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Your Numbers - Wealth Potential

Written by John D. Buerger, CFP®.

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John Buerger

(this is the fourth in a series of four posts)

We wrap our discussion of VIP$ - Very Important Personal Finance - Numbers this week.

These are NOT the numbers you likely have rattling around in your head. Those numbers (annual salary, size of your investment accounts, total net worth) are promoted by the personal finance industry as important gauges for THEIR success, but they are relatively useless for your ability to make great financial decisions.

Our VIP$ Numbers are specifically designed to battle your brain's wiring and human tendency to make important decisions based on bad (usually emotionally charged) information. There are ony four numbers to remember so this is a SIMPLE framework and the numbers don't change rapidly so you only need to revisit them every few months.

 

QUICK REVIEW

The first number is your Daily After Tax Income (DATI) - the amount of money you have slipping through your fingers every day. Rather than thinking in terms of annual income (which is a big number), daily spending decisions are better when compared to daily income. Your brain is more likely to see each decision as important and significant.

The NumberThe DCE - Daily Control Expense number is even smaller. Even if your income is good, you only have control over 15-25% of that daily income. The rest is already committed to Past Obligations.

Last week we introduced the Future Bucket Rate - the percentage of your after tax income that is going towards future expenses - whether those be retirement, saving for college or just saving for your vacation later this year. If you always have expenses that are greater than or equal to your income, you will never build wealth.

The more money going into the Future Bucket, the more wealth you are creating.

YOUR WP - WEALTH POTENTIAL

The last of the four numbers is also (like the Future Bucket) more related to your future than your current state. Half of our VIP$ Numbers are based on the future because it keeps the whole process centered on positives. The biggest challenge for all cash flow management systems is the tendency to be focused on limitations, sacrifice, pain and self-discipline - all concepts that lead to poor financial decisions.

Your Wealth Potential is just like it sounds - the amount of wealth you have the ability to store up over your lifetime given your current income and expenses as a starting point.

This number can be pretty large. How much larger it is compared to your current Net Worth is more a function of time than anything, but even if you are going to retire in just 5-7 years, your WP can be a huge positive driver towards better financial decisions and the resulting Quality of Life improvements.

IMPORTANT ASSUMPTIONS

We do make a few, sometimes optimistic assumptions in calculating this number ...

--- We assume that your income will grow at a rate that is 1% faster than inflation. Over the past several decades, that rate of improvement is actually faster (as we have enjoyed accelerated productivity in the U.S.) but since the Great Recession, we have fallen short of this number. By most standards, 1% productivity improvement is considered a conservative assumption.

--- The other major (and optimistic) assumption is that you will successfully improve your FBR (Future Bucket Rate) by 3% per year until your FBR is 25%. We do adjust for the fact that some of your Future Bucket will get spent for things like vacations, college educations, etc. (our experience is that 3% of additional savings each year is quite possible - the historical average with clients is closer to 4%).

--- We assume that you will be able to collect Social Security at 60% of your inflation adjusted guaranteed rate starting at age 70 (a pretty harsh assumption but likely with the issues facing the Social Security system).

--- We assume that your investments will return inflation plus 4% and for the purposes of this number we assume that inflation will remain at the long term historical average of 2%.

AN EXAMPLE

Take an average, middle income family making $50,000 a year and saving nothing after taxes. They are each 35 years old. They have no assets to speak of - just living paycheck to paycheck and they want to retire at age 65 (in 30 years).

For this family, their DATI is $116.44. The Daily Control Expenses are just $29.11 (Weekly Control Expenses are $203.77) and their starting FBR is 0%. This family may think that they have very little to no Wealth Potential and if they keep living paycheck to paycheck that will certainly be the case ... but by working on their FBR they end up with a Wealth Potential of $2.1 million dollars (which they hit on the day they die at age 100).

Start with nothing and end up with $2.1 million, all by making better choices with all the money slipping through your fingers every day.

WHY REMEMBER

The reason we keep the Wealth Potential in the mix of numbers is that it helps to set a postive but realistic context to all the challenges presented by the current state of affairs. Living paycheck to paycheck may seem like something that will never end, and those first few years of savings will seem insignificant (less than $10,000 saved after 4 years) compared to everything else.

But even small incremental improvements over time will result in significant wealth being accumulated over the long haul and THAT is the point of financial planning, our Wealth Coaching process and working through change to make different and better financial decisions every day.

John

We can help you prioritize your goals and scope your focus.
Learn more. Schedule a Free, no-obligation 20-minute consult today!

Call 805-476-0333 or use the "Book Appointment Now" tab on the bottom right of your screen.

Your Numbers - Future Bucket

Written by John D. Buerger, CFP®.

