Uncommon Cents

One of my buddies on Twitter asked, paraphrased:

“What do you think about doing an HEI DRIP for my less than one year old baby?”

I love it when parents start thinking about the future of their child early.

Now, I do not advise parents to save for their child’s future education over their own retirement–that might sound harsh, but if the kids want to go to college (and I am all for that), they can, last resort, work through it take out loans, going to a state college to try to keep expenses down, or even a junior college (what in Hawai’i we call a community college) if needed, but you cannot borrow for retirement.

That said, let’s first consider this proposal of going with a single stock dividend reinvestment program (a DRIP)–unfortunately, we don’t have as much information about this situation as we’d like–versus other possibilities.

Putting all your money–whether it’s for a particular purpose like college (which I’m assuming is what is the driver behind this question) or retirement, or just for your own savings–into one stock is the opposite of diversification, and greatly increases your risk. Remember when I was discussing all of the different items in my portfolio, and how I took care to say that a particular stock or fund made up a certain percentage of my portfolio? That’s because I try to avoid having a high level of concentration of my money in a single stock (if it is, however, a diversified fund–like an index fund–then having a high level of concentration in the fund is fine). I try to have no more than 4-5 percent of my total portfolio into a single stock.

Putting that aside, the idea of a DRIP is in general a great one. Instead of getting paid the dividend in cash, more of the stock that paid the dividend is bought. Additionally, dividends have received preferential tax treatment for a few years (which is the key phrase here), adding to the attraction of dividend paying stocks. Unfortunately, as economic times have gotten tougher, many companies have cut their dividends, and if the reduced rate at which qualified dividends are taxed goes away, dividend paying stocks (and therefore DRIPs) will also become less attractive.

Let’s also remember that while many companies offer DRIPs, often brokerage houses let you reinvest dividends just as if you were involved in an “official” DRIP–call it an artificial DRIP. Firstrade and Sharebuilder, where I have brokerage accounts, both allow this.

Of course, if this stock is being bought in a sheltered account of some kind, the tax consideration changes. Since I believe the stock would be purchased for educational purposes, let’s consider the two best ways to save for education, the Coverdell Education Savings Accounts (ESA) and the 529. I do not know of a 529 plan in which individual stocks can be purchased; apparently there are some low cost Coverdells which are essentially brokerage accounts. If this stock is indeed being purchased for this purpose, I’d suggest using one of these Coverdell brokerage accounts with low costs (and I am very outside my area of expertise here, so consider checking out Saving for College on the Web).

In principle, if one wanted to buy an individual stock and create a DRIP program for their child’s educational future, I would suggest instead of HEI (which we will cover soon), the purchaser open a Coverdell ESA with one of the discount brokerages (E*Trade, Scottrade, TD Ameritrade, and Schwab all appear to offer these accounts) and instead go with an Exchange Traded Fund of a broad stock market index such as Vanguard Total Stock Market Exchange Traded Fund (VTI), where despite having just one holding you have the diversification of the entire stock market.

All of that said, let’s take a quick look at HEI:

HEICO Corporation (whom I had never heard of prior to researching this question) is apparently a company involved in electronics, defense, and aerospace. It is quite high tech. It pays a tiny dividend (12 cents a share, or .30%) but its performance has trounced the S&P 500 since it went public in 1992.

In other words, this stock has done well over time–extremely well–and if you got in early you’d be flying right now. There’s not much reason to think it won’t continue to do well. But that said, it’s still just one stock, and you still run the risk of it underperforming the market.

If it were me and I just wanted a single stock to run with, I would have to say to go with VTI and set up the account to reinvest the (larger than provided by HEI) dividends. HEI may make a great addition to that, but I cannot recommend putting all of your investing eggs into a single stock when you can easily get the diversification of the entire market in a single share of an ETF.

In response to the Total Portfolio Makeover II series of posts, I received the following email from a reader:

Hi, I like your website. Good post about investing in the Vanguard Total Stock Market Index Fund, however I think it’s important for people who are older to balance their equity holdings with a bond fund to soften the blow when the market goes down.”

