Tag Archives: finance

Where Do I Put Cash When Interest Rates Are So Low?

Let’s face it.  It’s been quite the dry spell for conservative savers.  Interest rates are historically low, and they have been quite low for some time.

Risk vs. Reward

In such an environment, it is really easy to get discouraged.  After all, what is the point of putting cash into a savings account when I am hardly compensated to do so?  At the same time, it is also easy to be tantalized by the prospect of pursuing higher yields elsewhere.  Generally speaking, the tradeoff with higher yields is that you incur additional risk – either to the sustainability of the yield received, or to the certainty that you will receive all of your initial investment back.

In this post, I’m going to consider the available options and the criteria to assess what might make sense.

Safety of Principal

In theory, investors demand a certain rate of return even when they incur zero risk to their principal.  In practice, however, there is no such thing as a perfect investment with zero risk.

When I was taking finance classes, the commonly accepted assumption for an appropriate risk-free rate was around 4%.  Generally, this was taken from the prevailing rates from U.S. Treasuries.  Current rates have not been very appealing.  As of June 2015, the 3-month T-bill yields a whopping 0.00%.  Since the U.S. has seen its credit rating downgraded in the past few years, it’s not even clear to me whether U.S. Treasuries still represent the closest proxy for a risk-free instrument.

I would break down safety of principal into what is perceived and what is realistic.  The most apparent form of perceived protection comes from Federal Depository Insurance Corporation (FDIC) insurance, which is an implicit government insurance program that protects deposits up to a certain amount (currently $250k).  This coverage amount is per depositor, per insured bank, and for each account, so an investor could actually receive quite a bit of coverage once all of those coverage limits are aggregated.  The types of accounts covered include checking accounts, savings accounts, money market deposit accounts, and certificates of deposit.

FDIC coverage has provided the most comfort to investors, as that coverage is backed by the “full faith and credit of the United States government.”  Moreover, the FDIC can also draw on a line of credit with the U.S. Treasury if it is ever necessary.  Since its founding in 1933, no depositor has ever lost any money of FDIC-insured deposits.

The counter to this protection is whether the FDIC is sufficiently capitalized to survive a bona fide financial crisis.  A viable insurance company would need to have adequate funds to cover its obligations.  The FDIC should be subject to similar standards.  It certainly surprised me to discover that the FDIC does not actually receive funding from the government.  To cover any bank failures, the FDIC maintains a Deposit Insurance Fund (DIF) that is funded by premiums paid by member banks.  The FDIC is required to maintain a designated reserve ratio in this fund, which has been determined to be 2.0%.  On the surface, that seems pretty low.  In actuality, it’s even lower.  As of December 31, 2014, the DIF has a balance of $62.8 billion and a reserve ratio of 1.01%.   This marked five straight years of DIF balance growth from a low of negative $21 billion in 2009.  The Dodd-Frank Act set a minimum reserve ratio of 1.35% that the FDIC needs to reach by 2020.

When the FDIC was first started in 1933, the insurance coverage limit was $2,500.  The coverage limit has since been raised multiple times.  The most recent raise occurred in 2008 in the depths of the financial crisis when the limit was moved from $100,000 to $250,000.  While inflation has been significant since 1933, I’m pretty sure that it hasn’t been 100x.

For an insurance fund that is meant to cover bank deposits measured in the trillions of dollars, it is a bit scary for me to imagine what might happen if we did experience multiple bank failures.  The FDIC is a “symbol of confidence,” but is it actually a legitimate insurance fund?  In a major crisis or other black swan event, it would seem likely that special emergency injection by the federal government would be essential to cover any shortfalls.  These symbols are perceived to be bulletproof until they are not.  Credit ratings had been regarded nearly as gospel until their integrity was questioned during the crisis.

This is not meant to incite panic.  It is meant to illustrate what the reality of the situation is.  As with any potential investment, you cannot take the marketing at face value.  This is what I mean when I say there is a difference between what is perceived and what is realistic.

