Academic Assets

The Financial Lives of Academics

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By John Vineyard

Imagine a game that requires you to divide people's lives into three stages. For an artisan, the trinity might be apprenticeship, competency, and mastery. For someone in business, it might be junior executive, senior executive, and CEO. For an academic, it might be tenure track, post-tenure, and retirement. The permutations are endless. But one pattern remains constant for everyone throughout: the struggle to pay one's bills.

I'm playing this game because my mission is to talk about the financial lives of academics, and the easiest way to do that is to divide the faculty career into three segments. (Administrative careers don't fall quite as neatly into three parts, but most of the same principles apply.) Your ability to make sound investment decisions at each stage can make a major difference in how everything else works out in your life.

Chances are, unless you are a business professor with a specialization in personal finance, the issues involved in investment planning can be a distraction from the core activity of your career. Indeed, they may seem like a gigantic bore. But getting your life right is seldom boring.

Stage 1: The Road to Tenure

Most academics spend little or no time thinking about financial planning and retirement while they're in graduate school, in part because most are struggling just to make ends meet. That's why I've defined the first stage of an academic's financial life as the period of six to seven years from the time you join the tenure track until the point you receive tenure -- or not.

In financial terms, that first hire is like receiving two very reliable bonds. Thinking about your first job that way can help you decide how to manage your money in the early stages of your career.

The first bond represents the salary and benefits that you will earn during those first six years. It's virtually certain in its term to maturity, meaning that you're likely to keep your job and earn a stable salary during those six years. We know that the payments will increase fairly steadily, at a fairly predictable rate, and that it's quite secure -- not as safe as a U.S. Treasury bond, but probably as good as a top-rated corporate bond. Unlike a real bond, however, there's no principal that you get back when this "bond" expires -- that is, when you come up for tenure after six years.

So, compared with other careers, like selling real estate or being a rock star, and compared with other investments, like common stocks or commodity futures, academic earnings tend to be easy to project. Your first hire is as close to a promise of lifetime employment as anyone working for a living is likely to find. And no matter what your salary, your institution is likely to have a fixed formula for determining how much it contributes toward your retirement, so that, too, is highly predictable, like a bond. The beauty of the deal is that it allows you to plan more reliably. Academics don't have to guess in fear as much as other investors do.

Your initial hire also comes with a second "bond," which is the value of the salary and benefits you will earn over the rest of your career if you get tenure six years down the road, or if you decide, as an administrator, that you want to devote your career to higher education.

Bond 2 has a term of about 30 years and will also pay increasing amounts of salary and benefits. At this point, the second bond is far less certain than the first one, not just because the tenure decision lies ahead but also because the amounts of your future pay increases are harder to estimate over such a long stretch. So we might consider that Bond 2 has a quality rating somewhat better than junk but certainly far below AA.

By using a spreadsheet, we can come up with a pretty good estimate of the "present value" of the second bond. ("Present value" is a financial term that makes it possible to make an apples-to-apples comparison of a sum of money today versus a point in the future, by using a discount rate for money you will receive in the future. The discount rate that we use to find the present value of future payments is based on the current cost of borrowing money. The further away those payments are, the greater the discount.)

You can take a reasonable stab at estimating the present value of Bond 2 by looking at the progress of older people in your field, demographic trends, and long-term interest rates. Although your life is loaded with uncertainties in your field, in your research, in your relations with colleagues, and in other realms, certain features of your compensation are pretty predictable -- more than for almost anyone else outside the civil service. Most academics find this high predictability a source of comfort, although it can also be a kind of golden handcuff.

As you step into your first job, can we make some kind of conservative estimate about the total value of the two bonds? Let's imagine that you receive a starting salary of $45,000, and that your annual raises for the next six years are steady at 4 percent. Under that assumption, you would receive total salary payments of $298,484 over the six years. What is that amount worth in today's dollars? Using 6 percent as a discount rate, we compute a present value of $243,000.

Assuming that your college generously kicks in 15 percent of your salary toward your retirement, that's an additional $44,773 (or a present value of $36,450). So between your salary and your pension benefits, that first hire is like being given a bond with a present value of $279,450. Not too shabby, considering the strong likelihood that this bond will actually pay off as expected, since you are unlikely to get fired before you come up for tenure.

