Four fundamental rules for financial security

In today's harsh economy, it may seem contradictory that many Americans in their 20s are earning quite healthy salaries. Those with engineering, economics, or nursing degrees make beginning salaries of more than $50,000. After five years in the workforce, some earn $80,000 to $90,000 annually. But many 20-somethings outspend their paychecks, addicted to expensive lifestyles financed with high-interest credit cards. They also put little – if anything – into savings.

Many consider investing for retirement to be premature. But be advised: There are fundamental steps that people in their 20s can take to achieve greater financial security. For them, as well as for those in older generations, I offer these four rules:

Rule No. 1: Own your future.

Today's economy presents many negative realities: escalating gas and food prices; depreciating home values; and disappearing solid middle-class, benefits-rich jobs. Given this distressing financial environment, feelings of a financial future beyond your control is understandable.

To counteract that, be proactive in managing your balance sheet. Don't depend on either a single employer or the government for your financial security.

Carefully set up a budget based on your income. Carlos Arreola understands that process. A high school teacher in suburban Los Angeles, he carefully allocates his $40,000 income to support himself without credit-card debt. "I really don't spend much money except on my car and rent," he says.

Mr. Arreola owns his future because he didn't become beholden to credit-card companies that charge interest rates that border on 20 percent. As a next step, Arreola hopes to establish a strong credit profile and eventually qualify for a 0 percent down mortgage program available to teachers to purchase a home.

Rule No. 2: Reducing risk is more important than maximizing return.

An unfunded healthcare emergency, job loss, disability, devaluation of residential property, and investment losses are among the risks commonly encountered as people journey through life. Many of these risks can be offset through cost-effective insurance and prudent planning to build and diversify an investment portfolio.

Ideally, an employer will provide a 401(k) or similar retirement savings plan as well as health insurance. But employees don't always maximize such benefits.

Cheryl Estep, an agent for State Farm Insurance in Whittier, Calif., recently experienced an increase in calls from her clients wanting to find ways to reduce their insurance costs or withdraw money from their investment accounts to help pay rising family costs.

"Letting life insurance lapse, withdrawing money from cash-value life-insurance policies, and canceling or amending insurance policies are among the actions some frantic clients have taken," says Ms. Estep. She recommends a more balanced response, asking her clients the key question: Are you comfortable with the exposure that will result from your actions?

Two sound suggestions that Estep has offered her clients include: (1), increasing deductibles on homeowners, auto, and healthcare policies, but not reducing coverage or liability limits; (2), deferring investment payments to 401(k)s or mutual funds, but not canceling healthcare or auto insurance.

Don't gamble that a catastrophic event won't happen to you by leaving yourself exposed without insurance. A prolonged illness or some other unfortunate event can cost you a lifetime of savings.

Rule No. 3: Make time your ally.

Time is your greatest ally if you take actions to build your savings. Don't wait for an expected inheritance or a promotion before investing in retirement savings or joining an employer-matched savings plan.

Leverage the power of compounded interest. A 30-year-old who begins investing $150 a month at 5 percent will have about $180,000 by the time they turn 65. To make that amount, a 40-year-old person would need to invest $300 a month. Simply put, saving early will make you more secure in the long run.

Arreola believes the pension benefits of his job offset his lower salary. "The benefits are definitely good – I will receive 80 percent of my pay when I retire for the length of my retirement. Few jobs offer that support today," he says.

Rule No. 4: Master change.

Life is not static – and neither is your financial plan. When events occur, it is necessary to respond by revising your plan.

Arreola did not have the advantage of leaning on parents to fund his college education. Emigrating from Mexico at a young age, he is the first in his family to graduate from college.

Through a combination of loans and part-time tutoring work, he was able to earn a bachelor's and a master's degree in mathematics.

Those tools, he believes, will give him what's necessary should his career path change.

"I believe there is a positive outlook for the employment of math teachers, but if school districts were to encounter layoffs, a math major with an advanced degree can get a job anywhere," he says.

• Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.