We’re continuing our overview of the 10 financial mistakes made by young professionals.
6 | No Life Insurance
Why would a young professional need life insurance? Let’s first define what life insurance is. It’s a contract between you and a life insurance company, in which you pay premiums to the insurance company, and the insurer promises to pay your designated beneficiary a sum of money (i.e. the death benefit) when you die.
If you’re married and you and your spouse have commingled finances, you might want to have life insurance to pay off debt. For example, if you own a house together, the life insurance proceeds can be used to pay off the mortgage, if one of you were to predecease the other. If you have student debt, life insurance can be used to pay it off if you were to die before making all the payments. If you have children, life insurance will allow you to leave funds for their care and education should you die prematurely.
There are two basic forms of life insurance. Term insurance is equivalent to renting the death benefit. It’s inexpensive, particularly for young professionals who are in good health. Permanent, or cash value, life insurance builds equity over time. The premiums are higher than for term insurance, but you accumulate cash in the policy.
If your need is short-term, buy term life insurance. If you think you may want to have life insurance in place for your entire lifetime, buy permanent insurance.
If you don’t know how much or what kind of life insurance you should have, work with a professional life insurance agent or broker. Try to find an agent who carries the Chartered Life Underwriter® (CLU®) designation from the American College.
7 | Not Saving Enough
It might seem far away today, but some day in the future you’ll want to retire. In order to retire, you’ll need to accumulate a nest egg which you can use for living expenses in retirement. It’s not too early to start saving for retirement.
Let’s assume that you earn $120,000 per year. We’ll also assume that your combined, overall tax rate is 25% and that your net pay is $90,000. In this simple example, we’ll assume that you’re living on $80,000. If you’re 35 today and plan to retire when you’re 65, you have 30 years to work and save.
If you wish to simply maintain your present lifestyle in retirement, and we assume that inflation averages 3% over the next 30 years, you’ll be spending approximately $194,000 in your first year of retirement. Now the question is: how much will you need to accumulate to maintain that level of spending, adjusted for inflation, over 30 years?
To answer that question, we first need to estimate your benefits from Social Security. Given your earnings trajectory, you’re likely to qualify for the maximum benefit. Today that benefit is about $3,000 per month, or $36,000 per year. If we inflate that figure at 3% over 30 years, the benefit amount will be about $87,000. So, now you need $107,000 per year ($194,000, less the $87,000 from Social Security).
Using the “4% Rule,” we can project that you’ll need about $2.7 million at retirement. How are you going to accumulate that much money over the next 30 years? You’ll need to save aggressively. Here’s a possible scenario: Your salary goes up by 5% each year. You save 20% of your salary every year. You earn an average annual return of 7% on your nest egg. If you were to do this, you would have over $2.7 million accumulated at age 65.
Young professionals too often put off saving for retirement. That’s a mistake and you should avoid it.
8 | Missing Out on Your Employer Match
If you work for a traditional employer, you probably have access to a 401(k) retirement plan at work. These plans allow you to defer part of your salary into an account that will grow tax-deferred until you withdraw the funds.
Let’s review the basics. In 2021, you can defer up $19,500 of your salary into your 401(k) account. If you’re earning $120,000 in salary, that’s 16.25% of your salary. Earlier we noted that you’ll probably need to save about 20% of your salary over 30 years to fund your retirement.
But what if you got a savings boost from your employer? Let’s imagine that your employer generously offers to match 100% of your contributions to your 401(k) account up to 5% of your salary. If you defer 16.25% of your salary, you’ll set aside $19,500. If your employer matches 5%, your account will receive another $6,000. The total deferral would be $26,500.
If we go back to our example above, you could get to your retirement goal ($2.7 million) faster, or by saving a bit less. Faster because your employer is adding to your savings. By saving less, because your employer is contributing 5% and you could reduce your savings accordingly.
The point is that the employer match on contributions to a 401(k) plan should never be left on the table. You should plan to make the maximum permitted contribution to your 401(k) account. But if, for whatever reasons, you can’t, at least contribute enough to get the employer match.
9 | Bad Investment Decisions
With the stock market currently hitting new highs, investors are becoming irrationally optimistic. Let’s review a few of the ways young professionals can get burned in the markets.
We’ve seen a dramatic increase in “day trading” activity that harkens back to the early 2000s, prior to the 2000-02 tech crash. This trading activity indicates that inexperienced investors are moving in and out of investments rapidly, because they believe they know something that other investors don’t. One of the fundamental tenants of investing theory is the “efficient markets hypothesis”, which states that securities prices reflect all information and that investors, particularly those who are inexperienced and unskilled, are unlikely to consistently make investment decisions that allow them to outperform the overall market. So, you should avoid frequently trading in and out of positions, and instead adopt a more conservative “buy-and-hold” strategy.
There’s been a related increase in options trading. Options give investors the right to buy or sell the underlying security at a specified (strike) price. Profitable options trading requires that the price of the underlying security move in the direction that you anticipate. If the price moves in the opposite direction (or simply doesn’t move far enough in the right direction), the option will expire valueless and the premium paid for the option will be lost. Options trading, therefore, is highly speculative and should be avoided.
The newest fad for younger investors who typically lack significant funds to invest is “fractional shares.” Interactive Brokers introduced the first fractional shares for investors in the fall of 2019. The objective of fractional shares is to allow investors to invest in companies for which they may not be able to afford the full share price. While this is rather appealing, there’s evidence that it has led younger, inexperienced investors to speculate more with their investing. As a young professional, you’re better off investing in mutual funds and exchange-traded funds across a broad range of global asset classes.
10 | No Estate Plan
In the past, young professionals rarely thought about dying. Then came the COVID-19 global pandemic. As we write this, globally over 100 million have been infected and over 2 million have died. While the virus has hit older, health-comprised people the hardest, there are many cases of young, vibrant people becoming seriously ill or dying from the virus.
The coronavirus has forced us to confront our mortality. Yet death is a fact of life that few of us want to consider. Surveys indicate that more than half of all adults in the US don’t have an estate plan. Not having an estate plan is a big financial mistake. If you pass away without an estate plan you’re leaving important decisions to the government. Let’s review the components of a basic estate plan.
An advanced health directive (or living will) is a written, legal document which indicates your preferences for medical care, if you’re unable to make or communicate them. This can be rather critical. Many Americans have living wills that indicate they don’t wish to have a breathing respirator, if they’re unable to breathe on their own. Yet, we’ve seen with COVID-19 that providing artificial respiration has saved many lives. So, think carefully about the care you wish to receive or decline.
A health care power of attorney allows you to identify someone else to make decisions about your medical care. So, if you’re incapacitated and your advanced health care directive doesn’t address a particular circumstance, the person you appoint can make decisions for you. You might name a spouse, a parent or a sibling as your “attorney-in-fact.”
A financial power of attorney allows you to name a person to make decisions about your financial and legal affairs. This could be the same person to whom you grant the health care power of attorney, or someone else.
You should have a will, because it allows you to indicate what you wish done with your property after you die. If you have children, you can name a guardian for them.
If you’ve acquired significant assets and wish to avoid probate, you should consider a revocable or living trust. Your trust would own most of your property and it would indicate what would happen to your property after your death.
Do you have questions about building a robust plan for your financial future? Contact us today to see how our team at Springwater Wealth can help you.
There are lots of pitfalls facing young professionals, and it can be hard to navigate them. If you need help, consider working with a Certified Financial Planner™ (CFP®) or Chartered Financial Consultant® (ChFC®). Advisors who hold these designations had to meet rigorous educational, experience and ethics requirements.