Cash Flow Planning for Life
October 10, 2012
As far as resolutions go, resolving to become physically fit by eating right and exercising is a perennial top-of-the-list favorite. Of course, success depends on more than simply creating a list—you have to take action. Sticking with a healthy diet and exercise routine may seem difficult at first, but the benefits build on each other as each small success breeds even more success.
The same holds true when it comes to your finances. As is the case with eating right and exercising, the important thing is to get started. Once you take action, you'll likely find that sticking with a financial fitness plan is easier and a lot more fun than you might have imagined. And just as seeing your waistline shrink while your physical stamina and health improve can make you feel good, watching your net worth grow over time can be deeply rewarding as well.
Plan for lifetime cash flow
The most basic aspect of financial fitness involves planning for adequate cash flow to cover ongoing expenses and major purchases. Financially speaking, life can be viewed as a timeline with a series of cash inflows and cash outflows. For adults still relying on wages to provide income, prudent cash flow management helps facilitate the savings and investment needed to achieve the overriding goal of an increasing net worth over time.
In turn, an increasing net worth leads to the fulfillment of life's most important long-term financial goals—buying a home, providing for a child's education and funding retirement during a time when you're no longer willing or able to rely on wages as a primary source of cash inflow. To that end, personal financial statements of cash flow (income minus expenses) and net worth (assets minus liabilities) are essential tools to evaluate and monitor your financial fitness at any given time, as well as your progress toward long-term goals.
Take these action steps
1. Create a cash flow plan (essentially, your budget).
- Start by tracking spending for at least 30 days. Project periodic expenses that occur less frequently (e.g., bimonthly utility bills, semiannual insurance premiums or annual property taxes).
- Separate the discretionary (fun stuff) from nondiscretionary (must have) expenses.
- If you're still working, put savings at the top of your nondiscretionary expense list. If your budget is tight, allocate savings toward higher-priority goals, such as retirement, first. Make the magic of compounding work for you by saving as much as you can as soon as you can.
Retirement savings rule of thumb
If you start saving for retirement in your 20s, save 10%–15% of your pretax income. If you delay and start in your 30s, save 20%–25%; in your 40s, save 25%–30%, and so on.
- Be sure to consider the impact of taxes—it's not what you make, but what you keep that counts. Save with pretax dollars in your employer plan or deductible traditional IRA when possible, or use a Roth IRA if appropriate.
2. Calculate your personal net worth (your assets minus your liabilities) annually.
- Your net worth should be rising over time if you're still working, at a rate consistent with your long-term objectives.
- While your net worth might start to decline during retirement, your goal should be to avoid a rate of decline that's too fast for your time horizon (i.e., plan for a sustainable annual cash flow designed to make your money last as long as you do).
- Again, consider the impact of taxes—seek to maximize your after-tax wealth. Consider which assets are best located in tax-advantaged accounts and which to keep in taxable accounts.
3. Determine your lifestyle goals (e.g., a comfortable retirement) and create a plan to achieve those goals.
- With personal financial statements in hand, the next step is to prioritize your long-term goals by their relative importance so that you can knowledgeably make prudent trade-offs.
- The more specific you can be about your goals, the better, because this helps to translate your goals into specific terms (e.g., time horizon and targeted savings rate).
- Use reasonable expectations of long-term investment returns and incorporate volatility into your planning.
- Revisit your plan annually to monitor your progress.
4. Determine how much money you'll need for must-have, big-ticket items coming in the next few years, and set that money aside in a liquid, safe investment.
- Examples include tuition payments, property taxes and vital property maintenance.
- Treat this money as already spent.
- Rates of return on cash and short-term fixed income securities vary, so shop around for a good rate.
5. If you're retired, conservatively invest assets that are needed to cover your normal living expenses for the next few years.
- Your goal is to provide a reasonable buffer against short-term market fluctuations.
- Keep any money needed for the next 12 months in highly liquid, relatively safe investments such as money market funds or short-term CDs (certificates of deposit).
- Keep the equivalent of an additional one to four years of spending cash laddered into short-term fixed income investments as part of your portfolio's bond allocation.
6. If you're still working, maintain an emergency fund to cover at least three months' worth of nondiscretionary expenses.
- An emergency fund allows you to avoid tapping volatile investments at inopportune times, incurring penalties by withdrawing from tax-deferred accounts or otherwise derailing your long-term financial plan.
- Keep your emergency fund money in a liquid, relatively safe place such as a money market fund.
Create your own cash flow statement
Whether you use an online calculator, a personal finance software package on your PC or a budget spreadsheet you've created yourself (perhaps using Microsoft® Excel), the important thing is to get started. Review your check register and credit card statement, and break down your expenses by category. As you get started, look for areas of waste (especially as you track your cash expenditures) and ways to cut back (e.g., increasing insurance deductibles to decrease premiums, consolidating accounts or bundling services to reduce fees, taking public transit instead of driving and paying for a high-priced parking lot, and packing a lunch instead of eating out).
Once you've created your own monthly cash flow plan, you're not done. It's important to keep track of your income and expenses and record any variance from your plan (e.g., maybe you received an unexpected bonus on the income side, or perhaps you spent less on clothing than you planned for on the expense side, a little more on vacation, etc.).
At the end of the year, you should take a look at the total annual variances for each category and make adjustments for the year ahead, if appropriate. Don't beat yourself up if you didn't stay exactly on plan. Rather, use this annual exercise as a learning experience, to see which areas you can improve on in the year ahead. Maybe it's unrealistic to expect food to cost $400 a month for your household. You can adjust that amount for next year's budget.
Also, at least once a year you should perform a comprehensive review and make adjustments for material changes outside your control—salary increases, changes in tax rates, changes in cost of living, and so on. Over time, be sure to make increasing your annual savings a priority as your income increases. If you need to bump up your savings rate, you may find it's easiest to do that as soon as you get a raise, so you don't get accustomed to spending that money.
Assess your net worth
Finally, when you take a look at your net worth at the end of the year, be sure to double-check what portion of the increase came from savings (as opposed to changes in asset values and debt reduction) to see if you're on track with your long-term goals. If you stick to your cash flow plan, your net worth should reap the benefits, especially in years when the financial or real estate markets return less than you had hoped for.
Calculate your cash flow
Take a look at the following sample monthly cash flow statement. Of course, it may look different for your household. For example, allocating $150 to clothing each month might seem reasonable if you're a no-frills guy who wears the same pair of shoes all year. But if you're more into the latest fashions, you might need to adjust that category (which means you'll need to reduce some other category). You get the idea.
You'll see in this hypothetical example that utilities and entertainment costs were less than expected in January, while food costs came in over budget. When you get a "win" of net lower expenses like that, you should boost the discretionary expense of "long-term savings," in this case by $50.
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