Sometimes we think that making a budget is a long, complicated process. But for the purpose of setting a financial target, it doesn’t have to be. It’s surprising how simple it can be, while still being useful.
When I was young a particular passage in Lewis Carroll’s “Alice’s Adventures in Wonderland” appealed to my juvenile sense of logic.
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
“I don’t much care where – ” said Alice.
“Then it doesn’t matter which way you go,” said the Cat.
That came back to me in connection with measuring your progress towards your retirement financial goals. If you don’t have a goal, it isn’t possible to measure your progress. True, in addition to numbers there are also guidelines in terms of activities and mindset, and that’s quite useful – certainly better than nothing. But if you have a financial goal, then it’s even more informative to be able to measure where you are in relation to the goal.
(Sidebar: OK, that’s a reminder to me that at some stage I need to tell you about those guidelines. Forthcoming.)
The passage from Alice is often misquoted as: “If you don’t know where you’re going, any road will get you there.” Yes, but if you don’t know where you’re going, you probably won’t bother to take the first step.
So I think it’s useful to have some notion of a spending budget for your entry into the land of life after full-time work. And if you aren’t used to budgeting and the thought scares you, you’ll be glad that my point is that a budget doesn’t have to be detailed to be useful.
In fact, any number at all is useful for this stage, even if it’s just one overall number, simply because it’s a number! If all you say is: “I’d like to be able to spend $X a year when my work income stops,” that’s enough to start calculating how much progress you’ve made.
Would it make a difference to your mindset if you discovered that you were only halfway to your goal? Or alternatively all the way there? Or alternatively that you have twice as much as the goal requires? Yes, of course you would think differently about your progress, depending on which of those turned out to be the measure. And so you ought to know which one you’re closest to. And, in turn, that’s why any starting point at all is useful.
You can refine the target in many ways and at many levels of detail, if you want to plan better. But somehow life never quite seems to work out as you’ve planned. So it’s the planning process itself that’s the real value, even more than the resulting numbers.
How might you choose that first number, $X? And how might you refine it later?
In my case (meaning for my wife and me together, of course), when I first thought about it, the $X I started with was my current salary. It was the gross amount, before taxes and other deductions.
I was still only in my 30s at the time, but I was developing the analysis I called Saving to Afford Retirement (or STAR, since I wanted a cute acronym), which I hoped (ha ha) would earn me money as I applied it to an older clientele. Oh well, that never succeeded, because I had no idea how to reach my prospects. But the thought process helped me personally.
I could equally well have started with my take-home pay, the net amount after taxes and deductions.
Would taxation change after retirement? I hadn’t a clue. So my first assumption was “no change in taxation,” and that solved that problem for the time being.
The more important adjustment was to allow for all the deductions and other spending that (I hoped) would stop some time before retirement. Of these three were obvious. One was mortgage payments. A second was regular retirement savings. The third was expenditures on children. Assuming all of these would stop at some (unspecified) time and not be necessary to continue after retirement, I deducted them and discovered that my actual ongoing lifestyle required much less than my current income.
Common sense, isn’t it? My current lifestyle is measured by what I’m spending on current stuff, not by my total pay packet.
That idea alone tends to make a huge difference, both psychologically and numerically. And the few clients I used it for got hooked at that point. They had just never thought about it.
Wait, won’t all these numbers change, every year? Of course. But the process was helpful – and what’s more, when a number changed, it was then possible to measure how much the change affected the target. Even a change in the rate of income tax, or in the Pillar 1 benefit (see Post #9), could be interpreted as: “Now I know how I’m affected by that change.” (It made the outrage much more specific, to know the impact.)
All sorts of other refinements are possible, such as allowing for an increase in credit card debt or alternatively its elimination. Or expenditures that aren’t regular, but you want to budget for them as an average annual amount. And so on.
How much detail you’ll want to get into will vary with whether you’re already running an analysis of your spending or not, what app you’re using if that is indeed what you’re doing, and so on. Apparently roughly one-third of Americans do so, according to a 2013 Gallup poll. That implies that most don’t. And my message to those who don’t is just that a tiny start is the most important step of all. The rest is detail.
(Oh, I should remember to add that, when you do your personal funded ratio calculations, you’ll allow for inflation, because what costs $100 today will cost more after inflation takes its toll. But don’t worry about that right now.)
You’ll notice that I didn’t use rules of thumb like “everyone needs 70% of their pre-retirement income to retire on.” For one thing, 40 years ago those rules of thumb didn’t exist. But it was also obvious to me that what mattered was my own spending, which might be very different from someone else’s, even if we both had the same total pay. And I got at my personal spending, not by creating a detailed budget, but simply by saying “it’s whatever is left after all the stuff that will stop, stops.”
I was delighted to discover, decades later, that Bonnie-Jeanne MacDonald independently discovered the idea for herself, backed it up with extensive analysis of data from Statistics Canada, and deservedly won global accolades in 2014 for identifying the “living standards replacement rate (LSRR)” as a better measure for evaluating retirement income adequacy than any rules of thumb.
By the way, respected Canadian researchers Malcolm Hamilton and Fred Vettese have also done extensive analysis, and have concluded that most Canadians will live just fine after retirement on something like 50-55% of pre-retirement income – and still save money out of that. So much for traditional rules of thumb.
OK, tell me: do you budget? If so, is your budget simple or is it multi-layered? Did it evolve over time? Do you create mental accounts for each category, so that over-spending in one category can’t be compensated by underspending in another? Was it a struggle to create your first budget? I’d love to know.
Having even a single aggregate number as a spending target is very useful. You can change it and refine it over time, but without it there’s no financial goal to measure progress towards.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.