SensibleSaver

Voluntary Savings

2005-09-25T13:35:00.000-05:00

This category is perhaps the toughest to understand in the Equation of Personal Finance. The problem is that it's not readily apparent what it's going to. While the others are quite obvoius (Retirement Savings is self-descriptive), Voluntary Savings has a different definition for each person.

Let's start by talking about a few things. First and foremost is the common misconception that many young people have nowadays about retirement. The message received from older financial advisers has always been "save 10% of your income in a retirement account, and you'll be fine". This may be shocking to hear, but this is no longer true. In order to retire, young people will need to save far more than 10% in order to enjoy a retirement they may have planned. Throw in the fact that Social Security is a huge question mark nowadays for people younger than 40, and you should quickly see that the old messages of retirement are no longer valid. On a more human note, you must also consider your quality of retirement if you are forced to work until you are 67 before you can retire. Although it may seem a long way away now, the difference between quality of life when you're 60, and when you're 75 tend to be significant. On that note, it may be very advantageous to think about the notion of retiring early - looking to retire at age 55 instead of age 65. In order to do that, you will need to live off of funds from other places than Retirement Savings - and that's where Voluntary Savings fits in.

Voluntary Savings can be thought of as middle-term savings. It's not the money you're going to spend right away, and it's not the money you're going to spend a long time from now - it's the money you're going to spend at some point in the future. The question often arises though, what can I spend Voluntary Savings on? Again, this is a potentially confusing area. Voluntary Savings and Splurgable Income are very different though. The simplest way to tell them apart though, is by asking yourself the question: Do I need this item, or do I want this item??

That question should help you see the light of whether you are spending Voluntary Savings or Splurgable Income. Even this though, is somewhat limiting. Future posts will go into greater detail over the differences between the two, but for now, good examples of times to spend Voluntary Savings are for a down payment on a house, a down payment on a car, or a vacation. Future posts will also address what to do with your Voluntary Savings (where to invest, what rate of return, what risk, etc.)

This site highly recommends that for every dollar you spend as Splurgable Income, you save 33 cents as Voluntary Savings. Again, let's start with the Fundamental Equation of Personal Finance and derive some equations for dealing with Voluntary Savings.

Y = B + RS + T + VS + SI
FC = VS + SI
Y = B + RS + T + FC

FC = Y - B - RS - T
In other words, your free cash is what's left over from your gross income after you pay your bills, your taxes, and put money away for retirement savings.
Further breaking it down...
SI = .75FC
VS = .25FC
You can see how your FreeCash breaks down. 25% of your free cash should be put into Voluntary Savings, and 75% of your FreeCash can be spent as Splurgable Income.

Finally, let's derive exactly how much you should be saving each month as Voluntary Savings. Let's start with the equation we derived to solve SI...
SI = .5Y - B/1.33
SI = 3VS
3VS = .5Y - B/1.33
VS = Y/6 - B/4

Using real numbers (the same real number we used in the Splurgable Income example), suppose you make $48,000 a year and spend $1400/month in bills.
To determine your VoluntarySavings/month...

VS = (48000/12)/6 - 1400/4
VS = $667 - $350
VS = $317/month

In conclusion, you would only need to save $317 a month in Voluntary Savings to build a solid foundation and over time build up a large savings that you can tap in times of need.

Personal Finance Equation - Broken Down

2005-09-21T13:45:00.000-05:00

A few posts ago I introduced you all to the Fundamental Equation of Personal Finance. Since that introduction, I've started to use it to explain personal finance situations and use it in examples. As you can see, there are many ways to examine the equation, and also different ways to break it down. This post will simply go through some derivations of the equation, and also show you some sub-equations. These equations will be used over and over again throughout future posts.

Personal Finance Equation
Y = B + RS + T + VS + SI
Y = Gross Income
B = Recurring Bills
RS = Retirement Savings
T = Taxes
VS = Voluntary Savings
SI = Splurgable Income

Gross Income
Y = TI + UTI
TI = Taxable Income
UTI = Untaxable Income

TI = T + NE
T = Taxes
NE = Net Earnings

Recurring Bills
B = HC + NHC
HC = Housing Costs
NHC = Non-Housing Costs

HC = I + P
I = Interest Payments
P = Principal

Retirement Savings
RS = TRS + NTRS
TRS = Taxed Retirement Savings
NTRS = Non-Taxed Retirement Savings

Voluntary Savings and Splurgable Income
FC = VS + SI
FC = Free Cash

SI = .75FC
VS = .25FC

VS = .33SI
SI = 3VS

Retirement Savings

2005-09-20T12:32:00.000-05:00

The story about Retirement Savings comes down to two words - compound interest. For those of you who aren't mathematically inclined, when you first see the effects of compound interest, it's nearly unbelievable.

