This is the second article in a series. The first is titled The Five Biggest Financial Issues for Pre-Retirees.
The years in which you are raising children are among the most important in your life, and financial choices and decisions are no small part. First, you are managing the widest range of financial demands. You may simultaneously be paying off student loans, buying or remodeling a house, assisting other family members, saving for your childrens’ financial needs (like college), and saving for your retirement. In addition, these tend to be the years in which people build their professional reputations. Many parents feel challenged about how to give their children access to the best education possible, whether that means private schools our buying a house in a neighborhood with the best public schools. Finally, an issue that gets very little attention, you are doing this while modeling financial decision making for your children. The example that you set cannot help but shape your childrens’ perspectives and behavior about money.
Here are my five top financial issues for people in this stage of life:
- Map out your future financial needs
- Plan for contingencies
- Build your financial literacy
- Maintain your human capital
- Teach your children about money
Now, let’s look at each of these in detail.
1) Map out your future financial needs
Retirement planning gets a lot of attention as an important issue, but people with dependent children have a number of other future needs to plan for. First, there is the cost of future education. Some parents will simply not have enough money to help their children pay for higher education. Some parents may feel that it is a child’s personal responsibility to pay for university or other educational needs. Part of financial planning in the context of children is determining whether you are planning for one generation (yours) or making a multi-generation financial plan. In my opinion, financial planning focuses far too much on single generation planning. Perhaps this is a result of there having been traditional pensions in previous generations (see, “The Peril of Underfunded Public Pensions”).
For the moment, lets think in terms of two big liabilities: college costs and retirement costs. Both of these are enormous costs. You will need $1 M in savings to fund $40 K in sustainable retirement income. On top of this, the average annual all-in cost of each year of university education is around $ 20 K. College costs, while much less than retirement costs, will occur much sooner, too. And, college costs are growing faster than inflation. Many parents are struggling with how to balance these competing demands and there are many personal decisions that go into this equation. The crucial starting point is to have a viable plan, and to recognize the relative magnitude and timing of these needs.
The most likely outcome from trying to get a handle on the combination of college and retirement costs is the recognition that you need to save more. The huge question, of course is what you are willing to give up today in terms of consumption on behalf of your children. Are you willing to live in a smaller house or to drive older cars?
2) Plan for contingencies
Far too many financial plans leave no room for error; they are not fault tolerant. Being able to cope financially with unexpected events is important for everyone, but particularly for parents with children living at home. Elizabeth Warren has emphasized the importance of this issue as a result of her extensive studies of the situations that tend to result in families going bankrupt. In her book The Two Income Trap, she makes the case that even as two income families earn money, they are increasingly susceptible to financial disruptions because they are already consuming the economic output of both parents. In previous generations, she argues, in which one person worked outside the home, the other spouse could enter the workplace to make up earnings shortfalls due to injury or a period of unemployment on the part of the wage-earning spouse.
The most direct way to make family finances more fault tolerant, of course, is to spend less and save more. The key here is that more savings are not just a sacrifice: they are a gift to your future self. Every family will say that it’s hard to save more money, but often this is a result of habit rather than of necessity.
Many advisors recommend that families have six months of living expenses available in liquid investments. This is a good idea, of course. There are other ways to add economic flexibility to your family as well. One of these is to have the ability to have at least one parent work from home. This provides a remarkable amount of resiliency to your economic situation. First, working from home will reduce your transportation expense and may even eliminate the need for a car. Second, being able to work from home means that you don’t miss a day of work when a child is home sick. My daughter was sick for an extended period during one school year–she missed forty days of school. Without a stay-at-home parent or a parent working from home, this would have been dramatically harder financially.
Having a 30-year mortgage even if you can afford a 15- or 20-year mortgage also increases your financial flexibility. You can pay down your mortgage faster in good times but you will have the ability to pay less if your income unexpectedly declines.
