Keeping track of every little purchase and rolling them up into categories at the end of each month is too much work for me, even with Quicken. I prefer the easy and low maintenance artificial scarcity method of budgeting.
If you haven’t heard of artificial scarcity, it’s the idea of taking money out of your hands before you have a chance to spend it. The theory is that the typical human being will spend all the money that they get their hands on. Perhaps the most common application of this concept would be 401(k) accounts.
My wife and I have maximized all of our tax-advantaged options, 401(k), Roth’s, and IRA’s. The government rules have changed over the years so the total amount invested has increased along with our salaries. This naturally lowers our take home pay by a considerable amount, but if you gradually turn up the savings rate you can save more than you ever imagined.
The same concept can be applied to your after-tax savings, if you have any money left after maximizing your tax-advantage accounts. Setup automatic investments and increase them until you start to feel a bit of a crunch. That’s when you’ve reached a limit and whatever is left is your spending money. Unless you have a lot of income, savings has to hurt a little or you aren’t going to accumulate enough.
If you run up consumer debt instead of living within your new budget then you are probably creating more problems than you are solving. If you simply can’t find a way to cut expenses then it’s time to turn down the savings rate.
Once you have reached equilibrium with your new budget, you are free to use all of your spending money without jeopardizing your future, because you introduced artificial scarcity to your finances.
If you can’t find money for tax-advantaged accounts, let alone basic savings, then this system will not work for you and you’ll need to take the harder road of strict budgeting and finding expenses to eliminate. There are numerous budget systems that you should look into.
Sunday, March 18, 2007
Budget Systems
You might ask why come up with a budget system? The standard answer is to control spending and “find” money for savings, but I think it’s more fundamental than that. Budgeting breaks the link between income and spending. If you run short on money while employed you can work harder and get a raise, take a second job or finance the purchase (apparently a very popular option) into the future in the hope that your savings or income will improve before the bill arrives.
In retirement, you are in a fixed income plan and the options to fix excessive spending are limited. Here is my list of the most obvious choices,
In the next post I’ll detail my lazy boy budget system. Being the benevolent blogger I’m giving it away for free. Plus it’s not my idea and I don’t provide any warranty or guarantee, so what would I be selling?
In retirement, you are in a fixed income plan and the options to fix excessive spending are limited. Here is my list of the most obvious choices,
- Go back to work, but then you wouldn’t be retired, by my definition.
- A reverse mortgage, which I might discuss at some point, if only to encourage people to shun them.
- Chase returns from the market and take excessive risks.
In the next post I’ll detail my lazy boy budget system. Being the benevolent blogger I’m giving it away for free. Plus it’s not my idea and I don’t provide any warranty or guarantee, so what would I be selling?
Tuesday, March 6, 2007
15% Shame
This is a quick followup to the previous post. Many employers limit their employees to a maximum savings of 15%, even though the federal limit is $15,500, up to 50%. So unless the employer matches 4% even a diligent, aware investor can't reach the target savings rate within their retirement account.
This isn’t all the companies’ fault, IRC limitations also come into play with an estimated 52% of people who aren’t maximizing their 401(k) being unable to because of plan nondiscrimination testing. Should you punish the diligent saver because their co-workers aren’t saving? You do if you are the US government!
With Social Security on shaky footing and pensions going the way of the Dodo, it's shameful that the government doesn't give employees a viable replacement.
BTW, I am still working on how I'm going to share my spreadsheet, I might end posting it on google sheet.
This isn’t all the companies’ fault, IRC limitations also come into play with an estimated 52% of people who aren’t maximizing their 401(k) being unable to because of plan nondiscrimination testing. Should you punish the diligent saver because their co-workers aren’t saving? You do if you are the US government!
With Social Security on shaky footing and pensions going the way of the Dodo, it's shameful that the government doesn't give employees a viable replacement.
BTW, I am still working on how I'm going to share my spreadsheet, I might end posting it on google sheet.
The 10% Lie
We’ve all heard the mantra, save, save, save, to the point that many people have tuned out the message. The scary part is that the message is not aggressive enough. I would argue that the amount that we should be saving is much higher than most experts claim. I’ve heard 10% as a target savings rate and people with 401(k)’s are more or less meeting this target. Current average 401(k) withholding is only 7%. Assuming that the company will contribute 3%, we reach the 10% level being analyzed.
