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Tuesday, January 31, 2012

Budgeting: Part 39: Looking Down The Road

"Never lend your car to anyone to whom you have given birth."

- Erma Bombeck

Back when I was 16 years old and first starting to drive with a learner's permit, I set out to drive around our quiet neighborhood streets.  My mother sat in the passenger seat and tried not to act too frightened.  While I was going along a straight road, things generally went well.  However, stop signs were met with a sudden slamming of the brakes halfway through the intersection, and turns usually involved a detour of about 10 or 15 feet onto the grass of the corner lot properties.  Realizing my reaction time could not possibly be that bad, my mother inquired whether I even had my eyes open.

After about 10 or 15 minutes of this nonsense, it finally occurred to me that I was looking at the road only about 5 feet in front of my car!  For some reason, it had not occurred to me that I was supposed to be looking much, much further down the road in order to be able to anticipate and react to things in time.

Unfortunately, this is exactly how many people approach budgeting.  They only look a few feet in front of them.  By the time the big transactions are in view, it's too late to react.  They only have time to slam on the brakes or swerve off the road.

Sunday, January 29, 2012

Budgeting: Part 38: Teaching Your Children

"The mediocre teacher tells. The good teacher explains. The superior teacher demonstrates. The great teacher inspires."

- William Arthur Ward

It's never too early to start teaching your children about budgeting.  A lot of parents use allowances and envelope systems and so forth to get kids used to the idea of spending and saving.  I certainly don't have a problem with these sorts of things, and they do seem to get kids used to the idea of handling money.

Be a good example of budgeting.

However, my feeling is that none of this will have a big impact on kids unless they also see some modeling of good budget behavior from their parents.  Kids are always watching, and actions speak louder than words.  Also, I think there are several budgeting areas where parents not only need to live by example, but also need to talk with their kids and guide them through these same decisions.

Talk about making choices.

Every dollar you spend on one thing is a dollar you can't spend on another. Every dollar you spend is a dollar you can't save. Every dollar you borrow is a promise that you will pay it back. Make sure that your kids understand these concepts. And above all, make sure you discuss tradeoffs.  Children need to connect how overspending on one thing leads to cutbacks on another.

I felt like such a bad parent the first time I ever did this with my kids. (I suppose the world conditioned me to feel that way.)  We had just gone to the store and purchased new bicycles.  We spent quite a bit more than I had anticipated because my kids gravitated to the high end models and I didn't stop them.  I could have just spent the extra money without tradeoffs and/or without discussing it with them, but I decided to put my cards on the table.  I told them that I was not unhappy and that no one did anything "wrong", but that we had simply overspent on the bikes and so now we were going to make it up elsewhere.  I explained that we were going to skip eating out for the next two weeks and that there were certain other small adjustments I would make to save money.  Interestingly enough, my kids seemed to completely understand and raised no fuss about this at all.  It only takes one episode to "break the ice" and now we discuss tradeoffs all the time. 

Acknowledge that money is limited.

Don't be afraid to admit to your kids that there isn't enough money to buy everything that everyone wants. Now clearly if you are living paycheck to paycheck, you don't want to worry small children by wondering aloud how you are going to buy food. On the other hand, I think it's very healthy to admit that you don't have the money to buy a giant TV and still go on a nice vacation to the beach this summer. Hiding this fact is not wise. Your children may handle their $5 allowance perfectly, but if they've come to expect (or think) that mom and dad can always buy everything, they will be very confused financially when they are on their own.

Discourage debt.

Explain the consequences of debt and show children how debt may be avoided by postponing spending. If they borrow money from you, insist that they pay it back. If they don't have the money, you can arrange work for them to make money. If you simply forgive debts all the time "to be nice", your kids will think that debt has no consequences.

Encourage critical thinking.

Teach them to be skeptical about advertising and sales techniques. Show them how you might find an item cheaper at another store or another time.  Show how recurring costs add up over time.

Avoid impulse.

A lot of parents have the "24-hour rule".  (Don't buy anything immediately; wait 24 hours and see if you still want it.)  This is a good start.  But parents also need to discuss why this rule is helpful.  It's not just that you might not want the item later; you might find something else better!  Opportunity cost is something kids should understand as a concept, even if they don't know it by name.

