Sunday, December 27, 2009

Crashproofing

In the book "Crashproof Your Life", attorney Thomas Schweich lays out a simple framework for mitigating the risk of individual financial catastrophe. At the heart of his book is his "pyramid" structure, with each of the four corners representing a different bank account:

1) a limited-purpose checking account
2) a discretionary "slush fund"
3) an untouchable savings account
4) an investment clearinghouse account

Although he does not appear to be formally trained as an evolutionary psychologist or behavioral economist, Schweich does recognize that human beings are inherently susceptible to some maladaptive decision-making pressures and his purpose is to create a four-account, autonomous direct-deposit structure that forces fiscal discipline. For instance, the limited-purpose checking account is used only for recurring expenses (house, car, utilities, food). The slush fund is for shopping sprees, vacations, and so on. The savings account is essentially a doomsday fund and is never accessed under normal conditions. The investment clearinghouse account is used to fund investment programs (more on this later).

As Schweich puts it: "Under the pyramid plan, the first two accounts control your spending and the second two accounts grow your savings...the purpose of this legal structure is to change the way you think about money. The pyramid system places absolute structural limits on how and when you can spend your money. As you will see, each of the four categories has some flexibility, which is necessary for any structure to last; but if you are to crashproof your finances, you have to structure your mind as rigidly as you structure your accounts: the limited-purpose checking account pays for day-to-day expenses, the slush fund covers extraordinary expenses, the savings account accumulates cash available for true emergencies, and the investment account grows your wealth and builds your long-term security. You cannot use money in one account to cover a perceived shortfall in another. Use the clear legal structures to create clear mental structures that will prevent you from dissipating your wealth in the way the forces of disorder want you to do."

The author goes on to discuss his allocation principles, which go something like this: an individual or couple should take after-tax annual income and then divide by ten. The ten units are then allocated according to a fixed-percentage schema: he starts by committing 7 units (70% of after-tax income) to the bill-paying checking account, then 1 unit (10%) to each of the other three accounts. It is vitally important to Schweich that the allocations be made automatically via direct-deposit, and that ATM card use is somehow strictly controlled.

One person's recurring expenses will obviously be different from another person's: a woman who needs to dress very well as part of her job, for instance, may be perfectly reasonable in viewing the limited-purpose checking account as the funding source for her wardrobe. However, Schweich cautions against this practice and he has some fairly draconian rules regarding what constitutes a legitimate recurring expense and what should be rightfully considered a discretionary/slush fund-sourced expense. For example, he says, "To qualify as 'routine', the total amount you can spend on entertainment should not exceed about 5 percent of the sum that you put into the account. In the case of our extended family, that would be about $210 per month (5 percent of $4200)."

Allocation percentages do evolve over time: for instance, after seven or eight years (depending on prevailing interest rates), the savings account will hold the equivalent of about 100% of average after-tax income. At that point, the individual or couple has a year's worth of income saved in the apocalyptic "end of days" account and can probably cease making allocations to the account and rebalancing. Perhaps after rebalancing the checking account still receives 70% of free cash flows, but each of the two other active accounts (slush fund and investment clearing house account) now receives 15%.

The "average after-tax income" issue is very important: if the saver(s)also grow living expenses over the time horizon being discussed, then it may take longer than planned to save the target 1 year (more or less) of expenses that are meant to be covered by the doomsday savings account. This is because the amount held in savings after, say, seven years may not be sufficient to cover a year of living expenses if the living expenses are now at an all-time peak.

Schweich's policy for the slush fund is to first use it to pay off debts, usually by starting with the highest interest rate problems (credit cards) and then working down. In this regard, he joins Dave Ramsey and a host of other pop-personal finance writers who have strong anti-debt leanings. In theory, of course, leverage can be very attractive if the interest-rate differential between money going out on loans and money coming in from investments is favorable to the borrower, but few true risk-free arbitrage opportunities exist, time/interest rate coordination activities can be perilous, and many of these writers are inherently conservative regarding leverage for other, usually good reasons. Leverage is an amplifier of one's fortunes, good and bad. Virtually no investment opportunities will ever manage to consistently clear the annual rate charged by credit card companies, so few would argue that this is ever going to be an application of favorable leverage.

My own feeling on this is that the slush fund should be used to retire expensive consumer debt like credit cards, but not for mortgage prepayment efforts unless the individual is truly conservative and so is his significant other. My fear is that an obsessive focus on total elimination of debt may result in negative consequences for the relationship, as the couple forgoes vacations, gifts, and so on. I doubt that Schweich would be sympathetic to this complaint---in fact, he'd probably say that potential mates could use this as a selection filter to avoid being hitched to dangerously irresponsible "party" people and the like.

The social problems potentially created by a zealous commitment to crashproofing may be particularly acute for men. A single guy looking for or trying to keep a romantic partner and competing in a world of strutting, peacocking males promising their potential mates exotic vacations, frequently buying gifts, and so on may find himself penalized for being so conservative and accused of being miserly or inelegant, so my suspicion is that this approach works best for either established (post-courtship phase) couples who are operating as a true economic team, for hardcore independent lone-wolf types who are not interested in marketing themselves to potential mates on the axis of lifestyle enhancement/generosity, or perhaps for singles who are socially networked into groups that share certain conservative lifestyle qualities (Helen Fisher would call these types "Builders"---more on that in a future post). I think that, for virtually everyone else, the courtship phase of a relationship will prioritize fitness-signaling and chivalry and thus an aggressively conservative "Crashproof" economic strategy may not work well in the dating/mate-selection environment. It is a fine line, I know, and I really am not qualified to offer any insights into this aspect.

For long-term debt retirement, my modification to Schweich's pyramid would be to keep the slush fund for toys and fun after the credit cards are paid off, and to use future growth in the amount of money allocated to the limited-purpose checking account for the more conservative prepayment stuff. In other words, imagine that a couple currently earns $100,000 and thus places $70,000 (using the Schweich basic 70/10/10/10 allocation rule; this may not work for everyone) in the limited-purpose checking account. Let's say that living expenses can be kept within this $70,000 envelope, and that next year the couple does wonderfully well and earns $200,000. Our lucky lovers now have $140,000 (70% * $200k)available for the specialized checking account, but their actual expenses are still only $70,000. There are good arguments for this surplus being allocated to the investment account, but in keeping with the highly conservative, "crashproof" nature of the Schweich plan I would submit that the money could in fact be intelligently applied towards early retirement of long-term debt, most specifically the house note.

In terms of his discussions of the investment clearinghouse account, Schweich is not a money manager and thus his descriptions of options are not meant to be exhaustive. I believe that a separate concept, one created by the late libertarian author and investment strategist Harry Browne, is very useful in maintaining the goals of Schweich's crashproofing financial pyramid structure as we move into the more dangerous and uncertain waters of personal investmment planning. I'll describe Browne's "Permanent Portfolio" in my next blog entry.

For Further Reading: Thomas Schweich's book is titled "Crashproof Your Life: A Comprehensive Three-Part Plan for Protecting Yourself from Financial Disasters".

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