Optionality (0% Yield)

Cash is king.  I realize that with lofty prices in many asset classes, cash seems to be in abundance right now.  But there has never been a boom that has persisted.  When the environment eventually normalizes and potentially swings to the opposite extreme, having available cash on hand will prove to be very valuable.  Here is an interesting post that demonstrates that doing nothing for 5 years but then finding superior returns for the ensuing 10 years will yield better results than 15 years of mediocre returns.

Cash held in brokerage accounts will likely not earn much in interest.  Fortunately, there are options that will let you earn a bit more yield while keeping liquidity constraints to a minimum.

FDIC-Insured Alternatives (1% Yield)

Having opened your eyes to the limitations of the FDIC, it is still generally preferable to hold money in an account that is FDIC-insured as opposed to an account that is not FDIC-insured.  I say generally because it really depends on how you are compensated for the risk that you are taking on.  We’ll examine those later on, but understanding what you are

Chances are you are being paid a pittance in your current FDIC-insured account.  Most of the major banks have rates that are measured in basis points.

A quick scan of Bankrate shows multiple options that will produce a 1% yield.  I use GE Capital bank which currently has a 1.05% yield.  Surprisingly, these rates are higher than most short-term CDs, even though these accounts do not require you to keep your funds there for a set time period.

CD ladders are also a popular option.  There are several 5-year CD options that yield about 2%.  It’s admittedly not a super compelling rate, and I’m not sure if tying up funds for that period of time is worth an extra point of yield.

A quick note on taxes too.  If you happen to be in an Obamacare income bracket, and if you happen to live in a state with high income taxes like California, the net income that you receive from your interest income is going to be paltry – approximately 45% to 50% of your interest income will be paid out in taxes.

Index Funds / ETFs: Bond or Equity or Dividend (2%+ Yield)

Once you let go of the FDIC-insurance requirement, there are opportunities to get more yield.  Unfortunately, you are now also subject to volatility in your principal.

Time horizon is a pretty critical consideration here.  As a place to stash cash for the short-term, this is probably not the best alternative.  If there is a sudden downturn, you will not want to be in a position where you would need to liquidate at a loss.  Once again, you need to ensure that you are being adequately compensated for the risk you are taking on above the FDIC-insured alternatives.

However, if you have a long time horizon and would be willing to hold on (by tapping other investments or savings for necessary cash) or tax harvest in a downturn, then it might make sense to take on this risk.  Most prudent investors are likely contributing periodic amounts to these types of investments anyway, and this is a way to add more yield by adding amounts that might have gone toward cash.  If the price increases, then you would happily liquidate and use the cash elsewhere as originally intended.  If the price decreases, then you would just attribute it as a long-term investment and hold on.  This assumes that you don’t actually need to use the cash in the first place, which might be a luxury that not many of us have.

An interesting way to tailor your holdings here would be to consult the credit ratings of the individual companies in the major index funds and ETFs.  For example, you could choose to invest only in companies with a certain credit rating or better.  There are actually only 3 companies that currently possess an AAA rating: Exxon Mobil (3.4% dividend yield), Johnson & Johnson (3.0%), and Microsoft (2.7%).  You might choose to widen your net to include A or AA companies, and you’ll need to pay attention to transaction costs.  However, the benefit of the credit ratings in this context, while not a pure assessment of the likelihood of the business to continue to support and grow the dividend, is that you’ll at least have some comfort in the financial strength of these businesses.

The tax implications are also worth highlighting.  Most dividends will be paid at long-term capital gains tax rates, which means more of the income stream will net to the investor relative to interest income.

Preferred Stock (~5%)

Now, we are looking at some more unconventional alternatives, so be sure to do your own research beforehand.  Preferred stock is senior to common stock, but is junior to most debt.  They also generally pay a heftier dividend than common stock and bonds.  However, these securities also have a lot of terms that may vary depending on the specific issuance.

I use Quantum Online for most of my research into preferred stock.  You’ll notice that most of the issuers are financial institutions, and that you can often earn a higher yield on their securities than in their saving account products.  Take Wells Fargo as an example:

Wells Fargo likely has one of the strongest reputations among financial institutions.  Yet, relative to the rates that you can earn in the savings accounts that Wells offers, you can potentially earn a lot more investing in different parts of the company’s capital structure.

