We hate to see people make costly money mistakes—especially when the financial missteps are preventable, and when those making the mistakes are high earners with the means to do better. In today’s article, we explore the surprising results of a new study—and money mistakes to avoid!
It is no surprise that many Americans struggle with money and getting their financial ducks in a row. What may come as a surprise is the level to which even comparatively “wealthy” Americans grapple with financial basics, too. It’s not uncommon for high income earners and millionaires to find themselves living paycheck to paycheck, chronically underinsured, and unprepared for a financial emergency.
That’s why the results of a recent survey by Financial Planning network and magazine caught our attention recently. The new Financial Wellness Report revealed that the majority of Americans—including high earners—can lack financial literacy, budgeting skills, a proper emergency fund and basic risk management tools.
Another study by Bank of America Corp. shows that even the majority of “mass affluent” Americans are stressed about money—with a 59 percent of respondents saying financial worries have affected their mental health, and 56 percent reporting their physical health has been negatively impacted. (The mass affluent have been defined as those earning 50% more than the median, with between $100k and $1 million in assets.)
Looking at the statistics and our own extensive experience of working with clients, we have to admit: even those typically defined as “wealthy” are prone to BIG financial mistakes. Let’s take a look.
Money Mistake #1: Overspending: Failure to budget or use a spending plan.
Almost a quarter of advisors reported at least 50% of their high-net-worth clients are living paycheck to paycheck, according to the Financial Planning survey. A separate Nielsen study found that 25% of families making $150,000 a year or more need their next paycheck to survive, with one in three earning between $50,000 and $100,000 in the same circumstance.
Why do high earners often find themselves with nothing left over? Steve Adcock gives us an excellent run down in his article on MarketWatch, “Why people who earn a lot of money still can’t pay the bills.” A former information technology worker surrounded by other six-figure earners, Adcock observed the fallacy of “the more money you earn, the more you have.”
In fact, high salaries are deceptive. They make us feel rich, but…(they) have a way of boxing us into a lifestyle that systematically drains us of the large majority of our wealth… We believe that we’re rich, and therefore, we spend accordingly.
We live in high cost of living areas in nice homes and drive expensive exotic import cars because our salaries — at least on paper, support that level of spending. We spend because we can.
Adcock names the root causes of this spending:
- high debt (student loans, new cars, credit cards, overly ambitious mortgages);
- lifestyle inflation, or the tendency to spend more when one earns more;
- the “I deserve it trap;” and
- high income optimism—the feeling that the gravy train will never end.
Too often, the high savings potential of high earners remains unfulfilled. In spite of the potential, “…unless we escape the draining culture of ‘spending = success,’ nobody is getting rich,” concludes Adcock.
Money Mistake #2: Lack of a proper emergency fund.
Alarmingly, the Financial Wellness Report found that fifty percent of younger clients (clients of financial advisors between ages 25 and 34) did not have proper savings. Clients working with advisors for the first time can present particular challenges. “New clients are often a breath away from financial ruin,” said one planner.
“A financial emergency would spell catastrophe for 40% of clients, according to the survey,” reported Financial Planning. “Another 26% of clients have emergency savings, but not enough to weather a real money crisis.”
Building a proper emergency fund should be the first priority of every person with any amount of income. We prefer to think of it as an “emergency/opportunity fund” because it’s so much more fun to save for opportunities than emergencies! But regardless of what you call it, having liquidity available for the unexpected is essential.
We recommend saving at least three months of living expenses. You may want 6 to 12 months of expenses if you are the breadwinner or if your income fluctuates. Without an emergency fund, investments are at risk. When “life happens” and a need for immediate cash arises, investors find they must liquidate a portion of a retirement account. Unfortunately, a 401(k) is a terrible “emergency fund” as you’ll pay penalties and taxes. Plus, you may have to sell funds at a loss, depending on the timing. Taking a 401(k) loan is no better, as you’ll be withdrawing pre-tax dollars and replacing them with after tax dollars—at a loss.
Money Mistake #3: Lack of a structured, automatic savings vehicle.
One reason high earners fail to have ample liquidity is the tendency for investors to jump straight into investing without saving first. They skip straight from a checking account for everyday expenses to a 401(k) without building up sufficient liquidity.
According to the research from Financial Planning, high net worth clients are more likely to stash their cash in retirement accounts (76%) than in savings accounts (54%). Yet investors need both savings and investments. Many people fail to establish a proper financial foundation because they have not established the habit and they have no structure for doing so.
If you want to become physically fit, a structured routine is extremely helpful. You might hire a personal trainer, workout with a partner, or join a local gym with classes you’ll attend regularly. Whether you go to spin class, train for a marathon with a pal or workout in a home gym, it must be a priority, it must be consistent, and you’ll benefit from the right structures.
Financial fitness is no different. It doesn’t happen accidentally. We like the “save first, spend the rest” strategy. When you save first, you make savings a financial priority.