Saturday, January 28, 2012

Budgeting: Part 37: Household Harmony

"You don't love someone for their looks, or their clothes, or for their fancy car, but because they sing a song that only you can hear."

- Oscar Wilde

Money issues are the number one source of marital problems.  Another source of conflict in any relationship is poor communications.  It is therefore understandable that couples would view budgeting with suspicion.  After all, discussions about budgeting are the nexus of money and communications.

But which approach is likely to yield better results in the long run: (a) writing down your budget priorities, tracking your progress, and routinely discussing them with other family members?  or (b) thinking in abstract terms about your money, guessing how much was actually spent, and only talking about money when there's a crisis or a disagreement?

The obvious truth is that a budget is an excellent vehicle for discussing money in a calm, rational way.  It reflects your values and priorities.  If your life and/or your finances are intertwined with others, then working on a budget together is a great way to ensure that your opinions about money are being heard and understood.  It's also a great team building exercise for your household.

As to whether couples should budget separately or combined, I personally don't think it really matters.  Do whatever makes sense for you.  The important thing is that budgeting takes place and is discussed.  But if you budget separately, don't assume that you can be an island.  I learned a long time ago that if money is shared between people in any small way, disagreements will inevitably arise, and if these disagreements are not discussed, they will breed resentment and conflicts.

When I was in college, for reasons that defy all logic, our dorm decided to share milk.  We had a large number of cereal eaters, and I think the idea was to pool our money together to purchase milk so that we would always have it when we wanted it.  This led to endless arguments.  Besides the obvious carping about people not paying their fair share, there were also complaints that people overpaid for milk at convenience stores, that people borrowed and didn't repay, and that certain people paid money but never took their time to buy milk.  This was the only financial commitment we shared, and yet it made everyone so uptight!  It only takes a small amount of money to get people worked up.

A year or two into our marriage, I told my wife that I wanted us to budget and track our money.  At first, she was a bit skeptical of this whole idea, but I explained that I was only trying to help us make better decisions and ensure that we spent our money on the things that were most important to us.  Gradually she warmed up to the idea, in part because I never criticized her spending and never complained if receipts or cash were missing.  I wasn't trying to create a money police state!  In fact, several years went by before I brought up anything at all related to our budgeting.

In the meantime, our simple budget saved us from countless petty arguments that might have occurred.  I hate to admit it, but there were many times when I saw a large grocery bill or something like that and thought to myself, "Wow, her spending is totally out of control."  Then I would quickly find out that in fact this was the same spending level we had always had.  One large grocery bill in one week is the same as two smaller bills in the same week.  I always felt like such a total jerk for jumping to conclusions.  Over time, I learned to stop being so judgmental.

My wife also began to appreciate our growing transaction database.  In seconds, she could find the name of a plumber we used 5 years ago, see how much we had typically spent at a particular restaurant, verify whether a check from six months ago had ever been cashed, or compare our current electric bill with all previous years.

But after several years, I decided it was time to discuss a problem with our budget.  I told my wife that our charitable giving was less than 2% each year.  She told me this could not possibly be the case, but I had the numbers to back it up.  We agreed this was not consistent with our values and we both changed.

Do you see how budgeting can be a force for good, both within your household and for others?  It doesn't need to be about controlling or arguing.  It can be a positive force in the world if you choose to make it so.

Friday, January 27, 2012

Budgeting: Part 36: Top 5 Excuses

"Ninety-nine percent of the failures come from people who have the habit of making excuses."

