As a kid, I remember watching Saturday morning cartoons that featured an array of colorful animated critters. One recurring gag featured an ostrich sticking its head in the sand to avoid danger. The joke was predictable as clockwork, but the screenwriters couldn't resist it. Years later, I learned that this supposed ostrich behavior is bunk -- zoologists will tell you that ostriches usually run away from predators, not try to evade them by burrowing their heads in the ground. But the myth won't die, maybe because it provides such an appropriate metaphor for human behavior. Ostriches don't hide their heads in the sand, but Homo sapiens do. That's especially true in the world of finance, because dealing with money is difficult. It's easy to ignore facts that cause us anxiety.
People usually fail to achieve financial goals because they don't take a hard look at their financial data. They have vague notions of how much they pay in taxes, how much interest their investments earn, or how much debt they've accumulated. They lack yardsticks for measuring progress.
Here's a case in point. I recently spoke with Allen Buckley, a financial advisor in California who oversees company-sponsored retirement plans, and he described a conversation that he had a few weeks back with a client. The client, a machinist at a manufacturing company, was 52-years-old and planned to retire at age 65. He earned roughly $48,000 per year and wanted to replace that income throughout his retirement, assuming that he lived into his 80s (which is plausible, given the state of today's medical science.). He casually asked Allen, "I want to retire at age 65. Is that a good idea?" From the beginning of the conversation, Allen realized that the machinist hadn't given the matter much thought.
The problem was that the client's 401(k) account, which made up all his retirement savings, contained about $83,000. At first glance, that seems like a big chunk of money -- until you consider that the client needs to have about $600,000 stashed away in order to last him for the rest of his life, which could last for a couple decades, depending on how well he takes care of his health. And the other variable was his $200,000 mortgage, which hadn't been paid off.
I'm operating here on several conservative assumptions: that inflation averages around 3 percent; that his balanced portfolio earns an average return of 7 percent (a historical average for a similar portfolio) and that social security doesn't suffer major cutbacks in the future. As I said, these are fairly middle-of-the road assumptions: I haven't taken into account any worst-case scenarios, such as runaway inflation, a huge stock market crash, or Congress eviscerating social security. Given those risks, we all want to error on the side of saving too much rather than saving too little. (It's not as though anybody ever had a problem with getting rid of money.)
In any case, by our calculations, the client would have to place around $20,000 per year in his 401(k), over 40 percent of his income, for the next 13 years in order to reach his goal. That goal is theoretically possible but requires more self-discipline than most people have. Austerity can be forced on countries and it can also be forced on people. Unfortunately, it's difficult for most people to sustain that level of self-denial. This guy might have to tighten his belt considerably, unless he dramatically increases his earning power in the next decade or so. His other alternative is to try to extend his career another five years or so, but that depends on whether his health will hold up for that long.
Well, better late than never -- the client should have considered his retirement goals earlier, but at least he still has 13 years left to salvage the situation. Not everyone is so lucky. For instance, a recent survey by the Employee Benefit Research Institute claims that 24 percent of workers over age 55 have less than $1,000 saved for retirement.
So how do you overcome the "ostrich approach" to retirement planning, and finance in general? By adopting goals that are SMART. "SMART" is an old business school acronym that stands for Specific, Measurable, Attainable, Relevant, and Time-Bound. Keeping those principles in mind will prevent your finances from wandering too far off track. In fact, it's a good set of criteria for judging the feasibility of achieving any goal in life, not just a financial one. Let's take a quick look at implementing those principles:
1. Specific: How do you know whether you've attained your goals if they were never defined to begin with? People often tell me something along the lines of "I want to be comfortable when I retire," but don't actually name a specific figure of how much they need to live comfortably. (Of course, that might be part of the appeal for some people: don't aim and you can't miss!) A more specific goal is this: I want to replace my current annual income, adjusted for 3 percent annual inflation, for the next twenty years. That goal gives you a clear mission and a way of knowing whether or not you've achieved it.
2. Measurable. Every sport has a time limit and a system of points to keep score. A football game would be pointless without someone keeping track of touchdowns and field goals. In the same way, a scientist records data when conducting an experiment: you can't reach accurate conclusions without hard data. Otherwise, you're simply making conjectures based on emotions and hazy impressions. It's the same way with your finances. You must have a system in place to analyze your monetary life. A good place to start is measuring your net worth: your assets minus your debts.
3. Attainable. This is the toughest part. There's no simple formula for determining whether your goal is attainable. An entire book could be written on this point alone. However, you can start by looking at the successes and failures of others to determine how realistic your goals are. Using retirement or investment calculators will also give you a clearer picture. And of course, talking to a financial planner couldn't hurt either.
4. Relevant. That is to say, relevant to your true desires. Ask yourself how much you want to attain your objectives. If you're setting financial goals that don't relate to your true desires, than those goals become trivial, and fritter away time and energy. And I hope that retiring in comfort and security ranks higher in your mind as buying a new car or a boat, given how much is at stake.
5. Time-Bound. In theory, any goal is achievable if you have enough time. If you give a monkey a typewriter for eternity, he'll eventually churn out the complete works of Shakespeare. But we humans don't have eternity to pursue our goals. Goals have to be attained before a deadline, and the last day of our working years in the deadline. The more specific you make the timetable, the more accurately you can track your progress. Ask yourself how much you need to save for retirement at age 65 (or earlier) and how much you need to have accumulated per year to reach that goal. Now you have more than a goal -- you have a schedule.
When you familiarize yourself with these tenets, SMART becomes more than an acronym: It becomes a lens through which you view your financial life. That lens filters out irrelevant data and helps you focus on things within your control. Then the haze of uncertainty vanishes and your objectives stand out in stark clarity.
If you're still young and earning an income, you have the power to dictate the terms of your retirement. When you're old and grey-haired, will you reflect with relief and satisfaction on the decisions you've made, or will you be kicking yourself for not taking better care of your money?