For preferred shares, there are a lot of unique risks that are introduced, including default risk and the risk that the company suspends its dividend payments.  However, this is an example where the additional yield may adequately compensate the added risk exposure.

Options (~5%+)

There are many option strategies that can generate income, but I’m going to focus on one particularly strategy that is fairly conservative as far as option strategies go: selling cash-secured put options.

We can take a look at Wells Fargo again as an example, which is trading at about $57.  If we are comfortable owning the stock at a lower price (say $55), we can sell a cash secured put to take the option premium today.  An option that expires in January 2017, or in about 18 months, currently sells for $5 per option contract, or at an implied 9% yield based on the strike price of $55.  Annualized, this is about 5%.

Wells Fargo is not even the best example, since it tends to not be very volatile.  The higher the implied volatility of the stock, the greater the potential yield by selling puts.  This strategy works on ETFs as well, and might be a good way to earn extra income while waiting for a good entry price.

The risk is that if there is a downturn, you may be committed to purchasing the stock at a higher price than the prevailing market price at the time of expiration.  However, as long as you consider only stocks that you would be willing to own, and at prices that you would be willing to own them at when you set the strike price, then all of the potential outcomes should be fine.

Conclusion

So where does that leave us?  This might seem like dodging the original question, but to me, the only solution to all of this uncertainty is to be diversified across all of these options.  How one chooses to allocate assets across these options is a personal decision since each option has its own risk/reward tradeoff, and it’s not necessary to be exposed to all of these alternatives.  I would probably prioritize optionality and safety of principal, which means that I’ll be holding on to more cash, even though I will still deploy some capital in the other categories.

As always, remember Warren Buffett’s first two rules of investing.

Disclosure: I may at any time hold, initiate or exit positions of any or all of the securities mentioned in this article.

 

Fuzzy Math – How Much Money Are You Actually Spending?

In order to get serious about financial independence, we need to first understand how the numbers work.  The problem is that the world is not set up to help us think through the numbers accurately.  In fact, we are set up to overestimate how much we make, and underestimate how much we spend.  With the deck stacked that way, it is no wonder that the path to financial independence seems so steep.

The last post discussed the income side of the equation: are we really making what we think we are making?

This post addresses the spending side.

Dining out

A common solve to this would be to create a budget.  Some people enjoy this process, but I can understand how this might not be for everyone.  But even if you have created a detailed budget, it’s not always the most practical tool for day-to-day decision making.  Suppose a friend were to ask whether you would like to go grab dinner later in the week, you probably aren’t going to ask for a moment while you determine how your dining spend is tracking to plan that month.  What you need is a convenient mental model to estimate what something like that will cost you.

If we continue this example, let’s say we decide to patronize a nearby steakhouse, a fine establishment.  After settling down and perusing the menu, we might notice that a ribeye is listed for $50.  (Hopefully, you are already in the habit of noticing prices on the menu before ordering).  You might think to yourself that is not so bad.  It will end up being $50 plus a little bit extra for tax and tip.

But it’s those little extras that always seem to add up to an astonishing amount.  With ~9% sales tax and ~15%-20% for tip, we are already 25% to 30% above the list price.  Throw in a bottle or two of wine, some appetizers and sides for the table, maybe split a dessert, which will all include the 25% to 30% tax and tip surcharge, and the final tally can easily end up being twice what you had expected:

 PerceivedActual
Total$50+$75 to $100+
Ribeye steak$50$50
Tax?$5
Service charge?$10
Extras (sides, apps, wine)?$10 to $30
Tax and service on extras?$3 to $9

That eating out costs a lot might not be a surprise, and many of you are probably already aware that you are paying for these extra costs.  You may even be vigilant for the cost of extras that are inserted into the group bill.  Even with this awareness, however, how often do we look at the menu prices and accurately gauge what the final damage will actually be?  And when we are wrong, how often is the surprise more than what we thought, rather than less?  It’s just not something that you would normally think about while out to dinner, nor are these topics of discussion among most social circles.  Restaurants and businesses generally certainly do not make it easy for you to know or calculate the fully loaded cost.  There simply isn’t any motivation for them to help you understand that you are really going to be spending upwards of 30% above prices they’ve listed.  It’s our responsibility to remain cognizant of the real price.