- George Washington
If I had to guess, I would imagine the most common excuses for not budgeting are the following:
  1. I don't have enough time.  As I have pointed out in an article about tracking, you can track all of your income and expenses in less than 5 minutes a day.
  2. It's boring.  News flash: almost all of the routine things we do each day are boring!  Yet we somehow manage to commute to work, clean the house, mow the lawn, and pay our bills.  Why is that?  We do these things because there are long-term social or financial rewards for doing so.  Budgeting is no different.  While the actual task of budgeting is not exciting, the rewards can be very exciting.
  3. I don't need a budget.  Translation: I'm already making (or saving) enough money.  This is probably the best excuse of the bunch.  For the person who lives below his or her means, why bother to go through this exercise?  There is no doubt that some people can save a lot of money without a budget.  The problem is that without a holistic approach to making choices, you are sure to make arbitrary decisions with the money you spend.  In other words, a good budget won't necessarily enable you to save more money, but it should allow you to focus your spending on what you really value most.
  4. It stifles spontaneity.  This is an understandable, but unfounded, concern.  Contrary to what some people think, you can actually budget for spontaneity.  If you like to eat, travel, or do activities without any prior planning (as I do), you can simply budget a certain amount of money for these activities with no particular category.  Of course, if you would like to be able to spend unlimited amounts of money doing these things...well, then I would argue this is not spontaneity, but decadence.
  5. It causes household friction.  This is another common misconception, and one that I will specifically address in my next post.  If done properly, budgeting should actually help reduce household friction.

Tuesday, January 24, 2012

Budgeting: Part 35: How to Budget for Retirement

"Before you speak, listen.
Before you write, think.
Before you spend, earn.
Before you invest, investigate.
Before you criticize, wait.
Before you pray, forgive.
Before you quit, try.
Before you retire, save.
Before you die, give."

- William Arthur Ward
The Magic Number

Whole books have been written about how much money is needed to retire.  Many websites have retirement calculators that will tell you how much you need to retire.  This is the so-called magic number - the net worth you will need to retire.  Based on this number, many calculators will even tell you how much you should be saving for retirement or how much you should be contributing to your 401(k) plan.  Other apps will calculate your retirement risk.  They may calculate the odds that you will run out of money in retirement by a certain age, or they may tell you what investment mix provides the optimal risk for you.  In order to properly discuss the magic number, we'll need a little background information.

Money Theory

One of the core concepts of finance is the time value of money.  The same amount of money is worth more now than it is in the future.  If you don't believe that, just ask anyone whether they would rather receive $1,000 now or $1,000 a year from now.

There are several reasons why everyone would prefer it now.  First, money that is available now can be spent now.  If you have to wait a year, you need to be compensated for the wait.  Second, money can be invested to earn interest.  Even if you don't plan to spend the money now, you will want to receive the money now so that it can be earning more money for you.  Third, ongoing inflation means that this money will not be able to buy as much in a year.  Thus, you will want compensation for inflation.

These reasons are interrelated.  The interest that you receive by investing is compensation for waiting and for inflation.  Hence, we live in a world where interest costs are ever present and embedded into the cost structure of everything.

Money Calculations

Given this time preference for money, we can derive various equations for what money is worth at different times.  Discounted cash flow analysis is the process of using the time value of money concepts to value things.  Future value tells us how much a certain amount of money will be worth in the future.  Present value tells us how much a cash inflow or outflow is worth now.  Future cash flows are discounted and past cash flows are increased to reflect the time value of money.  Net present value is simply the sum of the present value of all cash flows in question.  Businesses use net present value to value projects, loans, companies, and pretty much anything with cash flows.

Spreadsheets and financial calculators contain a collection of related time value of money functions.  These functions are simplified versions where the interest rate, cash flow amount, and time between cash flows are constant.  While these functions are simplified, they are nonetheless adequate for many common applications, such as mortgages, auto loans, annuities, savings accounts, and bonds.

If you use a spreadsheet like Excel or Google Docs, you will notice the following 5 standard financial functions:

FV = Future Value
PV = Present Value
RATE = Interest Rate
NPER = Number of Periods
PMT = Payment Amount

If you specify any 4 of these 5 items, the spreadsheet will calculate the remaining item.

Retirement Calculations

In theory, it's easy to calculate the magic number.  If spending is constant, we can use a simple present value calculation where we plug in the following numbers:

NPER = How long you live.
RATE = The return on your investments.
PMT = How much you spend.
PV = The Magic Number

Even if we want to adjust for inflation, we can just incorporate that into the rate (i.e. an inflation adjusted rate).  If the payments are irregular, we can still easily use a spreadsheet to perform discounted cash flow analysis.  We'll just need to use a few other financial functions.  Yes, the math to calculate the retirement magic number is reasonably straightforward.