Well, believe it. The power of compound interest is the single most powerful tool for you as a saver. Just how powerful is it? This example takes two people - one of them socks away $5000 in their 401k when they're just out of college, when they're 22. The other person parties it up after college, and doesn't get around to putting $5000 in their 401k until they've settled down, when they're 35 years old.
22 Year Old -> Starts with $5k, but at age 65 will have $140k.
35 Year Old -> Starts with $5k, but at age 65 will have $50k

The 22 year old has nearly 3 times as much money when they're retired. What did it cost them? The exact same amount of money as the 35 year old.

What are the important lessons to remember about Retirement Savings and compound interest?
1) Start early!!! The example above says it all
2) Don't stop contributing.
3) Don't ever take money out before you need it. Let it sit and grow.

Let's take a look at the Fundamental Equation of Personal Finance and derive some formulas.

Y = B + RS + T + VS + SI

Let's make some assumptions here to simply the formula and focus on some areas. Let's assume, all things being equal, that B and VS = 0

Y = RS + T + SI
Because, in general, you're not taxed on your Retirement Savings, and your SI is just what you're not taxed on, we can adjust the formula to be
Y = RS + TaxRate(Y-RS) + (1-TaxRate)(Y-RS)

Using this formula, let's take a look at the two options that everyone has when it comes to Retirement Savings - save now and spend later, or spend now and save later. By examing what occurs when Y increases by $1, we can see how each decision plays an impact on the equation.

Spend Now
By increasing Y by 1, we can see that
Y+1 = RS + TaxRate(Y+1-RS)+(1-TaxRate)(Y+1-RS)

You should be able to see that although your income increased by $1, your SI did not increase by that same $1. Part of that $1 went to pay taxes. So, you increased your Y by 1, but your SI only increased by (1-TaxRate). For example, if your TaxRate=22%, every increase in Y that doesn't go to RS becomes 78 cents of SI.

Save Now
By increasing Y by 1, we can see that
Y+1 = (RS+1) + TaxRate(Y-RS) + (1-TaxRate)(Y-RS)

You should be able to see that when your income increases by $1, your RS increases by $1. You've immediately made a return equal to your TaxRate on that money without doing anything.

In fact, that $1 is not even the true value of your money. Since you can't spend the money until you are retired, it's more accurate to look at these two differences in terms of Future Value.

Spend Now
We've already calculated that a $1 increase in Y will lead to a (1-TaxRate) increase in SI, that you spend right away. The Future Value of that $1 is simply (1-TaxRate)

Assuming TaxRate=22%, then
FV = 78 cents

Save Now
The Future Value formula tells us that that $1 increase in Y becomes

FV = 1 x (1+return rate)^(65-age)

Assuming return rate = 7% and age = 30, then
FV = $10.70

In conclusion, let's wrap this all up by using our 22 Year Old Saver from above to truly compare the present value and future value of their decision.
If the 22 Year Old decides to spend that $5k instead of saving, they're getting a Present Value of only $3900, and also a Future Value of only $3900.
Instead, assume the 22 Year Old decides to save that $5k instead, suddenly they're getting a Present Value of $5000, and thanks to the wonders of compound interest, they're getting a Future Value of $140,000.

The decision to spend vs. save for retirement may seem like a difficult one, but that's only true if you look at it in terms of present value. Think in terms of future value - would you rather spend $3900 or $140,000.

Fundamental Equation of Personal Finance

2005-09-16T14:22:00.000-05:00

Since personal finance is all about money and numbers, there must be an equation that can easily describe it. In fact, there is - The Fundamental Equation of Personal Finance. The equation is used to derive everything in this blog - where all your money goes, how much of it should go where, everything. It's important to see the equation and to understand it, since all the posts from here on out will build off of it.

