Americans plan for many things. We plan our vacations, we plan our retirements, we plan our weekends. But very few Americans plan on becoming disabled, on becoming ill, on having to leave work for an extended period of time. That's unfortunate because nothing can wreak havoc on a financial plan like a health-care shock. Case in point: David and Marcia Palmers, a married couple who live in the Pacific Northwest.
David, age 40, and Marcia, 37, were living the good life, he as a public employee and she as a professional in the health-care industry. David and Marcia, whose real names have been changed to protect their identity and exact state of residence, had household income of $75,000 and lived what they described as a frugal lifestyle, taking pains to avoid what some might consider an extravagant lifestyle. True, they recently moved into a larger home and took on a larger mortgage. But they could afford the larger mortgage payment based on their total household income. In fact, not unlike many American households, much of their discretionary and nondiscretionary or fixed expenses depended on both husband and wife's income.
Unfortunately, Marcia didn't have long-term disability insurance. And when she became unexpectedly ill and had to take a medical leave of absence, the holes in their financial plan became all too apparent. They didn't have a way to replace Marcia's much-needed income; she didn't have long-term disability insurance. What's more, they exhausted fairly quickly their emergency cash reserves fund. And so, as Marcia racked up medical bills, as their total indebtedness (excluding their mortgage) rose to nearly $70,000, making ends meet became a challenge. Once regular savers, the Palmers began living paycheck to paycheck, paying the minimum amount due on their auto loan payments, their mortgage, and credit card bills. Plus, David's eliminating what he calls unnecessary expenses — dining out, their video subscription, and his cell phone.
Up until recently, it was unclear whether Marcia would return to work. But after several months of treatment, Marcia is at long last able to return to work. The Palmers now need a plan to pay down all the debt they accumulated over the past year. Plus, they have to figure out a way to get their savings back on track. And, if all that wasn't enough, they have to figure out a way to keep paying for all the things they want and need now. David, for instance, needs surgery on his knee. What's more, Marcia and David want to start a family and adoption may be their only choice. "I'm not thinking about retirement," said David. "I'm hoping to stop living paycheck to paycheck."
What's a young couple to do? We asked FPA member, Bonnie Hughes, CFP®, a principal with American Capital Planning, LLC to analyze their finances and create a plan.
From a planner's side of the desk, it's important to start at the beginning. Financial planners and clients typically mutually define a client's personal and financial goals, needs, and priorities. The next step is what financial planners call the data gathering: Financial planners will obtain all the quantitative information and documents about a client before any recommendation is made and/or implemented.
In the case of the Palmers, it was critical to create a balance sheet — a snapshot of their wealth at a moment in time. The balance sheet reflects what they own (their assets), what they owe (their liabilities), and their net worth (the difference between their assets and their liabilities). A positive net worth indicates the Palmers own more than they owe. A negative net worth would indicate that they owe more than they own.
The Palmers' balance sheet reflected a negative net worth. There are many ways to increase net worth, but most center on the following tactics: Increase in assets from retaining income; Increase in assets from gifts or inheritance; appreciation in the value of assets; and decrease in liabilities through forgiveness.
The other important document needed was statement of cash flow. The cash flow statement typically reflects a household's annual income less its discretionary and nondiscretionary expenses.
Income minus expenses is what we financial planners call net cash flow. Positive net cash flow is good. Negative net cash flow is bad. The Palmers had, at the time of this analysis, negative net cash flow.
In all but the rarest of cases, the essential equation rarely changes except through inheritance or a lottery win. Families with negative cash flow must increase income, reduce spending and modify goals or both.
In the Palmers' case, getting a handle on their budget — or what we planners call cash flow management.
Now when it comes to creating a budget it's important to understand that there are two kinds of expenses; discretionary and nondiscretionary. Discretionary expenses are typically non-essential expenses that can be avoided or trimmed. Nondiscretionary or fixed expenses can be changed in some cases, but they must always be paid. Typically, nondiscretionary expenses include a mortgage, taxes, medical expenses and the like.
The Palmers noticed, given the set back from Marsha's illness, that they were spending an extraordinary amount of their income on servicing their debt, including high-interest credit card debt. In fact, they were paying $1,260 per month with interest rates as high as 20.24%. Their total credit card and personal debt, not including their mortgage or automobile loans, is about $53,000. (By way of contrast, the Employee Benefit Research Institute recently noted that the median amount (mid-point, half above and half below) owed by all families having credit card debt increased to $3,000 in 2007, up from $2,197 (in 2007 dollars) in 2004, up almost 37 percent.)