How Much To Retire?

So how much is needed for retirement?  Based on net present value calculations, the answer is zero!  The answer is not zero cash or zero assets, but a net present value of zero.  This means that if you stop working now and you discount back all future cash inflows and outflows in your life, the net present value must be at least zero.  In theory, if you discount all the passive income you have coming to you in the future (i.e. pensions, retirement accounts, dividends, social security, etc) and you also discount everything you are going to spend in the future (i.e. all living expenses, medical care, etc) and the net present value is at least zero, then you are all set.  In theory, it's simple to calculate how much to retire.

Magic Number Calculations Are Usually Wrong

Unfortunately, theory is not often the same as reality.  And if you haven 't already guessed, the problem is not the formulas, but the data to plug into the formulas.  Each of these inputs is almost complete guesswork.  No one really knows how long they will live.  No one really knows the (inflation adjusted) return on their investments.  And no one really knows how much they will spend during retirement.

In my opinion, it's foolish to blindly trust your retirement to a formula for which nearly all of the inputs are crude guesses.  The answer is likely to be way off from reality.  On the other hand, it's equally foolish to dismiss these calculations as nonsense just because we can't accurately predict inflation, spending, and longevity.  This would be a gigantic mistake.  Even though we don't know the appropriate inputs, we can still learn a lot from the model.  We can better understand the various retirement risks by understanding the sensitivity of the model to the data inputs.

Retirement Risks

We can start by thinking about what sorts of things can go wrong with our retirement plans.  While each person may have a few unique risk items, the most common risks have already been identified and elaborated by others.  The Society of Actuaries (SOA) has a very good list of post-retirement risks that can be used as a starting point.  I will summarize and bucket these risks into our present value model.

Spending (Payment)
  1. Inflation Risk
  2. Life Event Risk (Death, Divorce, Accident, Illness, Job Loss, Fraud, etc.)
  3. Public Policy Risk (Taxes, Healthcare, etc.)
Investment (Rate)
  1. Investment Risk (Stock Market, Interest Rate, Order of Returns, etc.)
  2. Business Continuity Risk (Company Pension, Company Stock)
  3. Employment Risk (Part-time work during retirement)
Longevity (Term)
  1. Longevity Risk
  2. Early Retirement (planned or forced)

Sensitivity analysis can also tell us the impact of these risks should they arise.  An increase in spending is linear.  If your yearly spending is going to be 20% higher, then you need 20% more money at the start.

An increase in longevity is actually sublinear.  In increase of 20% to your retirement timeline requires less than a 20% increase to your magic number.  This risk gets all the press because it's a scary thing to have money at 90 and then run out at 95 "because you lived so long".  But I'm not sure that is the most accurate way to look at it.  The difference in present value between 30 years and 25 years is small - you only need about 6% more money at the beginning.  So I tend to think that if you run out of money at 95, you actually had a really high chance of running out at 90 or 85, but you had thus far been lucky with the ups and downs of the market and/or inflation.

An increase in investment return is perhaps the most critical of the three factors.  First of all, the range of possible and likely values is much greater than the other factors.  You might live to be 100, but it's pretty certain you won't live to be 150.  If you have adequate insurance, your mandatory spending (not including inflation) might increase, but it's unlikely to spiral out of control (except for the obvious exception of healthcare costs).  On the other hand, the range of your inflation adjusted investment returns could be huge.  It's certainly not out of the question that you could make 20% or even 30% in a given year with essentially no inflation, or you could lose 40% while also taking a 10% inflation hit.  And don't assume bonds or cash will protect you because we are talking about inflation adjusted returns.

The difference in money needed for 35 years of retirement versus 25 years is not nearly as great as the difference between inflation adjusted returns of +5% and -5% in the first 10 years of retirement.  Frankly, although the chance of a protracted period of inflation is probably greater than your chance of living to age 110, most people don't worry about the former but do worry about the latter.  Part of the reason for this is that inflation is not so easy to visualize.  However, another reason is that the amount of money one would have to set aside to compensate for a truly bad inflation/market scenario is probably impractical for most people.  They would never retire if they had to set aside that much money.

