It’s safe to say most people have seared into their memory a few important numbers: Social Security number, home address, phone number, kids’ birthdays and wedding anniversaries (hopefully). Most people can also rattle off a few important financial numbers: annual income, account balances, how much they are saving, sometimes even the monthly mortgage payment.
However, one number that is critically important to financial success is underappreciated. What is this overlooked and often unknown number?
Annual Living Expenses
In short, “The Number” is often the key variable in assessing one’s financial situation. It is especially critical in determining the viability of retirement and legacy planning. Despite its importance, it has been our experience that this number remains elusive, usually for two reasons. First, The Number is difficult to discern because of the dizzying number of daily transactions occurring in various accounts (checking, savings, credit cards, retirement, etc.). Tracking all this movement of money is tedious at best and impossible at worst. It is obviously not how most people want to spend even one minute of their valuable free time. Second, knowing The Number can be psychologically uncomfortable. Some people would rather not face the reality of how much they are spending. Subtracting expenses from income could result in a negative number, an unavoidable proof illustrating spending is too high, and fat must be cut somewhere. Such an unpleasant experience is painful in the short-term. But once the initial sting passes, this exercise can lead to necessary conversations. Despite the practical and psychological challenges with confronting The Number it is the cornerstone of a working financial plan. So why is this so important?
What can The Number tell us at various stages of life?
1) The Working Years: The Emergency Fund
Knowing how much you spend each year allows us to plan for establishing a solid base of liquidity, sometimes referred to as a “rainy day fund,” or an “emergency fund.” This cash position serves as the cornerstone when constructing a customized investment portfolio. Before deciding on an asset allocation, risk tolerance, etc., it is wise to set aside six to twelve months of living expenses in a liquid, accessible account. Having this base of available cash can save money in several ways. Having sufficient cash available prevents the use of “bad debt” (i.e. credit cards) to fund an emergency. Surprise expenditures like these are a question of when, not if. It also prevents the need to “sell low” less-liquid investments (stocks, rental properties) when the inevitable emergency expenditure rears its ugly head. This fund can also help reduce the costs of insurance. Health, auto, and home insurance policies can be structured with higher deductibles, which usually lowers the premiums associated with protecting against these risks.
2) Pre-Retirement: Tracking Progress Toward Retirement and Other Long-Term Goals
When we have a good handle on cash coming in relative to cash going out we can then calculate how much is available to save for retirement, college, and other long-term goals. Without knowing The Number, we have no way to know how much we can or cannot save. Once spending is detailed, it may become apparent how much cash flow is “unknown” and in all likelihood, wasted.
3) Approaching Retirement: When Can I Retire?
The more accurate the estimate of The Number, the more confidence we will have in answering that critical question – “When can I retire?” Sometimes, the answer isn’t pleasant. This is the case when a gap exists between retirement cash flow projections and living expenses. This may create the need for a few more years of working and saving. As unpleasant as this result is for some, it’s much better than the alternative – a painful reduction in lifestyle in what are supposed to be the golden years. Happily, for some this calculation provides the necessary assurance that the nest egg and other sources of income will be enough to take that next step.
4) Retirement: Confidence in Sustainability
During the retirement years The Number becomes critical. The Number guides the discussion of risk tolerance and asset allocation. It is a necessary input in answering the question: “Will we run out of money?” There are many things out of our control: the economy, the markets, tax rates, medical costs, etc. But the better we know The Number, the more confidence we have in projecting the sustainability of retirement cash flow. The Number may fluctuate through the years and stages of retirement, as higher levels of activity in the early years transition to higher medical costs in the later years. This calls for periodic reviews to update the assessment and discuss the plan. With conservative assumptions and a firm grasp on spending needs, we can work with clients to answer the question with a higher degree of confidence.
A Note on Taxes
Taxes are usually the largest cash outflow throughout our lives. With this in mind, it is helpful to focus on efficiently managing taxes before and after retirement. The tax code is complicated and ever-changing, but managing the tax effect on the bottom line should be a high priority for any comprehensive wealth plan.
Even if all the sub-categories and specific details of spending aren’t spelled out, simply knowing the total of how much is going out is helpful. While tedious and potentially unsettling, digging in and identifying The Number is an essential exercise in the wealth planning process. Knowing it can bring the peace of mind that comes with a well-designed plan. Without it, wealth planning becomes nothing more than an educated guess.