“I have enough money to last me the rest of my life unless I buy something.”
Budgets: turning gold into chocolate. Is that so bad?
I recently wrote that budgeting when you’re working is an opportunity to practice living within your means so that when you hit retirement, you’ll be prepared. After all, if you miss your budget when you’re working, you still have the opportunity to make up the lost savings because you can work another year or three – though relying on working until you’re older isn’t a surefire bet – or you can earn more during your working years to cover the shortfall.
If you’re like many of my readers, that article felt like it was bordering on the harping over minute, de minimis numbers. Pretty soon, it could stand to reason, I’d be telling you to reuse coffee grounds two or three times when making pots of coffee (like I did when I was in college).
For some reason, the watch every penny advice reminds me of an old commander I had in the Army. His motto was “a unit that looks good fights good.” I should have known that someone who employed improper grammar wasn’t going to be the next Patton or Guderian. Indeed, that was the case. His units’ vehicles all were sparkling and spotless going into a field exercise, and they got blown off the battlefield by the enemy forces. It made me glad that we weren’t going into a real war. As a friend of mine once said, “You can’t shine a turd.”
In fact, I specifically called out missing a $4,500 budget by $200 as a potentially big deal. To wit, I said:
If you miss by $200 out of a $4,500 budget, spending $4,700, you think to yourself that it’s not a big deal because $200 is such a small proportion of $4,500.
YOU: “Yikes. We went over in the budget this month by $200.”
MONKEY BRAIN: “$200 ONLY 4.4% OF $4,500. ROUNDING ERROR. NO WORRY. GO SHOPPING.”
YOU: “Good point! Thanks!”
Am I making much ado about nothing?
Let’s see how much that 4.44% error in budgeting and spending plays itself out both when you’re in your earning years and when you’re in your retirement years.
To set this up, let’s first make some assumptions about a hypothetical couple.
This hypothetical couple makes $5,396.98 per month. Why that number? Because, according to Dr. Wade Pfau’s SAFEMIN calculations, to be able to live for 30 years in retirement using a 4% safe withdrawal rate and assuming that 50% of the spending is accounted for by Social Security, you need to save 16.62% of your income in the previous 30 years investing in a 60/40 split of stocks and bonds. So, they live on $4,500 per month when they hit their budget. Their paychecks and expenses are tied to inflation, so the budget miss is 4.4%.
We’ll assume that this family invests in the S&P 500 for stocks and in the AAA corporate bond index for bonds and use historical returns to simulate a world of possibilities for them. We will also use historical inflation numbers to create a set of potential inflation scenarios as well.
After 30 years, this couple will retire and live for another 30. They’ll need $4,500 per month to live on, adjusted for inflation, meaning that if they need $4,500 a month now, they’ll probably need much more than that when they retire, and Social Security will only cover half of their living expenses. They’ll need to tap into their savings for the rest.
I examined three scenarios and conducted 10,000 Monte Carlo simulations to evaluate how each scenario played out. A Monte Carlo simulation uses random number generation to predict a range of futures. Since we know that the future won’t look like the past, we use Monte Carlo simulations to generate a range of potential futures.
What did those futures look like?
Scenario 1: Over on the budget by 4.4% all 60 years
This was the case where the couple started out spending $4,700 per month and, consequently, saving $200 less each month, hopped on the hedonic treadmill, and never looked back. They figured budgets were for rough planning purposes only, and not really to live on.
No big deal, right?
46.6% of the time, this couple ran out of money before the 60 years expired.
The median couple ended with almost $458k in net worth, meaning that 50% of the time, they wound up with less money (and only 3.4% of the time did they end up with less than $458k and not go broke, meaning that there’s a very slippery slope down), and 50% of the time they wound up with more than $458k.
The chart below will look a little nonsensical, since there’s no way in the world they could borrow enough money to continue to fund their lifestyles, and they’d have to dial back to living just on Social Security once they ran out of money, but it’s instructive to see just how widely disparate the outcomes are and to compare to the other two scenarios.
Scenario 2: The couple overspends in retirement
This is a couple who lived a sure and steady life, but once they hit retirement age, they went a little overboard. They’d kept to spending $4,500 in current dollars during their working years, but once they retired, they spent $4,700 in current dollars. Naturally, we’d expect them to do better than their consistently over-budget counterparts, but how much better did they do?
29% of the time, this couple ran out of money before the 60 years ended.
They were much better off, in general, than their continually spending counterparts. 50% of the couples in this scenario had greater than $3.4 million after 60 years, and 50% had less than that amount.
You can see how the chart has shifted to the right for this scenario.
In general, it’s going to be easier for families in retirement to stick to a budget because they have a fear of falling off of a cliff. They don’t want to run out of money and be quite elderly. From horror tales of Medicaid nursing facilities (I’m not saying they’re bad, but I’ve heard them too) to the fear of living under a bridge, even Monkey Brain can be trained to dial it back when there’s no more money coming in from work.
But when you’re working, it’s easier to justify going over budget because, hey, you’re working. You can always earn more money, right?
Let’s see what happens to those people – the ones who don’t hit the budget while working and then get wise when they retire.
Scenario 3: Over budget when working but on budget when retired
It turns out that finding budgetary religion after retirement had almost no impact. 43.2% of the time, this couple ran out of money.
The median amount was slightly better than in scenario 1; it was $848k. If you compare the chart below with the first chart, you’ll notice that there’s not much difference.
The lesson from this exercise is that erring on missing your budgets has a cumulative impact regardless of the stage of life that you’re in. Comparatively speaking, the couple who stuck to the budget for all 60 years had a positive net worth 74% of the time and had a median net worth of $3.69 million. A 4.4% overage on the budget in retirement may seem like no big deal, but it made this hypothetical couple 11.8% more likely to run out of money and dragged the median net worth down by 8.5%.
Did these numbers scare Monkey Brain straight into sticking to the budget? If you have trouble sticking to a budget, what would it take to get you to create and stick to one? Let’s talk about it in the comments below!