The Elephants in the Room of Retirement Risks

All of the risks discussed above are important.  Yet, in my opinion, there are three risks that stand out above all the others.

In third place, we have healthcare risk.  Because the costs are potentially very large and the probability is high, healthcare dwarfs many other risks.  There are also many variations beyond just having to pay for an extended illness.  Medicare premiums may escalate in the future.  A serious illness or disability may limit your part-time employment opportunities, or your housing needs may change due to your health.  There are a lot of things to go wrong.

In second place, we have a risk that is well known in academic circles, but doesn't receive much attention in the popular press: the order of investment returns.  Note that this is not the same as the variability of returns.  Suppose you invest a sum of money for a 20 year period.  If you don't make deposits or withdrawals to your investment account, the markets may go up and down, but the order of these fluctuations is irrelevant.  If you could somehow take the annual returns for those 20 years, and scramble the order of those years, the end result would still be the same.

However, everything changes if you are making retirement withdrawals from that account.  Suddenly the order of returns matters, and in particular, if there is a major downturn at the very beginning, the odds are high that you won't be able to recover from it.  Why is that?  The problem is that your account could be shrinking significantly while you are also withdrawing from it.  One way to look at this is to realize that the money you withdraw for living expenses will never have a chance to rebound later with the market.  Another way to think about it is to calculate the withdrawal percentages.  For example, if you have a million dollar retirement portfolio and you withdraw 4% of the initial value each year, you will withdraw $40,000 yearly.  Now assume that a major market downturn occurs just as you retire.  The market gets cut in half over three years - this is always a possibility.  At the same time, you keep withdrawing $40,000 each year.  After 3 years, your portfolio has shrank to $400,000.  Since the market does not know or care about your retirement date, at this point forward, the odds are the same as if you had retired and chosen a 10% withdrawal rate.  This is highly unlikely to work.  Even if the market strings together a number of +10% years, your reduced portfolio will only tread water, and will likely be wiped out on the next significant downturn.  This is a very serious risk.

Finally, in first place, there is inflation.  This is the bogeyman that every academic paper and financial advisor warns about, yet it's treated as fiction or a minor nuisance by many people.  Please, please, please: take inflation seriously.  Einstein declared compound interest to be a wonder, but inflation is like compound interest in reverse.  It slowly but relentlessly eats away at your purchasing power, and you better take heed if you don't want your retirement derailed by it.

Retirement Strategies

When I read blogs and magazine articles, there seems to be two common retirement planning strategies for dealing with risk: (1) save much more money than you expect you'll need, and (2) refine your investments to align with complicated investment models.

I would suggest that the first approach is not really a retirement strategy, but just the idea of being ultraconservative with your estimates.  I don't have a problem with that, but for most people, it would not be a realistic strategy.  For example, suppose your retirement calculator tells you that you need $2 million to retire, but you don't trust these numbers.  So instead of $2 million, you shoot for $5 million or even $10 million.  What's so bad about that?

First of all, if the intention is simply to overshoot by a mile, how do you know where to stop?  Who's to say that $5 million or $10 million is really enough?  Second, the average person does not have a healthy appreciation for how hard it is to accumulate just the amount the retirement calculators suggest.  In many cases, it will simply not be mathematically possible to shoot for five times the target amount and hope to achieve it on a normal household income.  Lastly, there are enormous costs to such an approach.  Is it worth delaying your retirement 15 or 20 years, or skimping your whole life to achieve some huge sum of money?  I don't mean to be morbid, but clearly there is the very real possibility that you will die or become incapacitated before you achieve it.

As for the second approach, I am again not opposed to the idea.  If people want to try to optimize their asset allocation and run Monte Carlo simulations and hedge currency risk and interest rate risk and try to predict future tax policy, I am OK with that.  Truth be told, I try to do that myself at times.  I sometimes wonder, however, if all of that isn't just rearranging the deck chairs on the Titanic.  I don't have a lot of faith that investment returns and interest rates and inflation and tax policy can be predicted with any accuracy.  In fact, I would suggest that if you really think you can predict those variables with any remote degree of accuracy, then you could make a lot more money on Wall Street than you would by optimizing your retirement plan, because most of the predictions from even the highest paid people have been wrong.

