Replacement savings make real money

Published: Feb 7, 2013 6:15 a.m. ET



HenryK. Hebeler


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Working people should strive to save for reserves that can be used to purchase expensive items without borrowing. Everyone should strive not to buy things they can't buy with cash.

The difference between cash and borrowing can be huge. A reserve is earning interest. A loan is costing interest. If you can earn 3% return on your savings and have to borrow at 7%, the difference is 10% per year. Few investors earn 10% on their savings.

Producers of automobiles, appliances, furniture, etc., can make more money from their financing arms than they can from cash sales of their products. Buyers pay dearly for credit purchases. Using a credit card to replace something like a $1,000 appliance can cost the buyer even more as the credit card issuer takes in the real money from outrageous interest costs, charges and penalties.

Young people almost certainly must buy their first car with time payments. But if they can start saving enough to make a 50% down payment on their next car purchase, preferably a used one, they are on the path to getting ahead. I paid cash for used cars for over 20 years. Auto dealers may give you a better deal with a cash payment too because they are interested in volume. They don't share in the financing arm's take from time sales and may make more on maintenance than sales.

Workers should strive to build a replacement reserve that will peak at retirement because retirees who must always borrow are in real trouble. Few people realize how replacement costs can add up over the retirement years. Replacement costs can easily exceed $100,000 and much more if paid with credit.

It's enlightening to see how big a replacement reserve should be for a retiree. It's not hard to do. We can use disciplines similar to those used by competent home owners associations, time-share companies and the military.

The military cannot borrow, so it must include replacements in annual congressional requests. I have been on the boards of several home owners associations and have headed organizations that estimated military replacement costs. These experiences have gone from a community having to worry only about their private road resurfacing to an entire operating military system with thousands of elements.

A home renter may only have to worry about replacing a car periodically. A home owner may have more than a dozen items that cost a lot to repair. Few new home buyers recognize the costs that come with home ownership.

So let's take a look at two ways to account for replacement reserves. The first way is for workers to know how much they should be saving for replacements. Be forewarned that the numbers can be big for home owners and even expensive for a renter who has to worry only about a single car.

We'll use the example for a single car, because every other item on a replacement list will use the same math. Suppose that the car (after trade-in) costs $25,000 and that it will be traded for a similar vehicle every eight years. The cost per year is $25,000 divided by 8, or $3,125 per year. That means that the worker should be saving $3,125 each year to be able to buy the next car with cash.

Now let's consider a retiree who wants to start retirement with a replacement reserve large enough to buy a car every eight years in retirement. If he expects to live 24 years in retirement, he will need to buy three cars in that time. That means he will need 3 x $25,000 or $75,000 in reserve for cars.

This rather simple math has a couple of fundamental assumptions. The main assumption is that the replacement reserve is able to earn a return equal to inflation. This is not unreasonable considering that most of reserve money should be liquid and conservatively invested, perhaps in Savings I Bonds. The second main assumption is that items will increase with inflation. This too is not a bad assumption considering that there are larger uncertainties in retirement planning than inflation including how the higher-risk investments will perform and, most important, how long the retiree will live. Further, the replacement analysis should be done every year thereby reducing the time horizon of the forecast.

Expand the Replacement Reserve figures to the left to see how the analysis for the automobile might be extended to a number of other items for home owners. Of course many of the things in the analysis must really be crude estimates because, unlike the military, we do not have mean-time-between-failures statistics for such items.

That said, anything that can be done to reduce retirement borrowing is important and having a little surplus near end of life may be important if we live longer than expected or need long-term-care.

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