In David's case, we asked that he stop using his debit card for expenses and gave him a monthly allowance for out-of-pocket expenses. We do this not just for David but for others in this situation for the following reasons: There's no way to get to the future and saving for retirement with significant consumer debt on our balance sheet. First there must be a plan to pay off the debt and start saving the equivalent of those high interest rates.
Debt Management Plan
The Palmers have to consider some of the following strategies to get a handle on their cash flow and to get out from under the debt they've accumulated, which could not be until the year 2014. Debt Pay Down Plan — We put the Palmers on a debt payment plan, the essence of which does the following.
We have them on a 63-month plan to pay down their credit cards beginning with the balance on the highest interest rate card first. At the rate they were paying previously, it would have taken decades to eliminate this debt. The plan is strict and long — this is the burden of consumer debt. The couple is motivated however because they are tired of the pressure from the debt. They understand it is limiting their present and future options.
We have also recommended they choose one credit card to continue using and stop using every other card. As the accounts are paid off, we are asking them to close them except the one card they will continue to use.
Debt Restructuring — The Palmers should not consider paying off all their outstanding credit cards by consolidating debt into a personal line of credit. They had consolidated in the past and then put more debt on the cards. This is a common problem when folks consolidate their debt. Consolidating will also extend the time period they take to pay the debt off.
Asset Reallocation — In this time period when rates on cash have collapsed, they cannot benefit from investing cash for income to help pay these debts. They have no assets at this time except for a small amount of equity in their home which is unavailable to them because using it would simply increase their debt again. Should rates on savings go up, the Palmers might consider investing in a higher yielding investment that could produce income to pay down their debt.
Expense Control — The Palmers have done a great job of controlling their discretionary expenses, but they will need to continue this habit as they consider starting a family either through adoption or through fertility clinics.
Income Tax Planning — They should be able to deduct her medical expenses on Schedule A. That will provide some tax savings.
Retirement Plan Savings — They may be able to begin saving for retirement in less than five years but the priority in this plan is to reduce their debt load and ease the pressure on their paychecks.
Cash-out Refinancing – They'd simply be attaching their home to this high debt and should they fail in their payback plan, they may lose their home as well. Cash-out refinancing is not recommended.
Home Equity Loan or Home Equity Line of Credit — Under current guidelines, they wouldn't qualify. Loans on cash value of life insurance policy or from company savings plan – More loans are not recommended.
Debt Management Ratios
Knowing how much the Palmers spend on discretionary and nondiscretionary expenses is important. But financial planners also like to analyze the percent of money spent on various expenditures and liabilities. For instance, consumer debt (credit cards, auto loans, etc.) should not exceed 20 percent of net income (gross income minus taxes). In the Palmers' case, at the time of this analysis, it was 24 percent. In addition, their monthly payments on a home (including principal, interest, taxes, and insurance) should be no more than 28 percent of their gross income. In the Palmers' case it was 24 percent.
And the total monthly payment on all debt would be no more than 38 percent of gross monthly income. In the Palmers' case it was 25 percent. The Palmers payments are below the maximum. However, the problem is that if they continue to pay at the minimum rate they will not be out of debt for decades. The balance of their cash flow is being depleted by medical bills and regular monthly bills.
The Palmers first need to pay down their debt. But once that's down, they will need to come up with a savings strategy for long-term goals such as retirement and short- and intermediate-term goals, such as starting a family, as well. For retirement, for instance, they might need to accumulate an amount 20 times their annual expenses, or what the economists call consumption. When it comes to rules of thumbs on percentage of income to save for retirement, Bonnie recommends you save 15 percent of gross for retirement living expenses and another 2 percent of gross for retirement health care costs.
As for starting a family, they'll need to consider the cost of raising a child. The U.S. Department of Agriculture suggests that it costs on average an estimated $15,000 per year (in today's dollars) to raise just one child till age 18.
The other important expense that needs to be included in the budget is that for emergency expenses. Typically, financial planners recommend that families have three to six months of living expenses set aside in a rainy day fund. The Palmers, given their history, might need to consider building a fund with one-year of living expenses.
Insurance Planning & Risk Management
Life — Both David and Marcia would want life insurance to cover the sum total of their indebtedness so the other party is not left with an overwhelming financial situation in addition to their grief. If children enter the picture, they will want to consider life insurance to cover the cost of raising children to age 18, the cost of college, and any other expense that would be affected by the loss of one income.
