One area where I often see clients struggle is in managing expenses. Many clients simply don’t have a clear picture of how their hard earned money is being spent. Yet this is a critical aspect of being successful at managing your finances. If you are still working and you have financial goals like retirement, you need to know how much you need to save each month or year to pay your expenses in retirement. Further, if you are already retired, it is important to know how much you are actually spending each month or year to make sure your money will last for your lifetime.
Why is creating a budget difficult? Why do some clients struggle to control monthly expenditures?
In my opinion, there is both a mathematical component to spending, and an emotional component to spending. What can you do to overcome spending issues?
Mathematical Component to Spending:
From a mathematical standpoint, a budget is a simple concept. A certain amount of money comes in every month or year and a certain amount of money goes back out again for expenses and savings. In a healthy scenario where someone is still in their working years, this could be captured in the formula:
Income = Savings + Expenses
In this healthy scenario, savings is enough to accomplish all desired goals such as saving for retirement, sending kids to college, or buying or improving a home. In this healthy scenario, expenses are kept under control or reduced to the point of allowing enough savings to accomplish all of the clearly defined goals. Note that I put savings first in the equation and this is an important concept. If you save enough to accomplish your goals first, that leaves a certain amount left for expenses. If you instead prioritize expenses over savings, you may well come up short on savings.
For someone who is already retired the formula will look different:
Income = Expenses
In this healthy retirement scenario, the client is no longer saving. They are also limiting their spending to sustainable sources of income such as a pension, Social Security, dividends, and a sustainable withdrawal rate from an investment portfolio. What constitutes a sustainable withdrawal rate? There are many academic studies that have set out to answer this question but one of the most well-known and widely accepted studies has shown that a 4% annual withdrawal rate for a 65 year old individual/couple using a balanced portfolio has a high likelihood of being sustainable.
If income is not enough to cover expenses, an unhealthy scenario develops and the formula might look a little different:
Income or sustainable retirement income = Expenses + Debt
Clearly we don’t want this unhealthy scenario – at least not long term. In this scenario, we have two mathematical choices: raise income or lower expenses.
There are many reasons this unhealthy situation can develop and many of those reasons are unintended such as the loss of a job or uncovered medical expenses. Having an adequate emergency fund of 3 to 6 months of expenses is a reasonable strategy for trying to absorb a shock such as this. But sometimes even a solid emergency fund cannot completely prevent an unhealthy spending situation from developing.
Poor spending decisions are another way an unhealthy spending situation can develop and I will address this in the next section.
Emotional Component to Spending:
It would be nice if spending and saving decisions were purely mathematical in nature, but unfortunately, it’s not just about the math.
Emotional spending can take a number of forms such as:
- Making us feel successful whether it is our home, car, clothes, or a travel destination
- Preventing us from feeling bored
- Attracting a mate
- Having the latest thing
- Replacing something that seems out of date
- Escaping from our past
- Feeling a sense of satisfaction
Investopedia defines “Affluenza” as follows:
Affluenza is a social condition arising from the desire to be more wealthy or successful or to "keep up with the Joneses." Affluenza is symptomatic of a culture that holds up financial success as one of the highest achievements. People said to be affected by affluenza typically find the very economic success they have been so vigorously chasing ends up leaving them feeling unfulfilled and wishing for yet more wealth.
Moving beyond the basic math of income and expenditures, the emotional aspects of spending such as feeling successful, fighting boredom, escaping our past, and feeling satisfied can lead us to avoid taking the necessary steps to take control of spending.
What can you do?
- Start by creating a list of what you’re spending. This can be made easier in a few ways
- Open a free account on Mint.com and use Mint to automatically track your expenditures from your checking and credit card accounts.
- Utilize a single credit card for all your expenditures and use the year-end report to track where the money was spent
- If neither of those methods work for you, just listing out your expenses from the last month on a piece of paper or spreadsheet will work fine, make sure to add in annual expenditures like insurance premiums and don’t just list your main bills. You have to account for all the expenditures on your list of expenses.
- Work with your financial advisor to identify your financial goals and determine how much you need to save each month or how much you can spend without a high probability of running out.
- If you are with a spouse or significant other, try having an honest conversation about the goals you are trying to accomplish, why they are important to you, and how much you will need to save or how much you can spend
- Try to live within your means which means taking the income you receive, subtracting the requisite savings if you are still working, and reducing your expenditures to what is left.
- Be honest with yourself and your spouse or significant other about what you are spending on and why. You may just find that shelling out extra cash to help you feel successful, avoid feeling bored, have the latest thing, escape your past, or help you feel satisfied is really not worth it. Happiness can be found in other ways that don’t cost money.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results