Moving money systematically into a high-interest savings account is a good way to start, although you won’t earn more than about 2 percent there. After you have the liquidity to handle small emergencies, we recommend some of our clients save with high cash value whole life (your policy and/or potentially a child’s) as you’ll tend to earn substantially more on your long-term savings, while also protecting your earning potential—something a savings account can’t do for you.
Money Mistake #4: Lack of proper insurance.
Few people would even consider driving a vehicle without auto insurance. And mortgage companies won’t allow you to buy a home without proof of home insurance. Yet amazingly, many investors fail to ensure themselves! The Financial Planning survey revealed that 24 percent of mass affluent clients with assets of more than $250k had NO life insurance, and 25 percent had no health insurance. Even among accredited investors (those with assets of a million dollars or more), 15 percent lacked life insurance and 17 percent had no health insurance.
The fact is that YOU are your best and most important asset—even from a purely economical standpoint. Your financial management should reflect this fact.
There are two insurances we consider “essential” and one more worth considering.
Life Insurance. Without proper life insurance, your income can vanish in the blink of an eye—and the assets you have worked to build are often consumed quickly by those left behind unprepared for such a loss.
Some people talk about life insurance as an “investment,” but that is incorrect. Whole life insurance—the kind that builds cash value—is both a savings vehicle and an essential risk management tool. (We also recommend term insurance and convertible term, which do not have a savings component.)
So… what IS the financial value of a human life? Government agencies and wrongful death lawsuit courts are tasked with answering this question on a regular basis. According to TheGlobalist.com, “As of 2011, the Environmental Protection Agency set the value of a human life at $9.1 million. Meanwhile, the Food and Drug Administration put it at $7.9 million — and the Department of Transportation figure was around $6 million.”
Formulas used by life insurance companies to determine Human Life Value (HLV) often place it at 15 to 20 times income. For those who have retired, HLV may be equal to the value of all assets. (We don’t recommend a “needs analysis” approach as that tends to leave people under-insured.)
Health insurance. This should also be regarded as a necessity—and you should not depend on an employer for it! While you may have excellent company coverage (wonderful if you do), make sure you can receive medical or emergency care if needed. There may be affordable alternatives to traditional health insurance worth exploring, such as healthcare cost sharing programs. (Look before leaping… and also consider the oppportunity cost.) Your health should not be optional!
Disability insurance. This may make sense for you as well, depending on your circumstance.
Some people also opt for long-term care insurance, especially if there is a history of family health issues that are concerning to you.
An all-in-one policy? Something we recommend to some of our clients is a whole life insurance policy with a Long-Term Care Benefits rider. We also regularly recommend Terminal and Chronic Illness riders and Waiver of Premium riders. These riders allow a life insurance policy to provide at least some of the benefits that disability income insurance or long-term care insurance would provide. They also allow the insured to access their own death benefit in certain circumstances. In this way, a single, properly-constructed life insurance policy can cover many bases at once without requiring premiums for insurance policies that may never be used.
Money Mistake #5: Neglecting retirement to pay for education expenses.
The Financial Wellness survey found that respondents were 8 percent more likely to feel they were saving plenty of money for their children’s education than for their own retirement. However, only 26% of clients have saved enough for retirement, said the report.
Of course, many high income earners spend years paying off their own college debts—sometimes saving for their own children’s education before they have paid off their own student loans! According to data from Sallie Mae, household income is by far the main source of college funding, at 43 percent, compared to grants and scholarships, at 30 percent. As SavingforCollege.com notes, “when parents are repaying old student debts and saving for their children’s college education, critical household financial priorities like saving for retirement go by the wayside.”
We recommend that clients prioritize their own needs first—and work with their children to find win-win solutions for funding education. This may require students to work and contribute and/or earn scholarships, or it may guide them into choosing less expensive options. There are valid questions as to whether a private school education is worth the cost for many students.
Solving the Financial Literacy Crisis
“Financial illiteracy is a plague that has infected the majority of Americans,” one planner involved in the Financial Wellness study said. “The whole topic is very arcane to them. I try to guide them toward financial stability and economic freedom in their retirement years.”
So, what factors help people improve financial literacy and money management skills?
Get advice. Clients don’t always take the advice given to them, but those seeking out professional advice will do better than their peers. A recent study reported in The Globe and Mail showed multiple advantages to working with an advisor, including:
- higher returns in self-directed accounts
- greater diversification of assets
- less risk and more balance in portfolios
Grow up. Simply put, maturity helps! Older investors were less likely to be underinsured and more likely to have savings.
Educate yourself. Too many Americans focus only on saving in a 401(k) and/or IRA, or rely on investing apps that put their dollars into mutual funds and etf’s, while remaining naïve to other aspects of finances. Education and information is needed, along with curiosity and personal responsibility.
We recommend that every investor make learning about finances a regular part of life. Read—or listen to—a book a month about money. You can find books published by the Prosperity Economics Movement here. Consider different viewpoints. Ask questions. While professional advice IS important and helpful—ultimately no one will care about your money more than you!