I didn’t reach 10% using a dartboard. For the group of people who think the 10% savings rate is too high or too low, here’s a reference:
Assume a person makes $1000/year (it could be any number), averages a 3% annual raise and the country averages 3% inflation. That leads to stagnant wages, which is consistent with government reports. Finally their investment portfolio returns 8% annually. Eight percent might seem conservative, but once you factor in a mix of investments and fees I feel it’s a reasonable number.
When computing retirement salary I've excluded the employee portion of the retirement deposit, since you would not be making that in retirement. I've included 100% and 80% "living money" columns to provide some contrast, although I don’t feel that many people will want to retire on less money than they have grown accustomed to.
How much do you need to save and for how long? The detailed answer is in the reference spreadsheet and you should feel free to play with the assumptions.
Here is the summary,
This is obviously a very simple spreadsheet and doesn't attempt to consider variable returns of any type. It doesn’t delve into retirement investments that allow you to preserve your purchasing power. Plus you will probably change jobs at least five times during your working career, which might limit the number of years you are able to contribute to your retirement plan. I also do not discuss Social Security ... yet. Given the current situation I don't think you can accurately project your returns from the system, but you can make conservative estimates.
The most generous assumption gives you a working career of 41 years before you can take a 20% salary cut and retire. That seems like a big cut and a long career to me. The most conservative assumption requires you to work for 51 years before you can retire at full pay.
This means that if I am fresh out of college at 22, faster than I made it btw, I would need to remain employed and able to contribute to my retirement until I'm 63. I know that Social Security says I should retire at 67, but frankly I think they are wrong.
In my opinion the basic retirement plan would be to work for 35 years, which will likely happen at roughly 59 1/2 for many college graduates. To do that without a pay cut would require a 19% savings rate assuming a 4% withdrawal rate. Hopefully you'll get some of the 19% from your employer, but the current 7-10% is about half of what the employee is really going to need.
The 30% of people who are eligible to contribute to a 401(k) but do not are beyond the scope of this blog, since I simply can’t understand their thinking. The people who aren’t offered a retirement plan just have to do their best with IRAs, but they have my sympathy.
I didn’t reach 10% using a dartboard. For the group of people who think the 10% savings rate is too high or too low, here’s a reference:
"Total contributions—the sum of employee and employer contributions—were higher for participants who received an employer contribution as part of their 401(k) plan than for those who did not. The average total contribution rate was 10 percent of salary for employees in plans offering an employer contribution, compared with 7.4 percent for those in plans not offering an employer contribution." ebri.org
Assume a person makes $1000/year (it could be any number), averages a 3% annual raise and the country averages 3% inflation. That leads to stagnant wages, which is consistent with government reports. Finally their investment portfolio returns 8% annually. Eight percent might seem conservative, but once you factor in a mix of investments and fees I feel it’s a reasonable number.
When computing retirement salary I've excluded the employee portion of the retirement deposit, since you would not be making that in retirement. I've included 100% and 80% "living money" columns to provide some contrast, although I don’t feel that many people will want to retire on less money than they have grown accustomed to.
How much do you need to save and for how long? The detailed answer is in the reference spreadsheet and you should feel free to play with the assumptions.
Here is the summary,
| Saving % | Years of Work | % Withdrawal | % Final Salary |
| 10% | 41 | 4% | 80% |
| 10% | 45 | 4% | 100% |
| 10% | 47 | 3% | 80% |
| 10% | 51 | 3% | 100% |
| 19% | 35 | 4% | 100% |
This is obviously a very simple spreadsheet and doesn't attempt to consider variable returns of any type. It doesn’t delve into retirement investments that allow you to preserve your purchasing power. Plus you will probably change jobs at least five times during your working career, which might limit the number of years you are able to contribute to your retirement plan. I also do not discuss Social Security ... yet. Given the current situation I don't think you can accurately project your returns from the system, but you can make conservative estimates.
The most generous assumption gives you a working career of 41 years before you can take a 20% salary cut and retire. That seems like a big cut and a long career to me. The most conservative assumption requires you to work for 51 years before you can retire at full pay.
This means that if I am fresh out of college at 22, faster than I made it btw, I would need to remain employed and able to contribute to my retirement until I'm 63. I know that Social Security says I should retire at 67, but frankly I think they are wrong.
In my opinion the basic retirement plan would be to work for 35 years, which will likely happen at roughly 59 1/2 for many college graduates. To do that without a pay cut would require a 19% savings rate assuming a 4% withdrawal rate. Hopefully you'll get some of the 19% from your employer, but the current 7-10% is about half of what the employee is really going to need.
