get a loan from a bank, sell bonds, sell stock, etc. Each of these options has different pros and cons, which will be different for each firm, which is why different firms have their own finance professionals on staff. This staff is often led by the CFO (Chief Financial Officer).

Getting Started

I have set up this blog to discuss issues of finance and economics as they apply to all people. If the current crisis has taught us anything, ALL issues of finance apply to all people. So, there is a lot to discuss.

I often have friends asking me to explain finance stuff, and I am usually able to do so successfully with enough time. This blog allows folks to get some answers without being forced to listen to me blabber for 10+ minutes.

Although I think I know more than the average citizen when it comes to this stuff, I am not an authoritative source. Some may disagree with my thoughts and answers to questions. I welcome suggestions, corrections, and even spirited debate.

Most of all, I ask for questions. They will be the driving force of this blog.

Future posts could get long, so I'll keep this one short. Thanks for reading!