The reader makes an excellent point here. Asset allocation, which we’ve discussed many times on this blog, can and probably ought to be influenced by your age and time until retirement. As you may recall, asset allocation is how you divide your portfolio among different types of securities; in this blog we have basically split our assets among domestic bonds, domestic stocks, and international stocks, although it certainly is possible to include other types of assets such as precious metals and real estate in the calculation. We allocate assets to attempt to mitigate risk, and part of the amount of risk someone can afford depends on the amount of time before they need to convert the portfolio into cash. For someone in their 20s with four decades until retirement, having more risk is appropriate; for someone in their late 50s approaching retirement within a decade, reducing risk makes sense.

So, in Chris’s case, while I suggested an asset allocation of 50% domestic stocks, 25% international stocks, and 25% high quality domestic bonds, someone who was, say, 20 years older (meaning in their mid 50s), I’d probably be a bit more conservative, possibly 40% domestic stocks, 20% international stocks, and 40% high quality domestic bonds. In retirement, I’d likely be even more conservative as the emphasis switches from portfolio growth to preservation of capital–in that case I’d be looking at something more like 40% domestic stocks, 10% international stocks, and 50% high quality domestic bonds.

Are there cases when I would consider a more aggressive asset allocation as someone approaches retirement? Maybe. If the person was a late starter or just didn’t accumulate much in retirement savings and time is rapidly running out, I’d consider adopting a more aggressive stance, but the important word in all of that is consider. A lot would also have to do with the risk tolerance (or, rather, the volatility tolerance) of the person who owned the portfolio. If the portfolio owner had a high risk tolerance, then yes, I would consider a more aggressive stance. However, for the most part, I strongly agree with our reader: as the investor gets older, a more conservative asset allocation is definitely appropriate.

I was surprised to learn this past week that one of my blogging buddies who I consider a brilliant guy was not participating in his company’s 401(k) plan. I coincidentally got a request by a reader to cover some 401(k) basics, which has lead to this article.

In traditional Uncommon Cents fashion, I’ll discuss what a 401(k) actually is in a coming Working Backwards segment. In the meantime, just know that a 401(k) [or its equivalents, including the non-profit version 403(b)] is if not the best, at least one of the best ways to save for retirement. The 401(k) allows an employee to contribute a percentage of their gross income, typically up to a yearly maximum of (currently) $15,500 pre-tax (with “catch up” provisions for those who are a bit older allowing even more to be contributed) and let it grow tax deferred until you reach 59.5, at which time you can make withdrawals at your marginal tax rate (which is likely to be lower at retirement than when you’re working)–this means that if you’re someone like me, in the 25% Federal tax bracket with about a 5% state tax, I’m getting a 30% tax break on that money right off the top. In addition, employers often offer a “matching” contribution, meaning that, for example, for the first 5% of your money that you contribute to your 401(k), the company will contribute a matching 5%–which is, essentially, free money. Your employer is trying to give you free money!

For whatever reason, people don’t always use their 401(k) plans to their maximum, or, sadly, at all. That’s wild; can you imagine your boss telling you that they want to give you a raise and your turning them away? This is essentially the same thing!

If you are 401(k) eligible but haven’t started and want to–and it’s hard to imagine not wanting to–here are the steps you need to follow to get going:

1) Contact your human resources department and request to get started. They’ll likely send you some documentation and papers you need to sign.

2) Determine what kind of match your company offers. It may be in stock or in cash (hopefully the latter). Warning: if your company’s match is in stock, be very careful about having a high level of concentration in that particular stock! Diversification is key.

3) Contribute at least the amount needed to make the most of the match. If you can contribute more, that’s fantastic, but at the very least max out the match. If not, you’re leaving money on the table!

4) Determine your asset allocation and which funds to purchase to reach your allocation targets. Remember that costs are critical (as they always are); if you decide to have actively managed funds in your portfolio (and I typically don’t recommend them), this would be the place to have them, as the tax deferral of the 401(k) allows you to sleep easy with capital gains.

5) Pull the trigger. Go ahead with your plan and don’t worry about it!

Seriously, the 401(k) is one of the best investment vehicles available, and for most of the people who are offered it, not using it is essentially turning down free money. That’s really not something I want to do! We’ll look more at the 401(k) in the coming weeks, but if you haven’t gotten started, get started now.

One of the biggest expenses that can face parents is the cost of education. Education is also one investment that has the potential to pay off in spades. I couldn’t do the job I do without the degrees I have, so I know personally how much having an education can make a difference in someone’s life.

