Financial Life Planning
Financial life planning is a hot idea. For good reason. The key to success with a money management plan is achieving an integration of life, work, and money goals. No one cares about the money itself. What we all care about is the exciting things we can do with our lives if we win higher levels of financial freedom early in life. So the key to becoming motivated enough for your financial plan to succeed is focusing on how the success of that plan will enhance your enjoyment of life.
The hard part of making the pitch for financial life planning is that there are no cookie-cutter solutions with this new approach to money management. The rule-of-thumb that advises you to aim to save 10 percent of your paycheck is not financial life planning. That rule is the product of the conventional approach to money management, an approach in which all aspiring savers are presumed to be saving for roughly the same purposes. In reality, some savers should be saving 10 percent, some less than 10 percent, and some more than 10 percent. It depends on where the saver is in regard to realization of his most important life goals and how important realization of those goals is to him. With financial life planning, rules of thumb generally do not work. And that makes it a lot harder to communicate what this approach to money management is all about.
Set forth below is a description of my personal financial life plan. This plan is not one that you can apply to your own particular circumstances. That just will not work. But it may be that by viewing my plan you will be able to gain a good sense of the sorts of considerations that come into play in crafting a financial life plan for you.
This is a description of my Passion Saving plan that I wrote back in early 2002. A good number of aspects of the plan have changed since then. Why? Because my financial circumstances have changed since then. And my life goals have changed since then. It makes sense that my financial life planning ideas would have changed since then too, doesn't it?
On the spending side, our family spending has increased to $38,000 because we now have two growing boys, have moved into a single-family home, and have experienced big increases in spending on health insurance. On the earning side, I have completed my first book and am about halfway toward completing a second, and have recently taken this web site live. On the investing side, I possess a far more solid understanding of what the historical stock-return data says about how to invest in a data-informed way as a result of all that we learned from The Great SWR Debate. Still, I believe that the words below provide a good sense of the basics of my plan and how the various elements work together. Please note how the changes that have been made in the plan in just three years demonstrate the flexibility of the financial life planning approach.
Amount of annual spending: $30,000. The $30,000 figure was made possible by our having paid off the mortage on our old home some years ago. Also, our tax liability is a tiny fraction of what we were paying in our two-income days, as most of our earnings are "protected" from tax by the standard deduction, four personal exemptions, and two child credits.
This is a number that changes for me at least once, and generally twice, a year. My wife and I schedule a re-do of the budget (which is also a redo of our financial life plan, of course) for January 1. Often, special circumstances require a touch up at least one other time during the course of the year.
There have been lots of changes since my "retirement" date in August 2000. We had less than one year of spending experience on the first child at the date I turned in my resignation, so we are still getting a handle on what all the added costs will be. The second child just came along in March. My wife had some extra hospital time in connection with the second pregnancy, so there were added costs there. I've had some added costs with the start of my writing business, such as paying for internet access, getting lots of books on writing and publishing, attending conferences, and such. There also were some new costs associated with a move to a new home (the new home itself was a little less expensive than the old one).
All of these costs are integrated into the budget/financial life plan as they occur. The integration does not always happen in the same way. If there is a new recurring cost, such as the need to pay for food for growing children, that needs to be added to the monthly budget figure for groceries. If there are one-time costs that are not addressed in the monthly numbers (the cost of a moving van), they need to be covered in some other way.
There are several ways of covering the unexpected costs. One is that the new home was less expensive than the old. Since my wife and I owned the old home without a mortgage, the move left us with free cash. Some of that money went to cover unexpected one-time costs incurred over the past six months or anticipated for the next six months (but not anticipated at the time the budget for the year was prepared). Again, please take note of the flexibility of the financial life planning approach.
Retirement Stash: $400,000
Annual Earnings Assumption: 4 percent. I spent a lot of time researching the question of what number to use as the annual earnings percentage on my investments. My conclusion was that a 3 percent rate was clearly attainable and that a 5 percent rate was within the realm of the possible in some circumstances (not without stocks, however).
For my personal financial life plan, I went with 4 percent. My view is that this number should vary with your personal circumstances. If I had left the work world altogether, I would have used 3 percent. If stocks had been at better price levels, I might have gone with 5 percent.
I had three retirement dates in my plan: the one I would use if I really got to a point where I couldn't stand the job another day; the farthest-out one if I felt at the time that I would rather continue putting assets away and thereby allow for a greater measure of freedom from financial worry in my retirement; and the middle one. I ended up electing the middle one.
The reason for the three dates was that, it undermined my daily motivation to see my date for realization of my goal as being too far out in the future. I needed one date that could be achieved in just a few years to keep me focused on doing everything possible to make progress. However, I didn't want to lock myself in to the quick date. Once I got to the first date, I felt that if now I could bear the thought of collecting a regular paycheck for a few more years, it would make more financial sense to do that.
