Most people are keenly aware of the need to save more money. You may have real concerns about enjoying retirement, helping to care for elderly parents, adjusting to the rising cost of healthcare, and many others. Therefore, you understand that losing money hurts your balance sheet and jeopardizes your financial security. Unfortunately, what many people do not realize is the devastating extent to which it does.
Cost Number One - The out-of-pocket outlay
When you incur an expense, you usually see what is obvious… dollars leaving your pocket. You pay for dinner out with friends and you leave cash on the table; you lease a car and write a check for that every month; you buy a new shirt with your credit card, then settle up and pay the bill at the end of the month.
These are all examples of dollars that you possess that subsequently leave your pocket. Therefore, the total cost of an expense is usually measured in those terms. What you may fail to see is that the real cost is far greater. In fact, there are THREE costs that you incur when you give money away and take it off your balance sheet:
1. The out-of-pocket outlay, as described above
2. The Time Value of Money cost
3. The loss of potential retirement income
A successful retirement is defined as one that provides you with sufficient assets and cash flow to achieve your income, lifestyle, and legacy objectives. Though you cannot predict the future, you need to prepare for what is probable, and still protect against what is possible. What is probable is that a healthy couple approaching retirement age (let’s call that 65) has a 50/50 chance that one of them will live to be age 95. Knowing this at 40 can help you make better cash flow decisions about how much you spend and how much you save.
Let’s take a look at the impact of various cash flow decisions until retirement only (for now); so let’s say 25 years. If you paid for college for your son at the rate of $50,000/yr., you clearly see the first cost: that is, the actual out-of-pocket outlay for an expense (tuition, fees, etc.); $200,000 in total. In this example, there is no return of or return on that money.
Cost Number Two - The Time Value of Money
However, there is a second cost that most people don’t measure. Every time you lose a dollar, you lose not just that dollar, but everything that dollar could have become for you if you had saved or invested it. That is, if it were earning a rate of return, it would have grown into something far greater than the $200,000 out-of-pocket outlay. We refer to this as the cost of the Time Value of Money (TVOM).
Loosely described, this is an opportunity cost. It’s a way of measuring the cost not only of money that leaves your wallet, but also the cost of money that never gets the opportunity to get into your wallet. The way we measure it is by saying the following: Consider that the rate of return on a dollar that is lost is not 0%. In fact, it’s far worse… it’s -100%. The loss of it is not a risk; it is a guarantee. And so therefore, if you can develop a strategy that allows for a reduction or elimination of that expense, AND if you can find an asset somewhere on your balance sheet that carries a better than -100% return, then you should be able to put those savings into that asset and have more money on your balance sheet. For our purposes, we describe the TVOM rate as being the best after-tax return that is available to you.
In this example, it might be that your 401k is providing a long-term rate of return of 8% pre-tax. If you net that out for taxes, then that might mean an after-tax return of 5%. So then, if you could have held on to those assets, by retirement you’d have not only the assets you gave away for college, but an additional $206,000 on your balance. Therefore, the payment of tuition, etc., really cost you $406,000 that could have been on your balance sheet at retirement.
Cost Number Three - The loss of potential retirement income
And that brings us to the THIRD COST. At 65, by not having that $406,000 on your balance sheet, and not being able to earn a modest return during retirement (let’s say 5%), you forego potentially as much as $20,000/yr. in retirement income if you spent the income only, or as much as $31,000/yr. if you chose to annuitize that over your lifetime… guaranteed never to run out for as long as you live!
And that’s just the cost of college. When you begin to compile ALL the areas where you incur costs, the numbers can become astounding. Clearly, not all costs can be avoided. Some costs such as certain taxes and insurance premiums, are ones that need to be paid in order to avoid adverse consequences, financial or otherwise. However, you need to think differently about how to mitigate the impact of the costs you incur. And while there has been an entire industry that has risen out of the need to help parents plan and save for college, few people are talking about how to help you not just save for college, but measure the true cost of it, then devise a strategy to recover that cost.
To learn more about strategies that will potentially enable you to do that, be sure to speak with your Financial Representative.