Elizabeth Warren’s work on how families end up in financial distress has emphasized how important it is to be able to respond to the financial contingencies that life throws at us. She has proposed that your inflexible financial needs take up no more than 50% of your household after-tax income. Warren refers to these expenses as the ‘must-have’ part of your budget, and this includes housing, utilities, insurance, groceries, and minimum loan payments.
3) Build your financial literacy
There is no better investment in time and energy than becoming highly financially literate. Think about it. Many financial advisors charge 1% to 2% to manage your investments. If you take on this role yourself, and you learn enough to do it right, you can save this expense. Even if you decide to hire an advisor (and there are plenty who are worth their fees), you need a fair amount of knowledge to select the right advisor for you.
The world has changed in ways that make personal financial literacy crucial, not least because of the disappearance of traditional pension plans. You could get away with being fairly ignorant of many financial topics in the days when your employer automatically took money out of your paycheck each month and guaranteed you an income for the rest of your life when you retired. Today, things are far different. You are the one who decides how much you need to save, and you are the one who has to decide how to invest these savings.
Another way that the world has changed is in the relative cost of a college education or other advanced education. Education remains a crucial predictor of future financial success, but the economic burden has risen to the point that many people are carrying student debt well into their post-college lives. By learning about the range of alternatives for higher education, you can more effectively help your children navigate this crucial process.
In the same way that having a good doctor does not absolve you of the need to take personal responsibility for being healthy, even people with a good advisor need to be financially literate and be fully cognizant of the financial choices they are making. In the years when you are raising your children, there are enormous competing demands on your time and finances. Really spending time thinking through your financial situation and choices will be time well spent. As parents, you want your child to have all of the opportunities that are available. There are seemingly endless ways that you can spend time and money helping your children. Deciding what makes sense can be challenging.
4) Maintain your human capital
Human capital is your store of skills that allow you to make money by providing goods or services to someone else. One of the main trends that we are seeing in society is that demand for certain skill sets is increasing and demand for others is decreasing. We emerge from college with new and timely knowledge. The challenge is to ensure that our human capital does not grow stale over the years. In the same years when you are raising children, you also need to ensure that your skills and knowledge stay current. In many fields, an entire industry can change dramatically over short periods of time. It is much easier for a single person in their 20’s to stay abreast of new trends and technologies than for the parent of young children, but there is simply no alternative. We must maintain and build our human capital through our working lives, not least because of the rapid pace of change in almost every field of endeavor.
5) Teach your children about money
Given the amount of misery that bad financial decisions create, one of our most crucial financial tasks when we are raising children is teaching them about money. Research has shown that money management lessons that children learn at home have a substantial impact on their knowledge and future decisions. Take, for example, the following conclusion drawn from the 2009 study, “Financial Socialization of First-year College Students: The Roles of Parents, Work and Education,” published in the Journal of Youth and Adolescence:
“…we want to emphasize that parents who intentionally teach their children about financial management may exert a greater influence on children’s financial knowledge than do the lessons learned in high school and those learned in the work place combined. This finding, once again, underscores the importance of parents in the financial socialization of children at home. Clearly, if young adults receive positive lessons from their parents and observe positive parental behaviors in addition to receiving a formal financial education at school and an informal education in the workplace, they have a better chance of acquiring extensive and useful financial knowledge and confidence in their ability to make sound financial decisions.”
The result from this study can hardly surprise anyone, I hope. Parents model behavior on a wide range of issues for their children and issues around money and financial management often have dramatic and visible impacts on family life. Seeing your parents stressing over how to pay the bills or being told that there is not enough money for something that you want can be powerful formative experiences. Of all of the areas in which parents can model positive behavior for their children, financial issues are among the most important. Financial literacy is crucial not just for your child’s personal well-being but also in allowing your child to understand the complexities of modern society and to be an effective participant in representative democracy.
Looking at the Big Picture
Raising children is immensely rewarding – I am in the process right now. It is well-known, of course, that raising children is pretty expensive, too. As parents, there are a range of competing demands on our time and money. By keeping a focus on the five topics discussed here, we will be better off as will our children.