That said, college costs are escalating. At a state university known to be a bargain, I paid about $1,000 in resident tuition and fees for a full-time semester as a graduate student over a decade ago; today, that same semester costs over four times as much! At that kind of rate, we will be looking at astronomical pricing even for residents at a public university in a couple of decades.

If you are the parent of a young child, expecting a new one, or just planning for one, you may want to get informed and get working on your financial plan for their education soon–if not immediately. Like any investment (which we will look at shortly), time is a huge factor–if you start early, time is your friend and if you start late, time is your foe.

Consider college savings like any other investment

Like any other investment, college savings is affected by your time horizon, your risk tolerance, taxes, fees, and inflation. Start today if you haven’t already! Every day you wait is one less day you have for the magic of compounding returns to work for you. Eighteen years is a fantastic time horizon to work with for investment, but if you wait until your child hits kindergarten, you’ve lost almost a third of that time. Consider what you can deal with in terms of risk, which may be related to your time horizon–I’d be more than comfortable with 80% of the money I’m saving for a college education being in the stock market when I have fifteen years to go, but a lot less comfortable with that if I’ve got three years left.

Take advantage of whatever tax advantages you can get

The two primary investment vehicles with tax advantages for education are the Coverdell Education Savings Account and the 529. Both offer tax advantages; the 529 is meant for higher education only and allow much higher contribution limits than the Coverdell, but the Coverdell allows more flexibility in investment choices and can also pay for expenses for qualified elementary and secondary schools. Don’t be confused by the state run 529s–you don’t need to invest in your own state’s plan, although there may be some advantages if you do so (this is not the case in Hawai’i). Investigate both options.

Do not prioritize education over retirement savings!

No matter how much you love your children and how much you want them to do well academically, do not prioritize their educational savings over your retirement savings. In a worst case scenario, your child can borrow money for their college education–you cannot borrow money to fund your retirement! Yes, both are worthy causes and both deserve your financial attention, but don’t put the education above the retirement. It can leave you in a horrible spot when you would like to retire even if it helps your child.

Consider public institutions and junior/community colleges

Public colleges and universities are generally not as prestigious as private ones, and junior or community colleges are even less so, but honestly, the price difference may not be worthwhile. The difference in the milieu between a big university and a smaller community college could also work in the favor of your child. It’s a much smaller jump for high school students who are used to being in smaller classes and checked on regularly by their instructors. I know for myself I was in trouble at the university as soon as I was in a lecture section of three hundred students and heard the lecturer say that they don’t take attendance!

There is an important caveat, however: your local college or university may not offer a program that your child is interested in. In that case, this may not be as useful a tip.

Look far and wide for financial aid and consider prepayment plans

Don’t look a gift horse in the mouth. Fill out the FAFSA form, check if your place of worship, employer, or union offers scholarships or educational funds, investigate if any of your child’s unique talents or activities in high school and earlier offer any kind of assistance, and scour the countryside for any other kinds of scholarships. There’s nothing to lose but time and paper, so search for any kind of aid they’re eligible for.

Some schools offer “prepayment” plans–pay for your child’s tuition now, at today’s rates, and when it’s time, your child’s tuition has already been taken care of. There are some huge risks with this plan, primarily in that your child would have to actually qualify for and attend that particular school. What if your child ends up not being college material or wants to attend another college, or that college doesn’t offer the programs your child is interested in? Consider these with a grain of salt.

You have many things to consider in saving for a child’s college education. Think about it as if it’s a long term investment–which it is. Start early, use whatever tax advantages you can, consider lower cost in-state options, and search, search, search for any funds, scholarships, or grants your child may qualify for, but don’t save for your child’s education at the expense of your own retirement. Good luck with this financial goal!

As a side note, one of my life goals is to set up a scholarship fund for Buddhists who live in Hawai’i who intend to study social work with children and families, so maybe someday I’ll be able to help aspiring social workers with their educational costs. I don’t anticipate it’ll be a huge scholarship, but I know from experience that every penny counts!

What timing. Following my rather less-than-knowledgable discussion last night on keeping finances separate vs. combined in a marriage–not surprising given that I’m a lifelong bachelor–I came across a number of posts by other personal finance bloggers on similar subjects.

Him and Her of Make Love, Not Debt, discussed Ten Financial Considerations for Newlyweds. They take a clear position on having joint accounts, but also stress communication and working together.

