Babywatch: Prepared Uncertainty

My sweet wife is due with our second child any day now, which puts me on Babywatch. A time to make sure we are ready for the new arrival - or at least as ready as we can be. The “go bag” has been packed for a couple of weeks, aunts have braved the elements to help with our toddler. The nursery is decorated a forest theme as we haven’t found out if we are having a girl or boy. The dogs are pacing and want more snacks. It’s a time of prepared uncertainty.

Prepared uncertainty is an odd place for a financial planner. It scares the daylights out of me but provides a rich context to evaluate my personal financial plan. Switching between parent and financial planning professional hats inspired me to share my Baybwatch strategies.

1) Health insurance cards are ready to go and insurance benefits understood

We both have insurance cards in our wallets. But this time around we contacted my wife’s care provider and asked for approximate costs. They based these costs on our insurance policy, and we know to reserve around $3,000 for the big event. This $3,000 includes copays and deductibles, which help me plan out the next few months. We’ve also chosen a hospital and taken a tour which better sets our expectations. I have ten paternity days that I can spread in half day blocks over two weeks.

Most importantly, if there is an emergency, we know how additional hospital days work and a general idea of in and out of network coverage.

2) Do I have enough life insurance?

I’m currently holding two term life insurance policies. The first I bought before Liz and I were married, the second when Lily was born. Both policies are still in force and will be for another couple of decades. But does another child warrant additional coverage? If so how much more?

Generally speaking life insurance death benefits are calculated using one of three methods: 1) Multiple of earnings 2) Survivor needs analysis or 3) Human capital valuation.

I’ve always found the multiple of earnings method fairly capricious. Why should I buy 3 times my annual income? Why five times? Why not pull a number out of a hat instead?

A survivor needs analysis is more sophisticated. This method couples lump sum and cash value needs at death. As an analytical personality I am attracted to this method, but I’m living at the peak of unknowns. We just changed jobs, bought a new house, moved to beautiful Illinois and are on the cusp of our second kiddo. If I had more security and experience in my new professor and consultant roles I’d be more apt to perform this type of analysis. But my budget currently hangs under a fog of war and likely will through next year. I’d have to make too many assumptions at the moment for a survivor needs analysis to hit the mark.

Human capital valuation solves for the pile of loot needed to replace my income if I died. I’m forty-one and I’d like to work another twenty years. Over the last century inflation has averaged around 3.2%. I’m comfortable assuming a twenty-year rate of return of 7%, considering a blended basket of stocks and bonds. Human capital valuation has two steps.

Step One: Find a rate to discount your human capital. The Fischer equation helps calculate a discount rate that encompasses both market returns adjusts for inflation.

(1 + Inflation Adjusted Rate) = (1 + Nominal Rate) / (1 + Inflation Rate)

(1 + IAR) = (1.07)/(1.032)

(1 + IAR) = 1.0368

IAR = 0.0368 or 3.68%

Step Two: Find the present value of future income

Number of year’s I’ll continue working: 20

Discount rate: 3.68%

Annual Cash flow to be replaced: 100,000

The present value needed to generate inflation adjusted cash flows of $100,000 for twenty-years is just under 1.4 Million. If I made my way up the river Styx tomorrow, 1,400,000 invested in a portfolio of stocks and bonds could replace my income over the next two decades.

3) We need to open new 529 plans.

Illinois helps make this decision a little easier by offering a significant state income tax deduction for contributions made into the Bright Start Direct 529 college savings plan. Additionally, Illinois recently revised investment offerings in this plan to include passive management and made sweeping cuts to fees and expenses.

The Bright Start Direct 529 college saving plan is 529 plan offered by the state of Illinois. 529 plans provide tax-deferred growth on plan contributions. If these assets are later used for room, board, tuition, fees or technology costs distributions from the plan wind up being income tax-free. Plan proceeds do not have to be used exclusively at Illinois Universities, and would be available for college and higher education costs nationwide.

A taxpayer is allowed an Illinois state income tax deduction of up to $10,000 per beneficiary for contributions into a plan, giving Liz and I a combined deduction of $20,000 per child on an annual basis. At a 4.95% income tax rate we have the potential to save about $990 per year. My daughter’s current 529 plan is housed in PA, and Illinois would does not provide a reciprocity of income tax deductions if we continued investing in her old plan. Every state offers some type of college savings plan, they are well worth investigating.

The stark reality of college savings is that we aren’t able to save anywhere near $20,000 annually into a 529 plan. Education savings must be weighed alongside retirement plan contributions, living expenses, taxes owed and other financial goals.

Assuming a 7% growth rate; $250 a month over eighteen years will grow to around $100,000. In eighteen years, $100,000 will probably pay for around two years of college. Inflation is a jerk.

4) Set it and forget it.

My life is about to go from two parents per bambino to a 1:1 ratio. Looking at time as a commodity, every minute just became more precious.

I’ve invested in individual stocks, bonds, option contracts, mutual funds and even a rental house. All in an attempt to create a diversified portfolio that will live through some ups and downs as I trudge towards financial independence.

Over time I’ve come to believe that I can’t beat the market. There isn’t a magic bullet or product that will whisk me away to my goals. Slow, steady and low cost progress is my best hope for success. Most of us can’t beat the market, and I’d follow the Wall Street Journal that most professional managers can’t either. This brings me to a philosophy of simplicity in wealth management. Match your investment portfolio to your goals and risk tolerance and then invest as cheaply as possible.

My personal portfolio is made up of four exchange-traded funds. This boat is not sexy, it will not beat the market but it will get me to retirement. A similar one will help kiddos get to college.

Bonds (30%)

International Stocks (25%)

Domestic Value Stocks (25%)

Domestic Growth Stocks (20%)

Babywatch has provided an opportunity for financial reflection. Health insurance planning, life insurance analysis, college savings and investment management are pieces of my comprehensive financial plan. They are shaped by prepared uncertainty and a touch of wisdom from our first kiddo, and will continue to be shaped as when we meet the next one. Hopefully we will meet them soon.

https://njaes.rutgers.edu/money/riskquiz/

https://www.chicagotribune.com/business/ct-illinois-529-plan-fee-cuts-0607-biz-20170606-story.html

https://www.wsj.com/articles/indexes-beat-stock-pickers-even-over-15-years-1492039859