At the time I hit the second date, we had just had our first child and my wife had given up her own paycheck. So, while she had been supportive of the plan throughout the process, she was not at all opposed to me staying at the job until the third target date. What decided things was the Motley Fool's creation of the Soapbox site. That offered a means of making a small amount of money outside the corporate context, so I wanted to devote my full energies to that.
This is another example of the flexibility of my approach. Just as there is no fixed annual spending amount, there is also no fixed retirement target date. There is planning. I see it as essential to have specific targets because the process of picking those numbers or dates forces you to come to terms with all the issues you should be dealing with. But the benefits come from the process, not any particular dollar or date target. Once you engage in the right process to put realistic goals in place, I see it as okay to modify them regularly, always being sure to maintain the realism of the initial choice, of course.
Spouse Earnings: $4,000
My Earnings: $10,000
My wife earns $4,000 a year doing occasional work for her former employer. I have no regular income, but need to earn $10,000 a year from freelance writing (my goal was to make this career shift, not to "retire" in the traditional sense) to make the financial life plan work.
This earnings component of my particular financial life plan has its flexible side too. In the first six months of retirement, I didn't earn $5,000 (half of the annual $10,000 target), but $15,000 (from sales of my Soapbox.com report). That "paid" for 18 months of writing freedom. When Soapbox went under in February 2001, I began writing a book and set a target completion date of January 2002, so that I could use the income from a publisher's advance to "finance" the next year of writing freedom.
The book has taken longer than expected to complete. My new target completion date is January 2003. By then, I will be one year "behind" on my freelance writing income just as I had at an earlier time been one year "ahead." None of this concerns me greatly. The money will come in. If there is no publishing company in the world willing to pay me a penny, I will flip hamburgers or deliver newspapers. I highly doubt that it will ever come to that. I set the $10,000 figure low enough so that I could be certain to meet that target on an annual basis without too much trouble (so long as I was willing to work at least 40 hours a week, as I expect to continue doing even past age 65). These circumstances are of course unique to me, and, thus, I would not expect to see similar numbers apply in the financial life plans of too many other Passion Savers.
I considered working at the old corporate job longer so that I could eliminate this need to produce an annual income from freelance writing. There's some appeal to that, but I rejected the idea for several reasons. First, it delays your retirement a lot to come up with the added retirement stash ($250,000) to replace the easy annual earnings of $10,000. Second, I knew I would be doing this work whether I needed the income or not, so I viewed it as virtually "free money." Third, knowing that I have to generate income from my writing forces me to approach the writing career in a more professional manner (while still having the freedom to turn down any unappealing assignments). It's work I do primarily for love, but also partly for money. That's the mix I like best.
Please note that the financial life plan does not address only saving issues, as a conventional budget might. Work issues are given important play. Investing issues are given consideration. My hopes for where I want to take my life, and when, are drivers as to what sorts of assumptions and goals go into the plan.
1) TIPS at 3.5 percent real in tax-protected accounts
2) ibonds at 3.4 percent real in non-protected accounts (not taxed until cashed in)
3) Certificates of Deposit still held from pre-retirement days (and, thus, held at higher rates than those available today--some are at 7 percent). The CDs are being phased out as they come due into other investment classes. I expect to move a portion of the CD money into stocks. If stock prices came down, I would move it all into stocks.
Stock Allocation Goal: My goal is to get to a 50 percent stock allocation. I initially made the zero percent allocation to stocks for two reasons:
(1) I accumulated all of my retirement stash in a short amount of time. It was nine years from having zero in the bank to retirement date. So any stock purchases made in anticipation of retirement would not have been "for the long term." My worst nightmare was that, one year short of my retirement date, stocks would go into a downturn. I was not counting the months until retirement, I was counting the weeks. There was no way I wanted to take the risk of losses that could put off the retirement date for years. This serves as yet another illustration of the flexibility of the financial life planning concept. Do you see how different this approach is from the conventional money management approach?
(2) Stocks were at extreme levels of overvaluation at the time I began accumulating large sums for investment. I preferred to put money ultimately to be allocated for stocks into safe investment classes until stocks could be purchased at prices closer to average valuations. That way, I can purchase many more shares for the same portion of my retirement stash. Once I find reasonable purchase points, I intend to hold the stocks for the long term (no "timing" in and out of the market).
I have maintained a binder of stock ideas. The purpose is to learn during the time that I do not participate in the market, and to not lose the sense of "being part" of the market. Participting without a financial stake is not the same, but I think it is healthier to do this than to adopt an "out of the market" mentality.
