Bucketing Costs to Build a Budget
Fixed? Variable? Wants? Needs? It's all money.
Budgets are powerful, but they also go out of date almost as soon as they are drawn up. Income fluctuates, prices go up, and priorities change. And there are always surprises, and they usually aren’t good.
A lot of people manage risk through mental accounting. They allocate money for different purposes, and maybe even keep it in different accounts, and they don’t mix the two. There’s fun money and emergency money and a college fund, and they do not mingle. Accountants, most notably Richard Thaler, consider this to be a behavioral bias. (If you want to download the paper, click here; you don’t need to have taken higher-level econ courses to get the gist of it.) He has a Nobel Prize and I don’t, but I think he’s missed a key point: individuals have a lot of financial risk to manage on their own, especially in the United States where we have a ripped safety net. And so, we are constantly balancing the sources and uses of our money.
I’ve been mostly self-employed for a very long time. Before that, I worked in finance, a field where bonuses can dwarf regular compensation. My husband has what seems like a stable job, in environmental consulting, but he has lost one job when his employer lost a big contract and another when his employer went bankrupt. Steady paychecks are rare. We have always managed our money to keep our fixed costs as low as possible, then spend extra money when times are good. We will always go on vacation: one year, it was Cedar Point and a budget hotel; another time, it was London with lots of bells and whistles.
Economists would argue that money is money; we should keep our consumption steady and use credit and savings to manage variations in income. And maybe that’s logical, but it is very difficult to know what will happen to income over time. If I knew what my lifetime income would be, the economically rational system might work better. But I don’t. So I want to make sure the bills are covered, and I want to have a few splurges when I am sure that we can afford it. And it’s not like Cedar Point is a sad vacation. It’s fantastic, if you like roller coasters. We live close enough that it’s a car trip, and it’s easy to find discount coupons.
We’re not sure how we’ll manage into retirement, when our income will be more fixed thanks to Social Security and our plan to buy a fixed annuity with some retirement savings. But our spending will be harder to fix, in large part because of the costs of healthcare and assisted care.
In December, The Financial Analysts Journal published a paper by David Blanchett entitled Redefining the Optimal Retirement Income Strategy. Blanchett uses an alphabet soup of variables to break down the problem. The biggest innovation is looking at retirement as two portfolios, one of wants and one of needs.
This is simple budgeting advice, yet it helps manage longevity risk and medical expenses. Many people kick off retirement with a list of wants from epic travel to immersion in a new hobby. While spending on wants usually decreases over time due to declining health, expenses related to needs tend to increase steadily thanks to inflation and medical costs. The needs portion calls for a steady income such as that from Social Security, a defined benefit pension, or an annuity. The wants portion can handle investments with more variability and more risk.
Blanchett’s paper is a starting point for more research that can help quantify the risks and allocations for a particular investor and the development of new products that better balance the trade-offs of retirement planning. The portion of workers with defined benefit pensions has been falling steadily since 1980, so there are literally millions of people who need more information on prudent retirement spending. But they may not get it, and so they may do things that would make Richard Thaler shake his head.