"Among workers at firms sponsoring 401(k)-type plans in 1983, only 38 percent participated, compared with 70 percent in 2003 (Figure 4)." ici.org
The 30% of people who are eligible to contribute to a 401(k) but do not are beyond the scope of this blog, since I simply can’t understand their thinking. The people who aren’t offered a retirement plan just have to do their best with IRAs, but they have my sympathy.
Monday, March 5, 2007
Look in the Mirror
I am not passing judgment on anyone's choice for his or her money. Spend every dime, plus a few of VISA's dimes as well, it makes little difference to me, but I do feel that people should be honest with themselves.
Observe your spending habits and make conscience tradeoffs. If you need a new furnace, that's understandable, but remember it's a tradeoff. If you start exercising your consciousness it will gradually creep into every purchase and might help you sacrifice something besides your retirement when a big purchase isn't optional.
For reference, my parents lived in a moderately cold local for many years without a furnace because of the monetary tradeoff. They had to use a wood fireplace and electric blankets but they are in good shape for retirement. And I learned how to use a chainsaw and split wood as a consequence.
Observe your spending habits and make conscience tradeoffs. If you need a new furnace, that's understandable, but remember it's a tradeoff. If you start exercising your consciousness it will gradually creep into every purchase and might help you sacrifice something besides your retirement when a big purchase isn't optional.
For reference, my parents lived in a moderately cold local for many years without a furnace because of the monetary tradeoff. They had to use a wood fireplace and electric blankets but they are in good shape for retirement. And I learned how to use a chainsaw and split wood as a consequence.
Getting Started
I wish there was a magic formula that would suddenly make saving for retirement easy, but if that was possible I suppose that the US population would be better prepared for their retirement years. The magnitude of the gap between ideal retirement assets and actual retirement assets is hard to quantify and any discussion seems to generate arguments about the assumptions. I think the following book covers many aspects of the discussion.
Coming Up Short: The Challenge of 401(K) Plans by Annika Sunden, Alicia Haydock Munnell
That’s a lot of reading though, so let’s keep it simple. There are two areas to consider:
Saving (Average Joe)
Spending
If you read Walter Updegrave’s article then you already understand that saving is the key and you need to maximize your savings rate to have the healthy nest egg that most of us want. Spending is on the other side of the teeter-tooter. If you can reduce how much you are spending while still having a happy and satisfied life then you open the door to many other choices. I plan to discuss both sides of the issue after establishing a baseline for discussion.
Coming Up Short: The Challenge of 401(K) Plans by Annika Sunden, Alicia Haydock Munnell
That’s a lot of reading though, so let’s keep it simple. There are two areas to consider:
Saving (Average Joe)
Spending
If you read Walter Updegrave’s article then you already understand that saving is the key and you need to maximize your savings rate to have the healthy nest egg that most of us want. Spending is on the other side of the teeter-tooter. If you can reduce how much you are spending while still having a happy and satisfied life then you open the door to many other choices. I plan to discuss both sides of the issue after establishing a baseline for discussion.
Sunday, March 4, 2007
Background
I have been planning my retirement for nearly eleven years. Most of that time has been spent maximizing my savings but not thinking about spending it. The market downturn following the dot com bubble bursting was painful, but I never considered changing my investment strategy and I am now seeing the benefits. Once you have a sizable chuck of money in your retirement account, it becomes more real and I started to think about being able to spend some of the money.
A major shift occurred in 2006 when I married the perfect woman. She quickly figured out I would be the primary financial number cruncher in our relationship and has helped me in numerous ways. She is personally responsible for taking 5+ years off my working career, to quantify a concrete instance.
Since the plan is to retire before either myself or my wife turn sixty, I suppose this counts as an early retirement (ER) blog, although it also details our plans to become financialy independent (FI), so it's both kinds of blogs. We'll take a look at investments, taxes, spending habits and try to tie everything togther.
A major shift occurred in 2006 when I married the perfect woman. She quickly figured out I would be the primary financial number cruncher in our relationship and has helped me in numerous ways. She is personally responsible for taking 5+ years off my working career, to quantify a concrete instance.
Since the plan is to retire before either myself or my wife turn sixty, I suppose this counts as an early retirement (ER) blog, although it also details our plans to become financialy independent (FI), so it's both kinds of blogs. We'll take a look at investments, taxes, spending habits and try to tie everything togther.
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