Now let's consider that second, more speculative bond. Let's be conservative and assume that after tenure you get annual raises of 3 percent, and that you work for 32 more years. Pension contributions continue as before. The same calculations will work for administrators, although the job security is usually not as guaranteed.

We've already agreed that there are a lot more uncertainties in looking that far ahead, but what's our best guess about the value of Bond 2? Using the same process as before, I get a present value of $915,824. Adding the two bonds together gives us a present value of $1.16-million in salary and pension benefits. If you spent all of your salary every year but invested your pension contributions to earn 9 percent during the rest of your long career, your pension account would grow to $1.13-million in today's dollars, assuming an inflation rate of 2.5 percent, or about $2.9-million in future dollars.

Deciding whether that amount is enough is a highly individual matter, although for many people it would provide a long and secure retirement. Only you can say whether that amount will leave you comfortable or crimp your lifestyle. Knowing the present value gives you perspective in deciding whether it will be enough for you in the future.

You might do a good deal better or worse, but there is a lot of value in regularly repeating that kind of projection. One reason is to check to see if you are on a reasonable course toward financial security, and whether circumstances have changed to require that you change your spending or investments.

Say you get a sudden raise in your seventh year, to $75,000. By reworking the numbers, you can see how that raise is going to affect your retirement savings: Instead of $2.9-million in pension savings when you retire 32 years later, your higher salary will increase your retirement account to $3.5-million, the equivalent of $1.4-million in today's dollars. Knowing that can help you decide whether you would like to be more aggressive in your investments with the extra money. Despite the relative stability of academic life -- compared with that in the corporate sector -- it may be structured quite differently 30 years from now.

The relatively static arrangement of academic compensation allows you to plan your spending better than people in some other professions can, and it allows you to be fairly aggressive in investing, especially through the first half of Stage 2. If I worked for a Silicon Valley start-up, I would want my retirement nest egg to be heavily invested in some very stable stuff -- government bonds, A-rated corporate bonds, big-cap stocks, and such -- because my earnings are likely to be so uneven. You, on the other hand, as you organize your life in Stage 1, have good reason to invest 100 percent in stocks.

Stage 2: The Tenured Years

At this point, your first bond has matured and your second has either had a sudden quality upgrade or a sharp downgrade.

Let's suppose you are lucky enough to have gotten tenure. Your second bond matures when you are 65, the age at which most people retire. Let's say that point is 32 years down the road. What begins to get interesting is to consider the balance of your net wealth. At this point, even if you put everything into stocks for the rest of your career and keep earning 9 percent on pension investments, the preponderance of your future earnings still lies ahead, so it is still overwhelmingly like a bond.

As you get older, however, that proportion changes. Somewhere between age 45 and 50 the remaining bondlike value of your future salary payments falls below the accumulated value of your pension. It is at this point that you should consider beginning to shift some of your portfolio away from equities and into less risky investments. So if our hypothetical professor at age 58 has 80 percent of his pension holdings in stocks and the rest in bonds, it's probably time to shift more of those holdings to bonds.

In the real world, this calculation is more complicated because people tend to accumulate a lot of equity in their primary residence, a fairly stable asset, and so the imbalance is not as stark as I make it seem. You should disregard housing as an investment for the time being, since you presumably have to live somewhere. That money should be kept out of the picture because you'll always need access to it even if you sell your house and move into continuing care.

And remember: Retirement is not the only thing you need to plan for. There's also the matter of college costs for your children. Some people use their pension assets to help defray college costs, but it's probably best if you can earmark some savings specifically for education. At a minimum, setting aside 2 percent of your salary a year for those costs seems realistic, but that figure depends on how many kids you have and any other resources they will be able to tap (like grandparents).

By keeping all of your retirement assets in stock past age 50 you are, in fact, increasing your equity-market risk. That may not be appropriate unless you have significant resources in addition to your professional earnings. It is reasonable for most people to shift some portion of their accumulations into cash and fixed-income investments -- not primarily because they are safer, but because you need to maintain some reasonable proportionality between the two types of savings. If you had all of your pension savings in Internet stocks in 2000, you understand all too well why it's important to have a balanced, diversified portfolio.

It's sensible to maintain a strong equity profile in the years following the winning of tenure, and to keep that position in your early and middle years. Somewhere around age 45, however, it may make sense to begin shifting the allocations toward bonds. But not too far. You'll still need the long-term potential for growth that equities provide. The more certainty that you buy through your choice of assets, the lower your expected long-term growth. Professors tend to have long lives and active retirements.