Planning For Retirement

Given all that has been discussed thus far, how can we improve upon the typical retirement plan?  First of all, it would be helpful to stop blindly plugging numbers into retirement calculators and trying to reduce everything to a single magic number.  Secondly, it should be understood that portfolio optimization will only take you so far.

Instead, it's probably more useful to learn how these retirement numbers are calculated and the inaccuracy of these numbers.  Then understand the risks involved and how to mitigate those risks.  The importance of retirement planning cannot be overstated, but it's better to focus on areas you can control.  How to plan for retirement is perhaps less an exercise in mathematics and more an exercise in risk management.

Retirement Risk Mitigation

Here are some of the types of retirement risks I'm looking at mitigating.  It's not an exhaustive list, and I'm not recommending any particular strategy for any particular person.  I'm listing these ideas to illustrate the kinds of questions I think would be more useful to examine than to simply ask how much to overshoot the results of a retirement calculator.

Order of returns: Do I have a contingency plan to reduce spending or earn income should a major market downturn occur in the first few years of retirement?

Inflation: Is there enough slack in my budget to be able to compensate for inflation by spending reduction or product/service substitution?  Could I delay social security benefits since they are indexed for inflation?

Life Events: Do I have adequate insurance for accidents, fraud, and health problems?

Public Policy: Do I have a way of learning about public policy shifts before they become law?  Do I have some flexibility in the timing of taxable income?  Do I have a mix of taxable and nontaxable income?

Spending: Do I know my current spending level?  Have I accounted for employer benefits and depreciation?  Do I envision any material changes to my spending in any areas during retirement?

Longevity: Have I considered longevity insurance or annuities?

Investments: Have I reduced any obvious investment risks?  Do I have a diversified portfolio?  Is the diversification with respect to key risk factors and not just throwing darts at many different investments?  Are debt levels low so that debt repayment doesn't exacerbate investment risks?

Retirement Calculations Across The Blogosphere

In preparation for this article, I decided to peruse a large number of financial blogs, looking for how people were budgeting for retirement.  I was a little disturbed at the results.  I'm sure there are a lot of bloggers who budget and never blog about it, so I wasn't all that concerned about the general lack of budgeting posts.  I was a lot more concerned about the people that did post their budget.

I certainly applaud the fact that some bloggers stress the importance of budgeting to achieve their personal and financial goals.  Many of these people are clearly working very hard to keep their budget under control and many of them post their monthly budget.  But on the negative side, I didn't run across any posted budgets that accounted for depreciation, even though most owned a house and multiple vehicles.  I also saw no budgets that accounted for health insurance, presumably because their employer paid for it or perhaps because it was simply deducted from their paycheck before it hit their hands.  There was also no budgeting for repairs or for any irregular items of any sort.

But far worse was that fact that some of these bloggers projected their partial budgets into retirement.  There were, unfortunately, a lot of claims that mortgage plus utilities plus gasoline plus groceries plus dining equalled a certain low amount of money last month, and so this meant that they would be able to live on this amount in retirement.  In my opinion, this is a recipe for financial disaster. 

Budgeting For Retirement

While I hope you've found this background information about retirement finances to be informative, you may be wondering why all this information should be in the middle of a series about budgeting.  So let me try to explain the connection to budgeting.
  1. The most obvious reason is that saving for retirement begins now.
  2. A less obvious reason is that your budget should be as accurate as possible in order to peg a starting level for your retirement income.
  3. Another less obvious reason is that you may need to spend extra money as you approach retirement to mitigate some of these retirement risks.  In some cases, money that is spent on insurance, education, or maintenance may be just as important as your retirement savings.

Final Thoughts

I hope this post has encouraged you to really take charge of all aspects of your retirement.  Remember the quote from this top of this article: Before you spend, earn.  Before you invest, investigate.  Before you retire, save.