As an aside, steak was one of the first meals I learned to cook, and one of the primary motivations for cooking was the cost difference between eating out and eating at home.  It’s remarkably easy to reproduce near-restaurant quality for steak at home.  Many years and meals later, I rarely would consider ordering a steak at a restaurant.

Big purchases

To take another example, suppose that we are on the market for a new kitchen appliance – a new refrigerator perhaps.  During our research, we might read some reviews that indicate the list price for such an item is $1,000.

Once again, sales tax is a hefty component of your fully-loaded cost, unless you happen to live in one of the few states that doesn’t have a sales tax.  However, in making this purchase decision, are we also considering all of the other costs to get the new refrigerator up and running: the delivery home, the installation and other parts that might be required for installation, the disposal of the old unit, etc.?  If we purchase online rather than in a store, are we considering the potential hassle of having to return the unit?  How often do these extra costs wind up being a significant chunk of the total cost?

Businesses are motivated to anchor you to the initial purchase price of the main item and to obscure the total costs of ownership.  They may be perfectly willing to use the headline item as a loss leader in order to upsell more profitable ancillary services later on.  This is a logical razor-and-cartridges business practice that shows up in many different categories: financing and insurance, maintenance and repairs, extended warranties, installation, etc.  Once again, it’s our responsibility to think through the total cost of ownership throughout the lifetime of the item.

Housing costs

This is likely the biggest expense category for most of us.  And it may be even bigger than we think it is.

Given how obsessed Silicon Valley is about real estate, I’m going to skip most of the common ancillary expenses here.  There are plenty of additional financial costs to housing that are covered in greater detail elsewhere, whether its the nasty shock of that first property tax bill, the necessary cost of insurance, or the ongoing expenses around utilities and deferred maintenance.  There are plenty of primers on how to compare the cost of owning versus the cost of renting.  What I want to focus on are the non-financial costs to housing:

  • Distance.  How much time is spent commuting to and from work?  How would you be spending that time if you didn’t have to commute?  How much would you pay to have that time available to you?
  • Size. How much time is spent on cleaning, yard work and other chores?  How much time is spent on furnishing and decorating extra rooms?  Is that how you would prefer to spend your free time?
  • Opportunity.  How would you value the flexibility to be able to move somewhere else to pursue a new job opportunity on short notice?
  • Peace of Mind.  There is a ton of pressure that accompanies most housing decisions.  It may be coming to grips with the huge financial commitment this entails.  It may be the relief that follows a move after a long period of fruitless searching.  There is a cost to bearing this pressure, and it’s not always reflected in the direct financial costs.

 

This post has meandered a bit, but my goal was to highlight that we need to be mindful of all of the costs (financial and non-financial) of our spending.  To boil it down to the key points:

  1. Consider the fully loaded costs.
  2. Consider the non-financial costs.

Fuzzy Math – How Much Money Are You Actually Making?

Suppose you make $120,000 a year.

Just to be perfectly clear, this is a fantastic sum of money anywhere in the world.  Even here in Silicon Valley.  Though it is becoming increasingly typical, as it is the average salary of an engineer, most of us would be thrilled to be making that amount.

I selected $120k primarily because the math that follows will be more convenient to explain: it breaks down to $10k in gross income per month.

And yet, $120k doesn’t seem like it’s enough.  Why is that?  That’s because it’s not really $120k, and we should stop thinking that it is.

The reality is that we overestimate how much income we actually make, and we underestimate the actual cost of our spending.

This would seem as though we are deliberately deluding ourselves about money.  That might be partially true, but I don’t think that is the main reason.  The primary culprit has more to do with how we as a society have come to think and talk about money.