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John Buerger

(this is the third in a series of four posts)

This series of posts discusses the few but important personal finance "numbers" we believe every person should have memorized, but these are NOT the numbers you have been taught are important.

Our experience with clients shows that most "important numbers" do nothing to improve your financial decision-making and often actually make things worse. So forget what you've been told and focus on these numbers instead.

PREVIOUSLY - INCOME & EXPENSES

Contrary to popular belief, building wealth is NOT about your investments. It IS ALL about getting control of the money slipping through your fingers every day. The two primary variables of cash flow control are income and expenses.

The NumberThat is all well and good, but how those numbers are framed is equally important. Comparing a one time expense (we use the example of a $20 lunch) with an annual income number (which is the one financial number people commonly know) makes the expense seem insignificant. That is why the income number we suggest using is your DATI - Daily After Tax Income. It's a much smaller number and more meaningful when analyzing daily expenses.

The Expense Number we use is also different, because it gets rid of all the expenses you have (for most folks 75-85% of the money going out) over which you have little to no immediate control. These "past obligations" must be met (whether or not you feel like it) or else the consequences will be fairly severe pretty quickly.

That leads us to the WCE - Weekly Control Expense number as the second of the four numbers to keep top of mind (and some people have boiled that down to an even smaller DCE - Daily Control Expense number).

THE FUTURE BUCKET

Within this framework, there are only three places after-tax income can go: (1) Past Obligations (2) Current Control Expenses or (3) Your Future ... that is money that will be spent, but not right away.

If you envision your Cash Flow Income as a hose, it is feeding water (after tax income) into these three "buckets."

The more money going into the Future Bucket, the more wealth you are creating. If you always have expenses that are greater than or equal to your income, you will never build wealth. That might be OK for today but at some point in the future you will need that accumulated wealth: to pay for college for your kids and/or to someday retire and enjoy the same quality of life (or preferably better) than you had when you were working.

FBR - FUTURE BUCKET RATE

As we suggested earlier, most American families - especially those in the middle class - have a tendency to strap themselves with pretty serious Past Obligation type expenses (including mortgage/rent, car payments, utilities, fuel for the car and credit card payments). It is not uncommon for 75-85% of after tax income to go to past obligations leaving only 15-25% of after tax income to cover control expenses and feeding the Future Bucket.

The FBR - Future Bucket Rate is whatever is normally left over (expressed in percent form) from after tax income after you have paid the Past Obligations and spent whatever you normally spend on food, clothing and entertainment (Control Expenses).

When we start working with clients on this, their FBR is anywhere from negative (eating into savings to live) to around 10%. It is amazing how consistent that number generally is for people. The FBR for any particular family doesn't change much from month to month or even year to year.

HOW GOOD IS YOUR FBR?

When we start talking about saving money is when most people start to get discouraged ... especially those who have an FBR that is negative or very small. Increasing your savings rate can seem like an impossible task because there always seem to be expenses that "come up." I understand that, but can also share a number of experiences that clients have had once they embrace this new framework and these special numbers. 

Your FBR is neither "bad" nor "good." It's just a number. What DOES matter is that your FBR starts moving in the right direction.

While I said that the FBR doesn't change a whole lot from month to month or even year to year, a little bit of effort on a daily basis (only a couple of minutes a day) can improve your FBR number by 3-5% per year - all without taking away from your quality of life.

AN EASIER WORKOUT

Let's say you wanted to get into shape. If you went to the gym and on the first day you did 100 push-ups, 100 situps and lifted weights for an hour, the following day, your muscles wouldn't look a whole lot better but you would be in a world of pain.

What if instead you did 5 pushups, 5 situps and 5 reps with light weights the first day ... then the next day you did 6 of each ... and so on each day, adding slightly to the workout. By the time you reached the day when you were doing 100 of each, your muscles would already be looking MUCH better and your body wouldn't be in much (if any) pain.

We do the same thing with wealth health - looking for small, incremental gains in cash flow control. If your FBR was 0% the first year, by year 5 it could be as high as 15% or even 20%. When added up over time, these incremental increases in savings rates can mean a year's worth of income in savings in 8 years, 3 times income in 14 years, 5 times income in 19 years and 10 times income in 25 years (NOTE: we start with 0% FBR and add 3% to that rate each year until we max out at a 25% FRB rate. Assumes 2% inflation and 7% real investment returns).

A 35-year old making average income ($50,000 per year today) can have $1 million saved up by the time they are 60 without heavy lifting and without doing anything to diminish the quality of their life. In fact, being strategic and intentional with your money almost always improves your quality of life as there is less financial stress, fewer worries and it feels good to get control over your money.

So we have one more number to keep in mind ... we'll cover that next time.

