How to manage through personal life cycles
If you fail to plan, you plan to fail. To get somewhere in life, we need to know which way we are heading and a roadmap of how to get there. For some reason, so many of us leave our most important decisions to chance. Or we caught-up in the details and forget where we are headed. As music icon John Lennon had said “Life is what happens to you while you're busy making other plans”.
That is true, especially this time of year. The spending on presents, food and entertainment frequently goes unchecked. What is a holiday spending spree ends up a post-holiday financial hangover. But what is an appropriate amount to spend? A reasonable limit could be no more than two to three percent of your annual income. For example, someone earning $50,000 should really spend no more than $1,000-1,500 in total. This percentage should be scaled down for much higher income levels. However, there are no clear answers. There are guidelines. These are like guideposts on the way to long-term financial success.
Decades ago, there were holiday savings accounts. People would put away $10 to 20 dollars a pay-period into an account designated for their Christmas spending. Obviously it might be more now. With the advent of credit cards and their wide distribution in the 1980's, much our financial discipline fell by the wayside. Instead of deciding on how much to spend based on how much was saved-up front, it was driven by how much credit could be squeezed from the banks or lending institutions. We all know where led.
So, instead of having a plan on how to manage our finances, we end up trying to stay out of a financial ditch. Don't go there. The financial journey is longer than a one-year cycle from New Year to New Year. We need to take a broader perspective of where we are heading over our financial life-span. From that viewpoint, we need to stay on track and follow the financial guide-posts. Our financial life-span includes many twists and turns in life, some anticipated, others not. We will have to stop and check our bearings from time to time.
Over a financial life-span, we have years developing our financial engine. That is how we will generate an income in our adult years. Rick Miller Ph.D, CFP of Sensible Financial Planning and Management LLC calls it the 'development of human capital'. The education, training, and years of dedication add up to our life-time earning potential. This is the horsepower that will propel our financial journey. Then there is the years spent working, when we are at peak earnings speed. During these years we should be setting aside fuel reserves. In the latter years, we have built up momentum and a reserve to carry us to the final destination. Unfortunately, many of us are running on fuels before we get half way there.
Miller, in a recent presentation for the Financial Planning Association (FPA), suggested that we should gauge our potential earnings capacity and compare it to our potential consumption. It is an 'Economics Approach' to personal financial planning. This calculation should be based on a life-span view. Once there is an estimate of how much income there is to fuel our journey, we can decide on how much we can spend to get there. The point is to spread it out over the life journey and not end up running out of fuel in the wrong place in your journey.
We need to focus on our 'lifetime assets' and make them last. Miller counts the present value of our earning capacity and inherence. Present value brings it all back to a point in time, those times when we are checking the financial guideposts. It is basically discounting the assets by the rate of growth that might occur along the way. The earnings include salary, overtime, second jobs, government benefits, all the financial wherewith all you can amass. He also notes that the cost of education should be deducted from the financial asset side of the equation. It was the cost of building the earnings engine, not an expense of running it.
The expense side of the equation is what it costs to run our lives when we are busy driving through life's hills and valleys. These life-time liabilities as Miller calls them include housing, transportation, general living expenses such a food and clothing, insurance and medical costs, and charitable contributions or bequests. Again, these life-time expenditures are brought back to a present value by applying a discount factor. The factor takes into account how the rate of inflation will require more of the same in the future. For example, what cost $100 today, may inflate to $210 in 25 years if inflation runs at an average three percent.
Through a process of dynamic programming, computer software can run various scenarios to determine what is the right amount of spending based on the amount of anticipated earnings. Miller referred to ESPlanner as software programme that can work through the hills and valleys and twists and turns in our financial journey, in order to project how far we might travel on the human capital or financial assets we will amass in a lifetime. Professionally, it is called consumption smoothing.
Going back to where we started, we need to have a plan for how much can we spend, based on how much fuel is in the tank and how far we want drive in life. Part of this planning is how much to spend over the holidays.
A modicum of moderation is in order. Even better, start a separate savings plan for holiday expenditures each New Year. This will allow us to celebrate the holidays without a financial hang-over in the next year and without driving us into a financial ditch that will keep us from our planned financial destination.
Patrice Horner holds an MBA in Finance, a FINRA Series 7 License, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any productions. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.