Most people have seared into their memory a few important numbers: their social security number, address, phone number and anniversary (hopefully). From a personal financial perspective, most people can also easily rattle off a few important numbers: income, retirement savings or even the monthly mortgage payment.
However, I believe there is one number that is critically important to families’ current and future financial status that is under-appreciated and therefore, usually unknown. What is this mysterious number?
Annual Living Expenses
In short, I believe this number is a foundational building block used use to make crucial financial decisions to address and assess a family’s current financial situation. More importantly, the number is also used as a critical component to optimize a forward-looking plan to solidify a family’s financial future.
Despite the importance, it’s been my experience that this number remains enigmatic for two reasons. The first is that it is a difficult number to discern because of the dizzying number of transactions passing through the various family accounts (checking, savings, credit cards, retirement, etc.) on a day-to-day basis. Tracking all this movement of money is tedious at best and onerous at worst and is not how most people want to spend even one minute of their valuable free time. The second reason is that it is possible people may not want to know how much they are spending. Subtracting expenses from income could force a family to confront a glaring red number on spreadsheet (i.e. a negative value), effectively and starkly demonstrating they are spending more than they earn. This is not a comforting notion to come to grips with and usually smokes out uncomfortable, but necessary, conversations.
Despite the difficulty and mental block associated with this number I still believe it is a critical cornerstone to a family’s financial plan and is a key portion of my planning engagements with families. So the question begs- why is this so important? Below I detail four tactical reasons (see below) but really one strategic reason – a clarifying reality check, which I think is mandatory for sound financial planning. So let’s get to the tactical leverage this number provides:
1) Liquidity Needs: Knowing how much you spend each year (and therefore each month) allows us to plan for establishing a solid base of liquidity, a fancy name for a “rainy day fund”. This has the potential to save families money along two fronts. First, having sufficient cash available on-hand spares a family from having to use “bad debt” (i.e. credit cards, etc.) to fund near term emergency, big-ticket expenditures which in my view are just a question of when, not if. It also spares the family from having to potentially “sell low” on less liquid investments (rental home, mutual funds) when the inevitable emergency expenditure rears its ugly head. Second, this fund acts as a buffer against the initial portion of insurable risks in the manner of being able to handle higher deductibles on various insurance (auto, home, etc.) which usually lowers the premiums associated with protecting against these risks.
2) Attainment of Retirement and Other Long Term Goals: Again, when we have a good handle of what’s coming in relative to what’s going out we can then be crystal clear on how much a family has available to save for retirement, college or other long term goals. Without knowing this number, we have no way to know how much we can or cannot save. From here we can more accurately assess what retirement might look like (in the form of a retirement savings projection) or how long a husband and/or wife should plan on working. It may be uncomfortable to hear, but chronically spending more than you earn year after year makes the retirement discussion very brief: there will be no retirement.
3) Tax Burden: It’s my contention that taxes are usually a family’s #1 expense throughout the year. Who else other than Uncle Sam gets 20%, 30%, 40% (or higher) of your income? Knowing how much you are spending on taxes is usually a wake-up call to focus like a laser on efficiently and legally managing your tax burden. To date, reducing my clients’ tax burden has been the greatest leverage point on my value add and the reason is usually because it’s the greatest expense they have each year. While it may be boring and/or complicated, legally lowering your tax burden can pack a serious punch to the bottom line and should be a high priority for any holistic financial plan.
4) Revealing Priorities: This is usually the toughest aspect revealed by the after-tax living expense number. The reason it is the toughest is because what you spend your money on is an implicit acknowledgement to the world on what you value. Spending a good chunk of your income on flashy cars or clothes and not funding retirement or your kids’ college fund? Like it or not, that usually says something about the value placed these things. Even if someone does value the bigger picture it still can be shocking to see how much is spent on groceries or lattes or dining out. As an admittedly maniacal tracker of my spending (much to the chagrin of my Wife) I am still startled by some of the figures that jump off the page every month.
As part of a holistic financial strategy for families, I dedicate at least one meeting during the initial year to cash flow and the living expense number. As indicated by the reasons provided above, I view this as a critical piece to the broader engagement. Even if we don’t know all the categories and detail of the spending, simply knowing how much is going out relative to how much is coming in is a very, very important data point. Fundamentally, knowing this number provides clarity, for better or worse. If the situation is good, it’s really fun working with clients to best allocate those funds available beyond living expenses. If it’s for the worse, it’s not fun (at first) to figure out how to fix this dynamic. But the silver lining to this difficult scenario is that once addressed, the peace of mind is invaluable.