Debt Adds Stress to Retirement Planning

Two episodes separated by more than 20 years convinced Julie Smith it was time to get serious about planning for retirement.

The first came during the 1970s when her father, a steel salesman, was abruptly laid off after 35 years with the same company. The resulting financial headaches prevented him from enjoying the comfortable retirement he had long anticipated.

“He never saw it coming and it devastated him until the day he died,� said the 44-year-old Long Beach resident.

The second came a few weeks ago when the November statement for her individual retirement account arrived in the mail. The stock market’s dramatic plunge had wiped out $9,000 of her $77,000 account in just 30 days.

“I was shocked,� she said. “I just stared at it and said ‘holy moly.’ �

The galvanizing effect of these two events is understandable. Smith--divorced, with no children and no employer-sponsored pension plan--will have only Social Security and her own savings to draw on in retirement. And the $31,500 salary she earns as a warehouse manager leaves little margin for error.

Smith has made important progress. She funnels $2,000 a year into her IRA which, even after the recent hit, boasted a balance of $68,000. Another key point: Her housing costs--a $535 monthly condo payment--are modest by Southern California standards.

“You’re on a good footing to make a start� toward building a retirement nest egg, Elizabeth Elliott, a Los Angeles fee-only financial planner, told Smith.

But Elliott noted that a significant hurdle still stands in Smith’s way: $5,000 in credit card debt.

“I’m not a clotheshorse or an extravagant spender,� Smith said. But a combination of emergencies--repairs on her pickup truck, vet visits for her dog T.J.--have ballooned her balance. In addition, she got into the habit of charging vacations, such as a pair of trips to the East Coast to see relatives get married.

“By nature, I’m a worrywart and I know I’ve got to get serious about paying this off,� Smith said.

Besides removing a major source of stress, eliminating that debt would enable Smith to direct more money into her retirement savings, Elliott said. It also should free up enough cash to start an emergency savings account.

“Getting rid of this debt will not be about depriving yourself,� Elliott told Smith. “It will be about giving yourself what you really want most, which is peace of mind.�

Elliott prescribed a three-step process for paying off the credit card.

“The first thing is to cut up your charge card,� the planner said. This represents a symbolic and practical break from her past spending habits. “You need to make the decision now to stop using it forever,� Elliott said.

Next, Smith should try to get the card’s 14.9% interest rate reduced by calling the issuer. “You’d be surprised how often you can reduce your interest rate simply by asking,� Elliott said.

Finally, Smith should adopt an austerity budget to pay down the debt as quickly as possible. If she continues to make the minimum monthly payment--about $110--it will take Smith five years to pay off the debt. By increasing her payment to $300, the balance could be paid off in about 18 months.

Those higher payments are within reach. Elliott estimates that Smith could free more than $400 a month by clamping down on her discretionary spending. But Smith acknowledged that finding the extra cash will require discipline.

“I’ve got to start saying ‘No’ when friends call and say, ‘Let’s go out to dinner,’ � she said. “In the past, I’ve gone to the ATM and had a night out with friends who are on a champagne budget when I’m on a beer budget. I realize I can’t be embarrassed about telling them that I can’t afford it.�

Once the credit card is paid off, Smith will be able to concentrate on increasing her savings.

Elliott said Smith must raise her annual $2,000 IRA contribution by $736 if she wants to stop working at 66 and maintain her standard of living in retirement. The calculation assumes that about one-third of her retirement income will come from Social Security and that her IRA will grow at an average of 10% a year.

Any extra cash should go into an emergency savings fund, Elliott said. This would allow Smith to avoid running up credit card debts when unexpected car repairs or vet bills arise. It would also provide a cushion against a more catastrophic event, such as losing her job.

“You should aim for saving three months of expenses, which is about $5,000 for you,� Elliott told Smith. Half of that fund could be created immediately by cashing in a $2,500 mutual fund Smith owns.

When Smith raised the possibility of using the money to pay down her credit card debt, Elliott advised against it. For one thing, the planner said, an emergency fund should be easily accessible--which would not be the case if the money were invested in a mutual fund during a down market.

Moreover, if Smith is like some people who struggle to control credit card spending, paying a large chunk quickly can almost invite a new round of charging, Elliott said. A slower but steadier effort is likely to prove more enduring, she said. explained.

Saving money is only half the battle, of course. Smith also needs to invest smartly, and Elliott said Smith’s portfolio is badly in need of an overhaul.

Currently, her retirement funds are divided among three American Express mutual funds. Despite owning different funds, Smith is far less diversified than she thinks, the planner said. The stocks of large American companies dominate all three.

“You need to reallocate some of your funds to avoid the kind of volatility that made your account drop $9,000 in a single month,� Elliott said.

Rather than investing solely in large U.S. stocks, Smith should have 25% of her assets in international stocks and the same proportion in bonds, Elliott said. Ten percent should be in small American stocks and the remaining 40% can remain in large U.S. issues.

Smith suggested splitting the large stock holdings between a pair of no-load mutual funds--the value-oriented Sound Shore fund (five-year average annual return: 18.07%) and the growth-oriented Harbor Capital Appreciation fund (five-year average annual return: 22.8%).

Instead of buying individual bonds, Elliott suggested a bond fund, such as the Vanguard Intermediate-Term Bond Index (five-year average annual return: 6.43%). The remaining choices to round out her portfolio should be the small-capitalization Managers Special Equity (five-year average annual return: 18.98%) and Vanguard European Index (five-year average annual return: 15.5%).

“Nobody knows which will be the best-performing category in the next few years, so it makes sense to spread your money around,� Elliott said. “Your current position is too aggressive for someone in your situation.�

Because Smith lives alone and manages her financial affairs by herself, Elliott recommended that she prepare several documents to help relatives handle her affairs in case of death, serious illness or injury.

These include a durable power of attorney, which would designate someone to handle her financial affairs if she were incapacitated, and a health-care power of attorney, which names a person to make health-care decisions.

An advance directive for health care would allow Smith to spell out what level of artificial life-support systems she would authorize.

Finally, Smith should draft a will to ensure that her assets will be disposed of as she wishes.

“I’m not getting any younger,� she said, “and at 44 I know I need to be doing something about these things.�

Graham Witherall is a regular contributor to The Times.

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This Week’s Make-Over

Investor: Julie Smith

Income: $31,500

Goals: Eliminate credit card debt and plan for retirement

Current Portfolio

* Mutual funds: $2,500 in Templeton Growth

* Individual retirement account: $17,500 in American Express Stock fund; $42,000 in American Express New Dimensions; $8,500 in American Express Diversified Equity

Recommendations

* Cut up credit card

* Try to reduce interest rate on credit card balance

* Increase monthly credit card payments

* Diversify retirement portfolio; recommended purchases: Sound Shore fund, (800) 551-1980; Harbor Capital Appreciation, (800) 422-1050; Managers Special Equity, (800) 835-3879; Vanguard European Index and Vanguard Intermediate-Term Bond Fund, (800) 662-7447

Meet the Planner

Elizabeth Elliott is a fee-only certified financial planner and owner of Los Angeles-based Elizabeth Elliott Inc. She specializes in general financial planning for individuals and small businesses.