five steps: step 5 invest in the future

This is the final post in an irregular series on the five steps to solid wealth. Step 1 was spending less than you earn, step 2 was paying off consumer debt, step 3 was to grow an emergency savings account, step 4 was to insure yourself adequately and no more. Step 5 is to invest in the future - this is the step that you don't so much complete as begin and continuously work on.

First of all, I should start by saying that investing in the future means sacrificing money and/or time now in order to have an improved life at a later date. The most important way in which you need to invest for the future is to ensure that you are not reliant on the state to provide you with a comfortable old age. It is true that the state is likely to keep you off the streets by way, but there is unlikely to be enough money around to keep you out of poverty by the rest of society's definition. There are tax-advantaged vehicles that can help you out with this aspect.

Other ways of investing in the future could mean investing in your children's future by putting away some money for university fees or helping them with their first house or car. It could also mean investing money and time in your career by studying for additional qualification or moving to a location that will enable you to have a better salary or quality of life.

In any case, investment considered here is predominantly for the medium to long term. Over this time frame your biggest enemy is inflation and your best defence is a high average rate of return. Both of these are factors due to the magic of compounding, which by the rule of 72, means that an inflation rate of 3% will halve the spending power of your money within 24 years, whereas an average rate of return of 3% will double your money within 24 years. Some simple maths should tell you that a rate of return over inflation is needed to make your money grow and a return under inflation will make your money shring in real terms.

One of the worst ways to invest is therefore is by stuffing money under the mattress, the best ways are those investments that typically beat inflation - generally stocks and property. I favour stocks over property because the start up money required is lower and the rate of return has historically been at least as good as property. Whatever you invest in, the key thing is to be consistent and sensible. Keep an eye on your money, learn about ways of investing and eventually you will achieve solid wealth.

five steps: step 4 insure yourself adequately and no more

This is the fourth in an irregular series on the five steps to solid wealth. Step 1 was spending less than you earn, step 2 was paying off consumer debt, step 3 was to grow an emergency savings account. Step 4 is to insure yourself adequately and no more. I'll discuss the areas in which you need to consider insurance below.

The key principle in deciding whether insurance is adequate is to think about the things that you need that you don’t have the resources to replace or fix.

Most people in the beginning or middle of their plan to get rich and end life as a lad/lady of leisure are reliant on income from working (either for themselves or someone else) to not only keep on the plan, but also pay the bills. If you fall into this category, then you probably need to insure yourself against an accident or illness that means that you are unable to work. For this you need income protection and permanent health insurance (also known as short and long term disability insurance)

Anybody with dependents who rely on them for provision of housing, food etc also need to consider having a serious amount life assurance (or life insurance if you’re a Yank). The key word here is rely. If your husband / wife / partner currently earns their own income and you have no children, you probably don’t need major life insurance. On the other hand if you have a non-working spouse / partner you probably need some and if you have children, you probably need a lot.

pensions allsorts

In the UK, there are several different types of pensions, split into two groups:

occupational pensions

• defined benefit = final salary
• defined contribution = money purchase

private pensions

• personal pensions
• stakeholder pensions
• self-invested personal pensions

Occupational pensions are run on behalf of the employer, often by an insurance company such as Standard Life. You can generally contribute via salary sacrifice and often the employer contributes too. If your employer has more than a certain number of employees, they must either offer access to an occupational pension scheme, group personal pension scheme or to a stakeholder scheme, although they do not have to contribute. The two types of occupational pension available are defined benefit and defined contribution.

A defined benefit or final salary scheme is one in which the pension (benefit) is defined in advance as a percentage of the final salary. The percentage you can get will depend on how long you have been working at the company and is roughly positioned so that if you worked at the same company for your entire career you would receive a pension of approximately two-thirds of your final salary. This pension is paid for by investing your contributions sacrificed from your salary and generally the employer contributes also. With this type of scheme, the trustees of the scheme will choose how to invest the money they have so that there will be enough to pay out all the retirement benefits of the scheme to all members. The biggest risk that you face is that the scheme will be wound down or the company go bankrupt (potentially due to pension liabilities). Defined benefit schemes have become much rarer of late.

All other pension schemes work similarly. You contribute an amount of money every month which is then invested. In return for investing before income tax, you agree not to take the money out until retirement (due to rise to 55), there are further rules about how you may withdraw the money at that point. You are responsible for choosing the investments so that you will have a sufficiently large pot of money to live off once you are retired. These underlying investments are the important part of the pension and the bit that generates the money, everything else is just a set of rules.

Occupational defined contribution or money purchase schemes have the added benefits that often the employer will contribute to your pension pot in addition to your own contributions. Also as all the employees in the company are invested through the same scheme, discounts can often be negotiated on the investment fees. The main drawback is the limited number of different types of investment that the money can be placed into.

Personal pensions work in exactly the same way as money purchase pensions do in terms of risk. The main advantage of a personal pension is that it is not linked to any one employer and can be taken out by anyone. The disadvantages are that the charges can be high as an individual pension pot is not usually large enough for discounts to be negotiated, there are also often restrictions on the minimum amount of money that may be invested each month and the variety of investments available varies considerably depending upon the provider.