John

We can help you prioritize your goals and scope your focus.
Learn more. Schedule a Free, no-obligation 20-minute consult today!

Call 805-476-0333 or use the "Book Appointment Now" tab on the bottom right of your screen.

Your Numbers - Expenses

Written by John D. Buerger, CFP®.

Share/Save/Bookmark

John Buerger

(this is the second in a series fo four posts)

In this series of posts, we are focusing on the few but important personal finance "numbers" we believe every person should focus on. These are NOT the numbers you usually hear from the personal finance gurus, your financial planner (if you are lucky enough to have one) or even your parents, family members or friends.

They ARE the four numbers that our experience with clients has shown to be the most productive at enjoying a better quality of life through better financial decisions and also getting a real sense of control over the money slipping through your fingers every day.

LAST TIME - INCOME

The first number we covered was your DATI - Daily After Tax Income.

Once you know how much money you bring in on a daily, after-tax basis, it is much easier to start making better spending decisions. For example, rather than comparing a $20 lunch decision to the amount of money you earn in a year - a comparison that always makes that $20 lunch look like a bargain - if you compare that $20 to your DATI (which might be only $100 a day), it becomes a more significant expense.

The Number

The whole point of having these numbers be top-of-mind is to give yourself the tools and framework to make better decisions - those that are more in alignment with your long-term goals and personal values (what is most important to you). That cannot happen when you start by comparing apples (short term spending decisions).to a truck load of bananas (how much you make in a year).

THE EXPENSE NUMBERS

As with income, our take on expense numbers is different from what you've been taught.

We don't recommend using the expense numbers that are part of the traditional budget process. That approach usually leads to a lot of pain, shame and sacrifice as there is almost never "enough money in the budget" to pay for all the things you want to buy.

A budget is like a diet. I often joke that it is a six-letter-long four-letter-word. Like most diets, most budgets are set up for failure because they are built around pain, sacrifice and self-discipline. The focus is on what you can't have, not on what you can afford. The result is (also like diets) almost all budgets fail.

ONE SIMPLE NUMBER

With traditional budgets, there are usually a half dozen numbers to remember. There are budgets for food, clothing, entertainment, household, utilities and more, plus you have to track where you are relative to each budget number each week or month. No wonder these budgets fail. They are too complicated to track and take a lot of mental energy to manage.

We suggest that you only need to track two main expense categories: Past Obligations and Current Control Expenses but really, the only number you need to have rattling around in your head is the Daily or Weekly Control Expense number.

That's it. One number instead of six, eight or twelve.

A SMALL NUMBER

This Control Expense number is also usually pretty small and therefore even easier to track - with or without software.

That's because it doesn't include all the things you've already obligated yourself to paying each month. Past Obligations including your mortgage/rent, car payments, utility payments, credit card debt retirement and gasoline for your car are all excluded from this Control Expense number.

Control Expenses boil down to three basic areas: Food, Clothing and Entertainment and they have a tendency to be only 15-25% of total income. So if your DATI (Daily After Tax Income) is $125, your DCE (Daily Control Expenses) will probably be only $25. The weekly number might be $175. If you spent $100 bucks at the grocery store already this week, that leaves only $75 to cover that $20 lunch you're thinking about as well as this weekend's entertainment and maybe that new pair of shoes you want to buy.

TWO QUESTIONS THAT HELP

Clearly, resources are limited (unless you are Bill Gates or Warren Buffet). That means you can't buy everything you see or want without going into debt up to your eyeballs. While it is not part of the "numbers" we're discussing in this series, there are two questions that people who use this system find extremely helpful in making better decisions without loading up on pain, sacrifice and self-discipline.

Every time you are faced with a spending decision, ask yourself this two-pronged question:

--- "What value will I get out of spending this money here?"

--- "Could I get MORE value if I spent this money someplace else?"

Now you are no longer telling your emotional system that you can't have something it wants. Instead you are looking at the spending decision from a comparitive value standpoint. You're not eliminating the spending ... just choosing to spend the money in a different, more valuable way to you.

Example: "I could spend this $20 on a lunch, or I could brown-bag my lunch today and spend $18 this weekend on some special time with my daughter (which is way more important that having someone else cook my food and serve me). I still get to spend the $20 (which does feel good). I just get more bang for that $20 this way. I still eat lunch (it cost $2 to brown bag it) AND I get to spend more time doing something special with my daughter."

Next time we'll cover Savings Rates. As with these first two ... our take is different than what you might expect.

John

We can help you prioritize your goals and scope your focus.
Learn more. Schedule a Free, no-obligation 20-minute consult today!

Call 805-476-0333 or use the "Book Appointment Now" tab on the bottom right of your screen.

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