On the importance of financial shock absorbers
We live in an uncertain world. We may have wisely decided to be the casino, but the fact remains that occasionally markets take a nosedive, we lose our jobs, etc. To put it bluntly, sh!t happens.
Even if nothing dramatic occurs, small currents can add up to push us off-course. Inflation can rise slightly higher than expected, or market returns could go slightly lower. Raises could be non-extant for a while. Any of these, while seemingly small, can have a huge impact over the long term.
So the idea that we can create a financial plan and then sit back and watch our perfect life unfold, no further thought necessary, is a pipe dream. We have to have an Adaptive Financial Planning mindset.
But that doesn't mean we're completely at the mercy of chance.
The object of the game
We will have to make internal changes in our lives in order to compensate for external changes in our environment. The object of the game, then, is to keep those changes as small as possible.
Downsizing from a 2400-square-foot home into an 800-square-foot apartment in retirement is a big change. Increasing 401(k) savings by 0.5% of income is a smaller one.
Pulling your children out of private school their junior year is a big change. Delaying putting them into private school by a couple years is a smaller one.
Breaking your lease to go live with your parents is a big change. Putting part of your annual bonus into emergency savings each year is a smaller one.
In each case, you take on a small (sometimes barely noticeable) sacrifice now in order to avoid a gut-wrenching sacrifice later. This is at the heart of Adaptive Financial Planning. We can't control everything, but we can definitely smooth the path!
Expect the unexpected...
"No battle plan survives contact with the enemy." This is as true in your financial life as it is in war. There is going to be something you didn't anticipate, some threat or opportunity that comes at you sideways. But given that this fact is a near-certainty, you can still plan for it!
As you probably expect, this means a savings buffer. You're probably familiar with the advice to keep 3-6 months' living expenses in emergency savings; this is an excellent way to plan for the unplanned.
However, this also means an income buffer. It means lowering your nondiscretionary expenses as a percentage of your overall income, so that you can more easily move funds around to handle the little slings and arrows that come your way. How low? Consider the 50/20/10 rule as a good goal.
...and the expected...
Now, life isn't just a series of unexpected events; there are some things we see coming from a long way off. Your annual trip to see your parents at Christmas. Buying a new car, or a new laptop, or a new cell phone. Moving out of the apartment into a house. And, of course, retirement.
This stuff is going to happen. So...why not save for it? If the answer is "because it's hard now and it'll be easier later"...well, I hate to break it to you, but there's a 90% probability that you're fooling yourself. (And yes, I've learned this the hard way, myself.)
The good news is that you don't have to suddenly cut your standard of living in half. Rather, you can start small, and increase your savings over time. This "slow burn" makes the transition less dramatic (and traumatic), especially when you time savings increases with your raises!
...and even the probable!
But don't stop there! There are plenty of things out there that are quite likely, even if not 99% guaranteed, like getting married and going on a honeymoon, or sending the kids to college. I recommend you save for these things as well!
"But what if I don't ever get married -- or if we elope?" It's a far question. The key is to keep these funds in very flexible accounts, so that if you end up spending less than you anticipated, you can easily move the money from e.g. your college account to your travel account!
Which brings up the topic of 529 plans. They're a great tax-advantaged savings vehicle for education expenses -- but the costs are high if you spend it on anything but qualified education expenses (though the funds can be transferred from 529 to 529 between siblings or even between generations)! So consider carefully the pros and cons of putting money there versus in an account with fewer strings attached. My clients often compromise by contributing to a 529, but underfunding it somewhat in order to hedge their bets.
And speaking of Roths, if you're not already maxing yours out, they make a great flexible savings vehicle. Once you've had one for five years, your contributions (not the earnings) can be tapped at any time, with no tax or penalty.
Make cash flow changes slowly
A few paragraphs ago, when I was talking about funding savings accounts for probable events, I mentioned that you can start slowly and build your way there. I highly recommend taking this attitude towards cash flow in general: don't be too quick to make large changes.
For example, if you've been saving for retirement and suddenly discover that you need to accelerate the pace in order to retire before 70, don't try to just tighten your belt and double your retirement savings in one go. Rather, increase your 401(k) contribution by 0.5%. Then in six months or a year, do that again.
The same goes the other way: if you find that you're on track to slightly overfund college, and graduation is still five years away, don't just stop your 529 contributions. Rather, hold steady for a while, or decrease your contributions slightly.
But won't life be boring?
"All this saving and planning and slow changes and whatnot...won't this make my life boring?" Well, no, it won't. That's the thing -- life is going to throw you curveballs no matter how well you plan. (Trust me on this one.) Like I said earlier: you can't control everything!
And sure, sudden surprises can be exciting and thrilling...but they also take time and energy to handle. Do you find yourself with an overabundance of time? Whenever a crisis occurs, don't you find that there are other things you'd rather be spending your energy on? By planning ahead -- for the expected and the unexpected! -- you can better absorb the stuff that's thrown your way and get back to the things that are important to you!
Bonus reading: if all of this resonates with you, I highly recommend checking out Adaptive Financial Planning and Income Allocation. These frameworks build on and blend with each other, almost as if by design!
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.