Stakeholder pensions are like personal pensions with the added benefits that the fees are capped at 1% per annum, the lowest payment that must be made monthly is £20. The drawbacks are that range of investments available is generally small and that the fees are usually set at the maximum 1% despite the underlying investments being available with much lower fees (often 0.1% to 0.5%).

Self-invested personal pensions or SIPPs are like personal pensions, but with the added benefit of having a very much wider range of investments available. In particular it is possible to invest in almost any unit trust, exchange traded fund, investment company, bonds, individual shares and cash*. They may have higher fees especially if they allow investment in the more esoteric options, but that is not always the case, many SIPPs are run by discount funds supermarkets have very reasonable fees similar to those found in stakeholders, although they usually have stricter rules on the amounts of money that may be transferred into the pension.

I think that the best way of investing through pensions is to determine what your overall investment strategy is, taking into account the amount of risk you are comfortable with and the length of time you have until retirement, and then working out the cheapest way of getting there, taking into account all your own circumstances.

*It is almost always a poor idea to invest a pension fund in cash.

five steps: step 3 grow an emergency savings account

This is the third in an irregular series on the five steps to solid wealth. Step 1 was spending less than you earn, step 2 was paying off consumer debt. Step 3 is to grow an emergency savings account. Its possible (and often recommended) to pay off consumer debt and grow a little emergency savings account simultaneously.

Firstly, the purpose of the emergency savings account is to prevent you from needing to pay to access money in an emergency. By paying to access money, I mean by using an overdraft, a credit card or a personal loan. Having an emergency savings account is likely to stop you sliding into more consumer debt if you have any. It will also generate some income for you in the form of interest if you store it in the right place.

The best location that I can think of for an emergency savings account is in a mini cash ISA. These grow tax free and make more money than regular savings accounts. Whatever sort of account you use, you want it to be earning interest over the rate of inflation (above 4% if you can get it) and you want it to be easy to access but not so easy you spend the money. I've found that internet accounts are the best in terms of access, but I have also used postal accounts, which means that it takes me a couple of days to get the money out. I would suggest avoiding accounts with a debit or cash card, as its all too easy to withdraw the money.

The amount of money you need to have in savings depends on the sort of emergency you are likely to encounter. If you lost your job unexpectedly, how long would it take you to find another one? If there was a sudden death in the family, how much would it cost to travel to a funeral and/or take care of their affairs? If the boiler broke in the middle of winter, how much would it cost to buy a new one?

At the moment, my emergency savings are at three months living expenses. This would cover me if one emergency happened, but I'm trying to improve it so that I would be ok if a couple of things happened at the same time. If you are just starting out, it might be easier to set a relatively low goal, say something like £500. In the event of an emergency, this would give you some breathing space before you had to find any more money.

five steps: step 2 pay off consumer debt

This is the third in an irregular series on the five steps to solid wealth. Step 1 was spending less than you earn. Step 2, paying off consumer debt is generally (but not always) necessary to ensure solid wealth because consumer debt is expensive. It certainly puts you in the right mindset of not paying more (in finance charges) for something than you have to.

Consumer debt can be crippling. Interest rates are often high. You are paying through the nose for the privilege of buying what you can’t afford. It starts with stopping the use of credit. Pay it off by finding as much money as you can and throwing it at the debts. My favourite method is the Dave Ramsey debt snowball. I haven’t used it myself, but it comes with good references, and I can see why people stick to this method more than others. And that’s what’s important folks, sticking to it.

You can find great resources within the personal finance community on getting out of debt. In particular, no credit needed is the quintessential get out of debt blog and the archives on his site are immense. Get inspired and pay off your consumer debt.

five steps: step 1 spend less than you earn

This is the second in an irregular series on the five steps to solid wealth.

Step 1, not spending more than you earn is the true key to being wealthy, in that if you do not follow step 1, I can guarantee that you will not be wealthy.

To establish whether or not you spend more than you make, you need to know only two pieces of information. How much income you have and how much you spend. Both of these are relatively easy to establish with the help of your bank and credit card statements and a calculator. (I like a small glass of wine as well as I find a modicum of alcohol eases my thought processes).

Ideally, if you have three months of bank statements to hand, you should be able to establish whether or not you are successful in this rule. If you are, congratulations, keep up the good work - probably easiest accomplished by making and sticking to a budget - and move on to step 2.

If you are not successful in this rule yet, you could find yourself in the position of trent during his financial meltdown, so you need to take action.
There are essentially two ways of turning this situation around. You can either earn more or spend less. There are loads of resources to help you find which flavour of these solutions you would like.

To boost your income, you could get a second job, turn a hobby into a business, take in a lodger, start childminding, sell your excess stuff at a car boot sale. To spend less, you can cut down on frivolous spending, move to cheaper accommodation, switch your bills, and get the best deal on everything you do need to buy.

The important thing is that you need to do something, and the sooner you start the better it will be.

the five steps to solid wealth: part 0

I'm going to be writing an irregular series on the five steps to solid wealth. These are the things that I think cover everything you need to do to become comfortably well off.

Spend less than you earn
Pay off consumer debt
Grow an emergency savings account
Insure yourself adequately and no more
Invest in the future