Rethinking your financial plan

by Don Kuehn

It has been almost three years since the financial world went into freefall. In the painful months since the market peak in March 2000, we have endured a months-long rout in stocks, withstood terrorist attacks and the anthrax scare, gotten mired in a recession and watched as a president decided whether to go to war. It's safe to say that no one who had saved money for retirement or other goals has escaped without significant losses.

Three years ago, there was a general feeling that the fundamentals of investing had changed in this era of computers and high tech. The old laws of economics didn't seem to apply anymore.

Dreams of retiring at an early age on assets compounded in double-digit multiples have crashed. People's risk tolerance, job security, cash flow, assumptions about future market performance and retirement savings rules have been altered radically by the events of the past three years. The focus, most of us now realize, should be on long-term security and asset protection, not on dizzying, nosebleed returns with no regard for risk.

That new, clearer focus is causing many people to rethink their strategy and alter their decisions about what to do with their money. Building a "financial plan" involves a number of aspects including savings, investing, insurance, retirement planning, taxes and estate planning. When all parts of the plan are in sync they should help you make, save and protect your assets so that you can meet your long-term goals.

It's never too late to get your affairs in order. In fact, the reversal in the markets may be just the catalyst you need to start, or to review, your plans to build and protect your assets for the future.

When it comes to savings, an emergency fund sufficient to get you through at least six months without a paycheck is essential. Thousands, no, millions of people, have lost their jobs in the shake-out of the recession. Workers who depend on bonuses have found that they're off by more than 30 percent on average. Consider your worst-case scenario and decide how much you would need to have in your emergency savings to avoid tapping into your retirement or investment funds if your earnings stream were to run dry.

When it comes to investing, the key is to limit your risk so that you don't suffer again when the market hits its next rough patch. But limiting risk does not mean avoiding it altogether. Unless you are willing to accept reasonable risk, your money will not grow at inflation-beating rates. That means you lose purchasing power on the money you save. You can limit your risk by diversifying and by paying careful attention to asset allocation.

Investments should be divided among stocks and bonds, preferably through good, no-load mutual funds selected to keep taxes and fees as low as possible. The equity portion of your portfolio should contain small-, mid- and large-capitalization funds as well as a mix of sectors.

A common mistake many people made when the market was churning at a rapid boil was having too much money concentrated in the high-technology and telecommunications sectors. Avoid chasing the "flavor of the month," and trying to time the market or catch the latest media craze.

The insurance aspect of your plan isn't a question of "should I, or shouldn't I?" it is a matter of "how much?" and "what kind?" For most people, term life insurance is preferable to whole- or universal-life products. It's least expensive and can be purchased for the period of your choice. When the mortgage is paid off or after you retire, you may want to reduce the amount of coverage you have.

Equally important for just about every wage earner is disability insurance. You want enough coverage to replace about 70 percent of your pretax income in the event that you are unable to work. If your employer provides disability insurance, check it out. It probably only replaces 40 percent to 60 percent of your salary and may have long waiting periods before benefits actually begin. You can buy a supplemental policy to make up the difference.

Older workers and retirees should consider long-term care insurance. The younger you are when you first purchase this insurance, the less it will cost.

If you had a retirement plan based on the old reality of the pre-bust market performance, it's time to wake up. Many forecasters are predicting returns in the 7 percent to 9 percent range over the next decade. This is in sharp contrast to the historic 12 percent returns we were told to expect from the stock markets a few years ago. This means you are going to have to save more, work longer or take more risk to make up the difference.

Adding to the uncertainty is the fact that fewer workers are able to depend on fixed pensions as 401(k) alternatives continue to grow in popularity. These self-directed plans require a degree of savvy to get the maximum return for retirement. And as Enron workers found out the hard way, there is no guarantee that investments--especially in company stock--will produce the results you can retire on.

There is also a perception that Social Security will need to be tinkered with in order to guarantee benefits past the first third of this century. Whether Congress will step up and make minimal changes or destroy the program with privatized accounts is anyone's guess, but Social Security is sure to be the hot-button issue of the next decade.

The solution for individuals is to max out investments in employer-provided retirement plans, put as much as possible in IRAs, and tilt investments a bit more toward stocks rather than fixed-income investments.

Make the most of the new tax laws by putting as much as possible into investments that defer or exempt taxes. Under the 2001 tax law changes, the maximum contributions you can make to many kinds of investments--Education Savings Accounts, state-sponsored 529 plans, IRAs and Roth IRAs, and 401(k) and 403(b) and 457 plans, for example--have been increased. And for those over age 50, there are new "catch-up" provisions that let you add an extra $500 or $1,000 to your annual contributions.

I've written about estate planning before. The minimum you owe to your heirs is that you put your affairs in some semblance of order. That means naming beneficiaries, having durable powers of attorney, a will or revocable living trust arrangement, and a letter of instruction so that whoever has the responsibility to manage your estate does so as you direct.

Finally, whether or not you have the time to devote to the task, consider getting professional help. Changes in applicable laws, the outlook for certain kinds of investments and milestones in your personal life all dictate changes in your financial plan. Good fee-only advisers can save you and your heirs a bundle by showing you alternatives, strategies and asset preservation options that you may not have considered before.

Go to www.aft.org/pubs-reports/your_money to look at previous articles in this series for more on estate planning (February and March 2001) and finding a financial adviser (October 1999).