For example, you probably are already well aware that what matters to long-term financial goals is the amount you actually take home and keep, not the headline gross compensation number.  But that does not mean we regularly think about our finances in those terms.  In fact, I suspect that if I were to ask you how much you made, your first thought would almost certainly be your gross salary, and you probably would not have a clue about your take-home amount.  Depending on how long you have been working, you have probably grown accustomed to the surprisingly meager amounts that actually get deposited to your bank account periodically.  You might be vaguely aware that there are significant automatic paycheck deductions that are responsible for this, but you might not fully understand the details.

The Income Side

Let’s break it down, assuming you’re a single person living in California with no allowances making $120k in 2015 and paid monthly, using the salary paycheck calculator from ADP:

  • Monthly Gross Income: $10,000  ($120,000 annually)
  • Federal Tax: $2,169
  • Social Security: $620
  • Medicare: $145
  • California Tax: $761
  • CA SDI: $90
  • Monthly Net Pay (After Taxes): $6,215  ($74,580 annually)

We’re only looking at the government-related stuff, and we’re already at ~38% taken off of gross income.

Federal Tax: This is pretty self-explanatory.  The one item of note is that the income tax bracket tiers are adjusted every year.  For this example at $120k, we would be in the 28% income tax bracket, which affects income above $90,750 to $189,300.  The 28% tax rate would be applied on the incremental dollar.  The blended tax rate per the calculator is ~21.7%, which reflects the lower tax rates that are applied on the first $90,750 in income.

Social Security: This is a 6.2% tax that ostensibly will be used to fund social security payments.  Of note is that the tax only applies to a certain wage limit, which rises every year.  For 2015, that limit is $118,500, so the maximum tax is $7,347.  This tax is quite insidious in the way the wage limit rises every year.  As can be seen from that table, it’s practically doubled in the last 20 years.  It seems tough for income growth to outpace the growth in the wage limit.  This is where our $120k just doesn’t seem to be quite enough – you really need to have a super high income for the FICA rate to become negligible.  For most of us, we are all basically paying an extra 6.2% in taxes.  It also seems to be a tax that gets overlooked, even though this is such a significant chunk.  Obama reduced this tax to 4.2% for 2011 and 2012 as part of the various stimulus programs, but it’s unclear how many people actually noticed.  Had the federal tax brackets been reduced by 2%, it likely would have received far more attention.

Medicare: This is basically like social security, but with two differences: (1) the tax rate is 1.45%, and (2) there is no wage limit.  In fact, the rate goes up to 2.35% if you have income above $200k thanks to Obamacare.  This is likely why there was such an uproar on this tax.  For social security, there is at least a limit and maximum tax.  For Medicare, there is no limit, so the tax is effectively uncapped.  Once you were to make above ~$390k, you would actually pay more in Medicare tax than Social Security tax.  Social Security and Medicare are typically referred to together as FICA (Federal Insurance Contributions Act) taxes.

California Tax: Not only do we owe taxes at the federal, we also owe taxes at the state level.  By the way, not all states have an income tax.  California, in spite of its dire budget issues, still manages to levy pretty high tax rates.  What is more, there is no distinction in earned income or investment income in California.  All income is taxed at the same rate.  In this example, we are at the 9.3% bracket, and a blended rate of 7.6%.  The one silver lining is that the taxes owed to California is deductible for federal income tax purposes.

California State Disability Insurance (SDI): Another social program that covers short-term disability income replacement.  It’s mechanically similar to Social Security.  The tax rate in 2015 is 0.9%, and the wage limit is $104,378, resulting in a maximum tax of $939.40.  The rates and limits change year-to-year, but the maximum tax has stayed around $1k per year.  The growth in the wage limit has been disconcerting, and it wouldn’t be a surprise to see this continue to go up.  As with FICA and Medicare, this doesn’t seem to get the attention that the income tax rates enjoy.

