Budgeting: Part 2: Creating A Framework

"High achievement always takes place in the framework of high expectations."

- Charles Kettering

In the first part of this series on budgeting, I discussed the importance of starting the budget process by looking at the big picture. Now let's try to bring those lofty ideals down to earth. When I asked myself some significant questions about life (listed in the previous article), I found that some of the things that were important to me were:

• Travel. (...more specifically, wanderlust. More on that another time!)
• Learning.
• New experiences.
• Diversity of experiences.
• Family.
• Service.

I also discovered some things that weren't so important to me:

• Limited desire for structure.
• Limited desire for recognition.
• Limited desire for "things" or "stuff".

I've already generalized quite a bit of my life in constructing the list above, but it can be generalized further. Hopefully you can pick out some common themes in the above list. Newness. People. Independence. Freedom. So let's do one more level of generalization:

Most of what I appreciate in life requires a lot of time, but not a lot of money.

Now, of course, your desires are undoubtedly much different than mine. Maybe you really want to stay in the town where you grew up. Maybe you want to own a luxury boat. Maybe you want to run your own business. The important thing to understand is that with limited time and resources, only some of your goals in life can realistically fulfilled, so it's important to create a framework for what things are most important and work toward them. Otherwise, it's likely you may only achieve things that aren't very important to you, or worse yet, by failing to prioritize, you may not achieve much at all.

So far this all looks great as a theory, but like all theories, there is often a big disconnect when you attempt to apply them to the real world. Suddenly things get messy and you discover that what seemed so consistent in theory can often be quite contradictory in practice! So without ducking the issues any further, as an example, let's attempt to run a very common and very big expenditure through my personal framework. Let's talk about budgeting for a car. (Groan!)

So what kind of car should I buy? According to the above framework, the car shouldn't require too much of my time, or I won't have as much time for other things I want to do. I suppose that means reliability, so perhaps a new car? On the other hand, new cars cost a lot more and I don't care about impressing people with my car. Also, time is money, so buying a new car means spending more hours working so that I can pay for it. Well then, maybe I could take public transportation - it's cheap, and reliability is someone else's problem. But public transportation only runs at certain times to certain destinations, so this is not going to work out very well with the whole freedom and structure goals. At any rate, whenever there are mechanical issues, I should have someone else fix them to save me time, right? That sounds right except that I really like learning about new things and so I might actually enjoying performing the repair.

So it's easy to see that my goals are not always aligned with each other. Sometimes they can be complementary, while at other times they can be contradictory. Goals can also change over time. Prioritizing the goals or creating a hierarchy of importance can help a little, but in the end, everything is not going to be nicely consistent. We can't realistically expect that life can be reduced to a decision tree.

So what good then is the framework? The framework does not give you the answers to your choices in life. The framework is designed to make sure you are asking the right questions. That may not seem very helpful to some people at first blush, but think about how you would answer a friend who asked for your help with an individual purchase.

For example, suppose a friend who knows little about computers asked, "What kind of computer should I buy?" As a helpful response, you would want to ask your friend some questions. "What do you want to use it for? How much do you have to spend? Do you want to be able to take it on trips? Do you want to store photos and music on it?"

As another example, suppose a different friend who knows very little about investing asked, "I have $2,000 to invest, so what should I do?" You would probably continue the conversation along these lines: "When do you need the money back? How comfortable are you with potentially losing some of this money? Are there any special tax considerations with this money?"

In both cases, you simply want to make sure that the right questions are asked. However, there are no automatic answers to the questions and no automatic choices. After your friend has answered the questions, he or she will still have to mentally weigh everything and make a gut decision on the purchase. The best choice will not necessarily be clear and mistakes may be made. Nonetheless, your friend is in a much better position to make a good choice than someone who did not ask and answer these questions.

When making decisions, people often do not ask many questions or they ask the wrong questions. This is what I try to avoid by having a framework. Just as it is helpful to have a decision framework for an individual purchase like a computer or an investment, it is even more helpful to have a framework for the entire budgeting process.

Budgeting: Part 1: The Big Picture

"These people who are always briskly doing something and as busy as waltzing mice, they have little, sharp, staccato ideas, such as: 'I see where I can make an annual cut of $3.47 in my meat budget.' But they have no slow, big ideas."

- Brenda Ueland

Budgeting ought to be about very big ideas, yet somehow we have managed to trivialize the budgeting process and transmogrify it into various pedantic exercises. Budgeting has taken on such negative connotations that it is no wonder that one third of people don't budget at all and two thirds say they are unsuccessful at budgeting. For many people, budgeting has become merely:

• An exercise in arithmetic. "If the numbers all add up, then I've really accomplished something."
• An exercise in irrelevance. "I made up a budget once. I never did understand it. It was just a bunch of numbers. It never did anything for me."
• An exercise in technology. "I learned how to use all the features in Quicken or Money, so I guess I have a pretty good budget."
• An exercise in statistics. "If my spending conforms to what other people spend on average, then I must be doing OK."
• An exercise in fantasy. "I construct the budget I would like to follow, but it bears no resemblance to reality."
• An exercise in guilt. "I'm always over budget. I feel terrible. If only I didn't have a budget, I would feel better."
• An exercise in magic. "I thought creating a budget would magically make all my debt disappear and I would be on the road to riches."
• An exercise in power. "I will make make other members of my household conform to my spending plans!"
• An exercise in negativity. "I can never do anything or have any fun because of my stupid budget."