Health — The Palmers case illustrated the need to become familiar with the specifics of your health insurance plans. Knowing what's covered and what's not is critical. Knowing what the catastrophic limits are is equally critical. We all know someone who has suffered a health setback. What we may not have known is the financial impact of that setback to the family. Health issues are often expensive even if we have insurance. Everyone should consider separate savings to cover health costs.
Disability — It should go without saying, the Palmers case illustrates the need to have a disability insurance policy outside of that provided by your employer. Typically, employer-provided disability insurance plans cover 60-70%. But a policy that you buy on your own can be designed to meet your specific needs. In the case of the Palmers, much of their woes might have been prevented had Marcia a policy that did the following: Covered her income up to 70 percent with a short elimination period and disability definitions that were liberal enough so she can go back to her expertise vs. any position, even one she is not experienced in.
Income Tax Planning
The Palmers need to make sure they are using all available tax deductions including medical expenses.
This is down the road when they get closer to paying off their debts. Then, this includes the basics of setting aside a certain percentage consistently, choosing low-cost investments that match their risk tolerance (what they feel they can tolerate) and risk capacity (what their financial situation and outlook can tolerate).
Employee Benefit Planning
They are currently maximizing employee benefits but should either change jobs, they'll want to review them again to make certain they are getting the full value of them.
They will have a couple of decades to save for retirement once their debt is paid off. If they dedicate themselves to the process with the same determination they are using to pay down their debts, they have a very reasonable chance at a comfortable retirement.
- Wills — No matter what stage of life you're in, everyone should have a current will drawn in the state they currently live in.
- Trusts — Trusts can be written to do just about anything and as this couple's situation grows in amount and complexity, a trust may be useful to them.
- Healthcare Proxy — Everyone with a pulse should have a healthcare proxy or directive. No one likes to think about a time when they are not well but consider this: It is perhaps the most generous gift you can give to your loved ones. They are freed from the responsibility of deciding for you what should be done in an already stressful time. With your written wishes in this document, they can feel secure knowing they are simply carrying out your wishes.
- Durable Power of Attorney — The Palmers need to talk with an attorney about how best to use this tool of letting someone act on their behalf when either of them is unable to act on their own.
The Bottom Line
As with most plans, we generally want to clear the decks of debt first, then begin the planning process in earnest where we explore goals, values, and what the Palmers care most about funding in the world so that we can get them on the road for building a base of assets that will provide a secure income in their later years. If we don't get past the debt, we can't get to the planning, and the time value of money is lost forever as the years tick by. The Palmers have enthusiastically embraced a tough solution and dedicated themselves to the task of paying debt down first. We congratulate them in their efforts knowing it is difficult and necessary.
Many folks who are in debt are also suffering stress and therefore may feel somewhat paralyzed about seeking help from a financial planner. If you are unable to make progress on your own, consulting with a financial planner may help you immeasurably to get past your debts, stabilize your financial situation, and move on to planning your financial future.
A financial planner is trained to look at all aspects of your financial life, even those that may currently be out of reach. In this case, you can see that this couple was living close to the edge before they had a medical emergency and that one event tipped the balance of their finances to a negative net worth.
Many, many Americans are living paycheck to paycheck and what this case illuminates is how fragile our finances can be. As financial planners, we know what the pieces of a solid financial life should look like and the numbers it can take to fund a stress-free future which is not the same at all as being wealthy. When we talk about "money maturity" to an individual, that isn't a sarcastic remark reflecting a deficit in the person it's attached to — it is a reflection of the state of mind that recognizes and accepts responsibility for the way you use your resources.
In someone with that state of mind, they understand that too much debt puts them at risk of a financial meltdown if any of the common, yet unfortunate events happens to them (for example, a car accident, a health problem, the loss of a job) and so they put their resources to work in the direction of their dreams. They avoid unnecessary debt, they spend below what they earn, they maintain a rainy day/bad luck/emergency fund and they appreciate that this protects them when 'life happens'.
After they get through those steps, they know they must save diligently over many years to have enough in the pot to draw from when they stop working. And today, they also know they should save separately for health care costs when they stop working. Investment returns can rarely overcome a lack of savings. The couple in our makeover are good people who are trying to help themselves. They are taking responsibility for their debts and getting through their bad luck with humility and perseverance. If they stick to the plan, they will succeed in becoming financially stable and they are young enough to make significant headway on saving for their future at that time. All Americans should be encouraged to organize their debts and pay them off so they can get to the future with less worry.