Returns: While I use a 4 percent annual return assumption, you'll note that most of my investments do not earn a full 4 percent. The CDs do because they were purchsed at high yields (many between 6 and 7 percent) that result in a real return over 4 percent in today's low-inflation environment.) But the ibonds are at 3.4 percent and the TIPS at 3.5 percent. I make up this difference with a technique I think of as "the personal inflation rate." The inflation adjustment for the TIPS and ibonds are done according to government estimates of inflation. For purposes of my own records, I use a personal inflation measure instead.
My personal inflation rate is the amount that my spending goes up from one year to the next. If government estimates say that inflation is 2 percent, and my spending goes up 1.5 percent, I count inflation as 1.5 percent. Using this approach allows me to get by with earnings on TIPS or ibonds of only 3.5 percent.
I am considering a similar adjustment for when I begin purchasing stocks. I don't want to count the gains that come from bull market extremes as permanent gains or the losses that come from bear market extremes as permanent losses. Thus, I may set up a separate set of books where I add to the stock's purchase price some reasonable estimate of the corporate earnings for the year (but not "unreal" moves up or down). The goal is to have a better fix on the real value of my portfolio than what is provided through use of newspaper-listing prices (which are valid only if you intend to sell that day).
Bottom Line: My stash has to increase by at least the rate of my personal increase in spending for me to maintain the same level of financial independence i possessed on retirement day. If my spending were to be exactly the same after 10 years, and my stash were to be exactly the same size, that would show that I was generating enough income each year to cover all expenses and to lose nothing in the way of stash. If my spending goes up 3 percent per year, my stash must go up 3 percent a year.
If I see things I would like to add to my life that would require increases in spending, I need to increase my stash at a faster pace. The personal inflation rate is not necessarily a number that goes up slower than the government number. I can push it up faster than the government number if i care to. I just can't push it up any faster than the pace at which the stash is increasing.
Where do I get money to push the stash up faster than inflation? From earnings beyond the $10,000 minimum figure I've set from freelance writing. I view the book that I am writing as a capital asset. I cannot predict what income it will produce, but I believe it will produce something. If it does not, the second one will.
From a financial perspective, I view the writing career aspect of my financial life plan as a sort of oil drilling expedition. I know that every drilling venture is not going to pay off, but feel confident that one down the line will.
This is another reason why I did not want to wait too long to get started with the second career. The earlier in life I got started with it, the greater long-term gains I can expect from my "personal capital." A freelance writing career begun at age 43 is more likely to produce profits than one started at age 63. Any year in which I earn one dollar above $10,000, that's "free money" that can be used for a variety of purposes:
1) Luxury Spending: There were certain luxuries that I cut from my budget to get to financial independence sooner, but which I did not want to cut on a permanent basis. An example is vacations. Cutting this category allowed me to retire much sooner, but I would have viewed it as a bit of a deprivation to give up vacations altogether. So I arranged things so that, any year in which I earn more than $10,000 (most of them, I hope), there will be money for vacations. Any $15,000 year (not at all an outlandish scenario) allows for very nice vacations indeed.
2) Increases to Stash: My level of financial independence will continue to grow gradually post-retirement just as it did in the pre-retirement years. In any year in which I earn more than $10,000, I have the option of directing all of those dollars to stash. Since my living expenses have been covered from prior savings amounts, I can save at a 50 percent rate if I earn $20,000. If I earn $50,000, I can save 80 percent. Savings grows quickly at those sorts of saving rates.
3) Taxes: My tax rate will go up dramatically in years in which I earn amounts far above $10,000 (because it is so small in the years in which I do not). I sort of like this arrangement. In years in which I don't do that well, the pain is eased with the joy of a small tax burden. In years in which I do, there is a tax burden, but I'm adding enough to my savings that it doesn't seem like such a bad thing.
4) High-Return Investments: Since my basic living costs are covered by assets invested in super-safe investment classes, I can invest additions to stash in high-return, high-risk investment classes without incurring any significant personal risk at all. I want to see gains in the assets making up this portion of the stash, because it provides me with slack and with the funding for luxury spending, but I don't need any set level of gains on this part of stash (or even return of the stash itself, for that matter) to pay the bills. In theory, I could put all of this on one hot stock. I won't, but I could.
5) Charitable Contributions: At certain levels of income, I could afford to make generous charitable contributions. This is where the money will go if the stash gets high enough to cover not only all basic living costs, but all compelling luxuries as well.
Goals: Over time, I hope to acquire a 50 percent stock allocation at levels of overvaluation (not undervaluation) lower than those prevailing today. I do not expect to go above 50 percent unless my stash increases a lot, because I don't want more than 50 percent of the "basic stash" amount at risk. My theory is that I can take a 20 percent loss of my assets without too much personal anxiety. If you purchase stocks at reasonable prices, the risk of a loss greater than 40 percent is minimized. A 40 percent loss in an investment class comprising 50 percent of your portfolio leaves you with a personal loss of only 20 percent.
