We like to think that the planning work we do for our clients is based on mathematical principals. Although there is some art to financial planning, much is based on science. It’s true – we analyze, sort, manipulate and utilize a lot of data in our work. For years, I have used the phrase “I think in numbers.” What I have found, though, is most people don’t. Most families aren’t aware of the most important numbers that could impact the ability to achieve their goals. A lot has been written about these numbers, but I want to focus on one today – the most important number.
The amount of money you spend each year.
Notice I didn’t say rate of return, credit score, net worth, savings rate, allocation to stocks, or even your target “retirement number.” Sure all of these are important, but not as important as what you spend every year. Having situational awareness around what you spend each year is a critical component of your financial plan. Here’s why. What you spend every year represents your standard of living. It impacts:
- Capacity to save. If you don’t know what you spend and where you spend it, it’s next to impossible to know where you can cut back so that you can truly assess how much you can save.
- Ability to pay down debt. Debt can be a financial cancer; yet, in the US, we have extraordinarily high amounts of student loan, automobile and credit card debt outstanding. Any healthy financial plan devotes a robust amount of income to debt reduction.
- Capacity to make progress toward goals. Most people tell us they just can’t increase the amount they save, that their expenses take every dollar of their take home pay. Although living for today is important, there should be a balance between spending for today and saving for tomorrow. Much of today’s spending is actually optional.
- Ability to take advantage of opportunities. Many companies offer a 401k match; some offer the ability to purchase company stock at discounted prices. Sometimes investing when the market dips can be beneficial. If you don’t know where you can cut, you can’t take advantage of opportunities.
- Saving for retirement. Most people want to replicate their standard of living when they retire. My experience is that very few families voluntarily reduce their standard of living in retirement. In fact, many families increase their spending. If you don’t know what you truly spend, your retirement projections will not be accurate.
- Spending in retirement. Your post retirement investment strategy should largely be based on the amount and timing of money that you need from your investments. Without understanding your spending needs, it is challenging to optimize your investment strategy.
Knowing what you spend is important. So without tracking every penny you spend, how do you come up with this number? Here is an easy way. Grab last year’s tax return and W-2 forms, and fill in the blanks in the following formula:
Total income: __________ (wages from work, tax refund, any interest and dividends actually spent)
Federal taxes paid: __________
State and local taxes paid: __________
Social Security taxes paid: __________
Medicare taxes paid: __________
What you actually saved: __________ (401k, IRA, savings account, etc.)
What You Spent: __________
If this is as far as you get, congratulations! You know more about your spending than most people. This figure can be used for your retirement accumulation and retirement income planning.
If you want to make more progress, grab your credit card statements and checking account register and add up what you spent on:
Housing (rent/mortgage, HOA, required maintenance)
Must have utilities
Minimum debt payments
Grocery store (not eating out)
Medical care (not elective)
Clothing for work
The sum of these is your Fixed Expenses. Now subtract your Fixed Expenses from What You Spent. The difference is your Variable Expenses. In the short term, you have little control over your Fixed Expenses; yet, if they are so high that they are keeping you from making progress toward your goals, you will want to reduce them in the future. Your Variable Expenses are what you have the most control of in the short run, low hanging fruit, so to speak. These expenses are easily reduced so that you can divert money to other important goals.
I personally do this exercise once each year. It takes me a little over two hours. It helps that I use one credit card for all fixed expenses that I don’t pay from my checking account. I see it as an investment in my financial health. As advisors, we can’t force you to do this exercise. But if you do, it will help us develop more tailored financial plans so that we can be better advocates for your family. We want to help you make progress toward your goals, and when you achieve them, we feel a sense of accomplishment too!
So, as you think about your Second Half Strategies, please give some time to calculate and understand your most important number,the amount of money you spend each year!