 

That covers the primary government deductions.  There are plenty of caveats to the above, of course, as the amounts will change depending on your ability to claim allowances, whether you have investment income versus earned income, and whether you have ways to reduce your amount of taxable income.  It’s a lot of detail that won’t be covered.  The complexities and unique situations are why most articles will focus on the federal tax brackets as that applies to everyone.

I think the key takeaway is to not underestimate the amount of taxes owed to the other categories.  In this example, these taxes in aggregate ($1,616) are almost as much as the federal taxes ($2,169).

And still, we’re not quite done yet.  This is not the amount that gets deposited into the bank account.  There are plenty of other categories of paycheck deductions, but at least these will generally be within our control and be contributions to our benefit.  Some of these include:

Retirement Savings: 401k contributions are the primary example, and they have the added benefit of being tax deductible.  But not for the FICA taxes.  Did I mention how insidious these taxes are?

Investments: Some companies offer employee stock purchase plans (sometimes at a discount), but require employees to take paycheck deductions in order to participate.

Benefits: The costs of health care insurance and any other benefits payments will be deducted here.  Depending on how generous your company is and how much coverage you need, these payments can be quite significant.

Free Money: Not everything is a cost, but you may need to opt-in to take advantage of this.  This might include employer matching of contributions to 401k accounts or HSA accounts, or discounts of stock purchases.  This is basically free money for the taking.

 

So after all of that, what are we actually taking home in this example?  Unfortunately, I haven’t found a good calculator that can accommodate all of the different categories.  The following presents the details including the maximum 401k contribution.

  • Monthly Gross Income: $10,000  ($120,000 annually)
    • Federal Tax: $1,749
    • Social Security: $620
    • Medicare: $145
    • California Tax: $607
    • CA SDI: $90
  • Monthly Net Pay (After Taxes): $6,789  ($81,468 annually)
    • 401k: $1,500 (pre-tax contribution)
    • Benefits: $500 (estimate)
  • Monthly Take Home Pay (After Taxes): $4,789  ($57,468 annually)

The complication is that the amounts contributed to the 401k and to benefits are generally pre-tax dollars and would impact the amount of federal and state taxes owed.  It’s tricky to factor the benefits cost in since this varies widely by employer.  I assumed an estimated benefits cost of $500 per month after-tax in this example.

Note that the inclusion of the 401k contribution reduced the overall taxes owed significantly, by close to $7k.  It took the implied overall blended tax rate from 38% down to 32%.

Note also that our take home pay of $4,789 per month is now less than 50% of the overall gross pay.

I would consider this amount to be the true income, rather than gross income.  Although the 401k and benefits costs are both technically discretionary, I think both of these categories are mandatory expenses as a practical matter.  Maxing out 401k contributions (or contributing at least 15% of gross income to the 401k) should be considered the minimum.  The benefits portion can even be considered as a kind of tax as well.  Although there is some flexibility as far as the level of coverage selected, most of us are likely stuck with whatever our employer offers us.  And although we could technically opt out of benefits coverage, that’s just very unlikely to happen.

Where does that leave us as far as how to think about how much we actually make?  It is a complex question.  I think the best we can do is come up with ranges as a percentage of total gross income:

  • Net pay after taxes: 65% to 70%
  • Monthly take home pay: 45% to 50%
  • Disposable income after savings contributions: 35% to 40%

The savings contribution assumes that you save 10% of gross income, which seems to be the default retirement advice.  That advice would typically include amounts contributed to a 401k, but we’re aiming for an early retirement.  If we want to do that, what’s leftover just isn’t very much.

The point is that we need to move off the anchor of gross income ($10k per month), and we need to recognize that our income is in reality only about 40% of that ($4k per month).  That is, we need to budget our lives based on the $4k as the reality and disregard the $10k as merely fantasy.  It might seem like a small step, but when the average rent in Silicon Valley will easily consumer your entire income, it might help to put things in the proper perspective when making significant decisions.  We just need to realize that we make much less than we think we do.

It would be hard enough if that were all there was to it.  Unfortunately, we also tend to think that expenses are much less than they actually are.

We’ll examine the implications on the spending side in a future post.