As the years go on, I expect more of the "action" in my plan to be at the "stash plus" level. The original stash amount was intended only to finance the transition from dependence on a corporate paycheck to a self-directed career. If you are careful at that stage, you increase the prospects of having the real fun in Stage Two.
Risk: I don't measure risk in the way that some others do. For me, the risk is not in having my investments not earn a certain return. It is that I will not get to enjoy some of the opportuntiies that life would otherwise have to offer. To this way of thinking, there was more "risk" in staying in the corporate workforce another year than in making the break when I did.
There's also more risk in a Basic Stash portfolio heavy in stocks because that approach might force me back into paycheck dependence. All aspects of the plan (including those calling for career growth and the income that produces down the line) are lost if I give up the assets I worked for to accumulate financial independence.
I did not assign a certainty-of-success percentage to my financial life plan. I don't say that it has a 100 percent chance of working, or 80 percent, or 50 percent or any other percent. For me, the goal was to make the shift to a different form of employment without causing my family any negative financial consequences. I don't want my wife to have to live in a house she doesn't like, or my kids to not be able to afford college. To meet that test, I needed to be sure that the odds of doing two things were better than they were when I had a corporate paycheck: (1) pay all the basic costs of living; and (2) allow for luxuries and spending to open up life opportuities (such as college spending).
On the first goal, I am clearly better off than most peers, since most have not saved the amount of stash that I have at this age. None of this would have been done but for the motivation supplied by the desire for the career change. So I think of my entire stash as essentially "found" money. I had zero savings before I started saving for early "retirement." So there is no doubt for me that the adoption of the financial life plan did not increase financial risk for my family, but greatly diminished it.
On the second goal, I also believe that my financial life plan reduces risk. The risk of staying with the old job was that I would not fully develop my human capital over time. Only by becoming free to challenge myself in use of my talents can I hope to acquire real long-term wealth. The steady paycheck seems safe, but carries hidden risks if holding onto it requires you to allow yourself to stagnate.
So I am living a life of less financial risk after retirement than I lived before. That's the key question for me. If Plan A carries less risk than Plan B, and also provides a more exciting life than Plan B, you choose Plan A. There's no real need to assess risk beyond that.
The only really big risk for me is the possibility of allowing the plan to unravel. Without the basic stash in place, everything falls apart. In my mind, growth is an important, but secondary, concern. I focus on growth only after the fundamental stuff is assured.
Variations: I would not expect anyone else to follow the same financial life plan. I believe that each money management plan needs to be custom-tailored. So:
1) Someone who enjoyed the corporate job they were in when accumulating assets would probably want to remain longer and accumulate more assets before making the break;
2) Someone who began working toward early retirement at an earlier age would be able to go about achieving it at a slower pace. I had to act quickly because the chances of making my second career a successful one dropped with each passing year that I remained in corporate employment.
3) Someone not married or without kids could go with higher risk assets because, in a pinch, they could make do with less income. Thus, the ultimate risk of having to return to the workforce is less of a concern to someone in these circumstances.
4) Someone seeking to leave the world of work behind altogether would probably want to have a financial life plan calling for a 3 percent or 3.5 percent return rather than the 4 percent return assumption that I use. I haven't yet had a problem producing the 4 percent annual return needed. But if I ever do, I have the means available to make income needed to cover any gaps (after all, there are a lot of people doing freelance writing for a living that have no stash at all). My plan cuts things close. I wouldn't want to do that with a plan that called for the early retiree to leave the workforce altogether.
5) In times of average stock valuation, I would have at least a portion (up to 50 percent) of my basic stash in this asset class. I get that number by using 20 percent as an estimate of the highest loss with which I would feel comfortable. In today's market, it's hard to have significant stock participation without putting 20 percent of your portfolio at risk. In other circumstances it would be possible to hold up to a 50 percent stock allocation without much risk of a loss to the overall portfolio of more than 20 percent.
6) Stock allocations would go up if there were more assets in the Super Stash category (desired but not really needed). At $10 million of stash, even an 80 percent allocation provides a great level of safety. Volatility is less of a concern as you reach total stash levels where the basic stash is not at real risk.
Those are some of the basic considerations. I'm sure there's stuff I'm leaving out. But perhaps that gives an idea of the things I worked through in engaging in the financial life planning that helped me achieve my financial freedom dreams early in life. I help that this outlining of my personal plan will help you gain a better sense of what will be involved in putting together a plan that will work for you.
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