J.D. at Get Rich Slowly talks about how for many families, having both parents work doesn’t pay off, but the decision about who stays home isn’t as simple as dollars and cents and how the Parents.com Stay-at-Home Calculator can help them make a decision.

And finally, someone who is rapidly becoming one of my favorite bloggers, Mrs. Micah, has some tips that are not as specialized as they seem on how to save money if you’re the parent of a child with musical inclinations, but her post I really like talks about what could happen if your partner breaks your budget. Frankly, I can relate to her pondering if someone who’s single might be grateful they have more control over their money–yes, I am grateful, but at the same time, I think that I’d like the challenge. I hope SF is reading!

Turning the tables on this blogger, a reader asks:

I’d love to get your take on combined vs. separate finances in marriage. [My spouse] and I have always had joint accounts, but I know several married couples who keep their finances separate.

Wow. Being a lifelong bachelor, my personal experience with this topic is very limited. So, a bit of research and a bit of thought on the issue:

In the United States, marriage is an interesting mix of the religious and the legal. While marriage has tended to be most often performed by some form of clergy, it also has legal implications including financial ones. Social Security benefits and health insurance benefits are two examples of the financial implications of marriage. Marriages in America fail at an alarming rate, with estimates usually at about 50%, and very often, finances are cited as a reason for the failure. It’s idealistic to think in a relationship that it’s just about love and not about money, but in the end, it’s naive to think that money is not important.

Marriage can unite those with very different financial situations, which has led to interest in prenuptial agreements–agreements that often include predefined ways to divide the property of the married couple if and when that couple divorces. In the U.S., prenuptial agreements are recognized by courts but not always enforced. Basically, this is an attempt by those who have more money when entering the relationship to preserve that money for themselves if the marriage ceases to exist. Combine this with the fact that women often do worse financially after a divorce than they did entering the marriage and you see that the picture is cloudy.

Some thoughts on this: first and foremost, a marriage is supposed to be a partnership, so as separate as a couple may try to keep their finances, there are ways in which they will be lumped together by law if nothing else–think eligibility for health insurance or Social Security survivor benefits or Medicaid or Medicare. You’re in it together.

Second, finances need to be a part of the discussion leading up to marriage and to continue to be a part of the discussion all the way through. Couples talk about where they want to live, what they want to achieve, their religious beliefs, their desire or lack thereof for children, their sexual history, and dozens of other topics. It’s hard to believe that finances are off topic, but they apparently often are, given how many stories there are about spouses hiding debt from each other. Talk about it. Discuss it. Decide what’s priority and what’s not, and what you can afford and what you can’t. While it doesn’t seem a big deal that I would spend $50 a month on Diet Pepsi while SF spends the same amount on coffee, it could be a symptom of a bigger issue somewhere down the road–I may want to spend a given amount of money on a new MacBook Pro while she would rather spend it on a 40 inch HDTV. There needs to be open communication and negotiation on these issues.

Third, while many couples combine their finances and have one person as the CFO of the marriage, it’s important both parties have some idea of their finances and how to manage them. This is important not just in the event of a divorce, but also in the event of death or disability. Can you imagine not being able to balance a checkbook or know which bank your savings account is in? Being organized and having a list of accounts can be helpful no matter what. It’s also possible to keep some of each spouse’s finances separate; it’s not an all or nothing deal. This would require more bookkeeping, but might be a happy medium. For instance, bills for the family (rent, for example) may be paid out of a joint account, but bills for one spouse (my cellular phone bill or the veterinary bill for her rabbit) may be handled by the appropriate spouse.

One thing I would be vary wary of is buying something together that involves a substantial financial commitment (say, a house or a car) when you’re not married. While it certainly can be a sticky widget even if you’re married, it can be even worse if you’re not.

My feeling is that as much as couples may try to keep their finances separate, there are situations where it’s not really possible to do so. Like many other issues in marriage, communication, prioritizing, cooperation, and negotiation will be key to keeping the finances from becoming an issue. Finances can be an emotionally charged issue, so proceed with caution; it’s difficult to say if keeping your finances separate or not is a wise decision, so each couple must make a joint decision. For myself, at this point, I’m not sure what I would do; a lot would depend on what I know about the financial health of my betrothed.