Fundamental Equation of Personal Finance
Y = B + RS + T + VS + SI
Y = Gross Income
B = Recurring Bills
RS = Retirement Saving
T = Taxes
VS = Voluntary Savings
SI = Splurgable Income

As you can see, your gross income is broken down into 5 different areas, which will be explored further within each post. However, just from this equation, you can start to evaluate your spending habits and see how everything will come together.

Taking a peek ahead to stuff covered in the next few posts, let's take a look at how much we can spend each month. For all these examples, we'll be using percentages.
Y = B + RS + T + VS + SI
RS = .12Y
T = .22Y
.66Y = B + VS + SI

By using the rules of 12% of income should go to retirement savings (discussed more later) and that on average your T will equal 22% of your Y, we can see quickly that on average you will have 2/3 of your gross income (Y) available to spend on recurring bills, voluntary savings, and splurgable income.
Knowing that Voluntary Savings equals .33 of Splurgable Income, we can reduce the equation to:
.66Y = B + 1.33 SI

Finally, by solving for SI, you can find that
SI = (.66Y - B)/1.33
SI = .5Y - B/1.33

In other words, without knowing anything about your spending habits, by simply calculating your recurring bills and supplying your gross income, you can quickly calculate how much splurgable income you have each year.

Using real numbers, suppose you make $48,000k a year, and your monthly bills are $1400. You can see quickly what you can spend each month as Splurgable Income:
SI = .5Y - B/1.33
SI = .50(48,000) - (1400*12 months)/1.33
SI = 24000 - 12631
SI = $11369
SI/month = $11369/12 months = $947/month

You can spend $11369 a year (or $947 a month) as Splurgable Income, money that you can spend without sacrificing your personal finance goals.

Splurgable Income

2005-09-04T22:26:00.000-05:00

The biggest disappointment I get when I read other personal finance sites is their insistence upon sticking to a golden rule. Often times, this golden rule is "save 10% of your income", or some derivative of this. However, this doesn't always tell you enough. 10% where? In retirement or normal savings? Another thing that bugs me about other sites is that they make you feel guilty for spending money. I've read one book that suggested that everyone give up Starbucks, as the money spent on a mocha latte could be funding a future retirement.

The Sensible Saver outlines exactly where to put your money, but even more importantly, also lets you know it's ok to spend money. After all, why earn money if you can't spend it? You shouldn't feel guilty by eating out every once in a while. There's no reason to stress about buying some new clothes. The Sensible Saver knows exactly how much money they can spend, the so-called "fun money", that they have every month.

The Sensible Saver defines a new term - "Splurgable Income". This term may sound funny, but it stresses exactly what it is - money you can spend on anything you want. In terms of personal finance, Splurgable Income can be thought of the amount of money that can be spent in the near term without sacrificing medium and long term savings goals. The more fun way to think about it though, is to think of it as the money to fund your own entertainment - whether that entertainment comes from buying clothes, eating out, watching movies, partying, or short weekend trips, you should be fully comfortable that every month you have an allotted amount of money that is designated for fun.

How much money each month do you get to spend as part of the Splurgable Income? Well, the answer will come as you fill out the Budget Tool, but as a preliminary peek, Splurgable Income = Gross Income - Taxes - Retirement Savings - Voluntary Savings - Recurring Bills. (The Personal Finance equation will be discussed in more detail in future posts). The surprising thing to most people is that the average amount of Splurgable Income in the 22-30 year old age bracket is 32% of your Gross Income. That's right - you can spend almost 1/3 of your gross income every month and still be setting yourself up for a wealthy future.

Welcome to Sensible Saver

2005-08-27T20:34:00.000-05:00

This is the first, in what will hopefully be many, posts on the new Sensible Saver website. What is this website all about you might ask? Well, it's all about everyone's favorite thing in the world....Money. How to make money, how to save money, how to spend money. It's all designed to help you make smarter decisions on where your money is going. In addition to showing you where you're spending your money, it'll guide you through the process it will take to make you wealthy. Einstein once called compound interest the 8th wonder of the world. See how by simply saving a "Sensible" amount of money each paycheck, you can lay the important groundwork to become wealthy, and live the life you may have always wanted. Finally, this site will also offer tips and tricks to help you save money - for example, ways to cut utility bills.