Spending Shocks, Budgets and Savings: Working and Retired

Holiday_spending,_Creating_budgets_for_traveling_expenses,_bills,_gifts_can_prevent_going_into_debt_111117-M-DU612-007Whether you are still working, or retired, most people haven’t structured their budgets for spending shocks. In truth if you spend less than you could, regardless of working or retired, you build in a buffer that helps keep stress on your financial life lower.

Most recognize the below as logical. Yet, many spend everything that comes in while working … or, all they can withdraw from their retirement accounts once retired. We all have spending shocks – or unexpected expenses. Having savings is the logical solution so that you can withdraw from that pot for those unexpected expenses.

But how does that actually work on your budget? Does the principle work the same once retired as it did while working?

Let’s take a look.

Savings Buffer Approach

First, the working years – which most people can relate to better. Let’s look at how having a regular savings program looks like. The blue line above represents the steady net (take home pay) monthly income. The green line represents having a savings program already in place – that’s why it is below the blue line most of the time … not everything is spent. In other words, having the green line below the blue line = consistent savings ability.

Why does the green line go up and down? Because the monthly take home pay can’t go up and down! Take home pay is steady for most people. And as most people realize soon enough, expenses often go up and down! So how do you manage fluctuating expenses when your income can’t?

You build in a buffer! Savings builds in the budget buffer so that TWO things happen:

  1. Your budget has the capacity to NOT save as much when a spending shock comes along (periods when the green line spikes up). Yet … your take home pay can manage to cover the shock.
  2. Should the spending shock be more than what you save that month (green line goes ABOVE the blue line), you have savings built up to pay that unexpected bill.

Without having a savings regime in place, there is first, NO ROOM for the budget to cover the unexpected bill (a spending shock to be sure); AND second, there are NO SAVINGS either (a double shock)!

This budget structure looks something like the below:

Savings Commnon Approach

The shocks (upward spikes) and savings (downward segments) between the two graphs are identical. But, there is a dramatic difference in outcomes between the two situations! The Common Approach (bottom graph) typically results in debt building up which puts even more stress on the budget and your nerves. The Buffer Approach (top graph) gives you room to breath.

Does anything change once retired?

In a word – no!

Once retired, simply don’t set up your budget to spend everything that you can. I call this spending based on peak portfolio values. Peak values are described in my Ocean Wave analogy. You should set up a buffer by establishing your “monthly take home pay” based on the trough portfolio values instead.

By this approach, you retain money in your portfolio to do TWO things:

  1. During normal times (most of the time markets behave normally), you have reserved funds for those unexpected expenses that are outside of your plans (spending shocks – which people have their entire lives, not just while working).
  2. A buffer from the portfolio value to absorb the occasions when markets misbehave. The Ocean Wave analogy uses the portfolio value buffer to absorb uncertainty during these occasions so that your monthly spending doesn’t need to change under most circumstances because you’ve already set in a “savings” habit by not spending all that you could.*

Moral of the Story: Working or retired, setting up a prudent spending and savings plan plays a critical role in managing spending shocks over your entire lifetime. Don’t spend everything you can! You will actually live with less stress in your life.

Note: income from the portfolio value would be added to other sources of income you may have such as Social Security and/or pension.

Note: Most people picture income, whether working or retired, as “steady,” or at least idealize this goal. If you look at your Social Security statement, your earnings history is most likely far from steady. My experience looking at many of these with people tells me that variable income is the norm rather than unusual. How you deal with that is described above.

By Sgt. Alicia R. Leaders (https://www.dvidshub.net/image/490289) [Public domain], via Wikimedia Commons

*When markets misbehave, you should have in place evidence based decision rules (rather than react emotionally) to manage these events in retirement.

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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