In short, you ought to be able to assess the total earning power remaining in your career from time to time, and to consider the overall asset allocation you have in relation to that power. A commonplace allocation for people over age 50 might be to have 60 to 65 percent of their pension money in stocks and 35 to 40 percent in fixed-income investments. Individual differences in wealth, career track, family, and other interests and commitments mean that there is no one-size-fits-all rule. You have no choice but to become savvier and to adapt your finances to your particular situation.

In Stage 2, you are achieving your financial goals just as you are maturing professionally. Now that you've begun to accumulate some wealth, the opportunities and choices proliferate. Depending on your interests, you can maintain a plain-vanilla approach, as in Stage 1, or you can take the next step in diversifying your holdings -- into individual securities, international and sector funds (those that specialize in a specific industry or type of investment, such as gold mining or HMO's), real estate, collectibles, and vacation property, among other investments.

Stage 3: Retirement

There is no stark cutoff, comparable to the tenure decision, that will mark the beginning of your retirement years. But I would define this stage as beginning well before the date on which you actually retire, because too many things are already locked in place by then. This is the point at which most of the returns on your career are in, and it becomes possible to make a detailed retirement plan. A common point for this stage to begin is somewhere between 55 and 60, when there's still some time to make changes in light of what you decide you want to do with the rest of your life.

For a plain-vanilla professor aged 60 who is planning to retire at 65, the remaining value of Bond 2 is now definitely much smaller than his total net worth. By now his pension allocation ought to be somewhere around 65 percent stocks and 35 percent bonds. It's time as well to face the financial implications of a number of new challenges, some of which he has probably thought about in a general way already, but which now need to be confronted as imminent choices.

The foremost choice involves the next phase of your career. Although it is possible that the amount we project for our graying professor to have accumulated in pension savings by age 65 -- the equivalent of $2.9-million in future dollars -- will be quite sufficient in the money of those times, it is impossible to guarantee how much will be just enough.

Just a few of the many uncertainties are the continuously extended human life span, the propensity for baby boomers and later generations to live healthier and more adventuresome lives past 65 than their parents did, the steady increase in costs of medical and long-term care, and the diminishing prospects that Social Security will continue to pay at the levels we now expect, beginning about 10 years from now. I don't have any specific advice to provide when it comes to medical and long-term-care insurance, except to look carefully at what's available through your college plan and make sure you have some coverage.

After you retire you will have some additional choices, like rolling your retirement funds into a self-directed IRA, which you can either manage yourself or hire an adviser to manage. IRA's open up the entire universe of investments, which is naturally much wider than the list of mutual funds available to you through your employer's pension plan while you're still working.

Every person's needs are different, but you will almost certainly still need to provide for some long-term growth as you leave employment. After age 70.5, you will be obliged to begin taking minimum distributions from all of your retirement funds, even if you're still at the grindstone and don't need them.

For those who retire with the most resources, it will be possible to live comfortably using the most conservative investment allocation. For those with less, it may be necessary to take somewhat higher risks in order to improve the chances of making your pension funds last.

One common way of looking at how much of your pension savings you can live on is to allow for a rate of spending that stays about 3 percent above the level of inflation. That ought to allow you, under average conditions, to keep spending a portion of your pension savings while still roughly maintaining the purchasing power of your principal.

For our professor who retired after 38 years with $2.9-million (or $1.13-million in today's dollars), that would mean being able to spend $145,000 a year in those future dollars -- not including Social Security payments -- or about $57,000 a year in today's money. Most people don't feel that they have to leave a completely intact pension balance for their heirs, so a somewhat higher spending level may be reasonable, depending on your circumstances.

It's not difficult to push our model of projected income and spending to show that with a combination of a few bad choices, and some bad luck, our candidate could run out of money before running out of years. That possibility, plus the basic human need to be productive and relevant, means that even if you retire from academic life, there are very good reasons for staying in the job market[--]and not just doing volunteer work[--]for a number of years.

By keeping open the ability to be productive in the workplace at something you enjoy doing, you can enhance the rest of your days and greatly reduce the risks of running short. Academics are well positioned by temperament and training to take advantage of second and third careers. The beginning of this stage is the time to plan your post-retirement career. Waiting until you step down is not.

ALSO SEE: John Vineyard offers seven tips for understanding your investments and explains how to calculate your pension savings.