In order to avoid these traps, try to start with the big picture in mind before you begin to work on your household budget. DON'T start with the average housing or grocery bill in the country. Instead, ask yourself big-picture questions such as the following:

• When I look back at age 70, what would I like my life to look like?


• When was I the most happy in my life? Why?


• If this morning I was diagnosed with a terminal illness, what would I do during the next 6 months?


• Am I satisfied with my contribution to the planet?


• What do I regret NOT having done in life?

Unfortunately, while the average person may see the value in asking such questions from time to time, they probably think that such "heavy" questions have nothing to do with budgeting.

But the reality of achieving lifelong objectives is that the big picture needs to permeate everything in your life - including budgeting. With any endeavor, the first question you want to ask is: What is my objective? Budgeting is a tool that can help you accomplish your objectives, but how can you properly construct your budget if you don't know what your objectives are?

And pushing it further: Why limit your objectives to this year's income statement? I suppose you could read Dickens to "learn the street names in London", or you could listen to Beethoven to "hear what a violin sounds like", but how foolish it would be to stop at that point! In the same way, why use a budget merely to make ends meet or to save some money?

It is often said that money cannot buy happiness. Fair enough. However, we usually recognize that money can to a large extent be traded for time and vice versa. We also often define money as a store of value. Budgeting, being a tool to manage money, can therefore be extended to help manage those most precious of commodities - time and values. And if economics can be defined as "the allocation of scarce resources among competing ends", then I contend that the household budget is nothing but economics in action at that level. Budgeting is all about choices, and you are the decider!

When people find out that we have a formal household budget, they often ask why we bother. Surprisingly to many people, the real reason we have a budget is not to save money or to provide discipline (although it probably does both of those things). We formally budget our financial resources in order to make sure that our finances are aligned with the big picture of what my spouse and I are attempting to accomplish with our lives.

Are you doing the same?

Negative Reactions To Early Retirement

"Keep away from people who try to belittle your ambitions. Small people always do that, but the really great make you feel that you, too, can become great."

- Mark Twain

While I certainly don't associate retirement with "greatness", I nonetheless have found that when discussing the possibility of early retirement, I encounter a substantial number of negative reactions, occasionally bordering on the belittling attitude Twain mentions above. In my previous article, I indicated that our family and the Nielsen family experienced the same two negative reactions from many people: (1) You're going to be bored. (2) You're being quite irresponsible.

It seems our two families are not alone in this regard. A recent comment to same article on this blog asked the following questions:

"What keeps you going in the face of the two reactions by your friends? I am in a job that I dislike but is bearable for a few more years. I am working to pay my house off so I have choices of which job to have after I quit without worrying about pay as much. I have a few select people who understand this, and the rest (who don't know what I am doing exactly but are life-long friends and know something is going on) are really reacting to me not spending what they figure I must earn. I'd love to see your thoughts on how you have handled the reactions and kept going."

I think the negativity mainly comes from misunderstandings, along with a healthy dose of financial ignorance in some cases. Very rarely do I find that there is an undertow of jealousy or antagonism involved.

Many people feel that early retirement is irresponsible because they think it would necessarily involve abdicating my responsibility to adequately provide for my children. This is not the case. Obviously I owe my children a safe, loving environment and appropriate food, shelter, and medical care. Beyond that, I also owe them an opportunity for success and happiness in the broadest sense of the words - including education, recreation, and many other avenues of life. However, I do not owe them everything Madison Avenue advertises, nor do I owe them whatever someone else has in life. Specifically, for example, I don't owe them an iPod, an ATV, or a new vehicle just because they see them in advertisements, and I don't owe them a 7-bedroom house, weekly dinners at Morton's, and a yearly vacation in the Hamptons just because some of their friends choose to spend (and borrow) that much money.

Once you accept that many "needs" in life are unnecessary, a much smaller income level is possible. I've also learned that even if the desired income level is defined, most people still don't have an appropriate ballpark idea of how much money someone would have to accumulate to support that income level. Some people guess wildly too low and other wildly too high. Educated people sometimes guess way too high, and this leads them to assume that you can't possibly have that much money.

Financial articles in the mainstream press are often not helpful in this regard. I remember a prominent article last year on Yahoo Finance that claimed that even if one had a house that was paid off at age 65 plus $4 million saved for retirement, you were probably in trouble. The article suggested that under such circumstances, it was very likely you would have to downsize from a 4-bedroom home to a 2 or 3 bedroom home, and replace the mid-range sedan or SUV with a Honda Accord. This seems preposterous to me. We can talk all day long about sustainable withdrawal rates for portfolios, but at the end of the day, if a 65-year-old person (who incidentally qualifies for both Social Security and Medicare) has a $4 million stash and no mortgage, that is a lot of money. Did the writer of the article realize that with $4 million, a 65-year-old person can purchase an inflation adjusted annuity that starts at $250,000 / year, is adjusted up for inflation each year, and the payments are guaranteed for life? Think about it. You could buy a new Cadillac every year on that kind of income. (I don't necessarily think an annuity is the best choice, but because it's a defined and guaranteed income stream, it lucidly supports my contention that $4 million is a decent chunk of change!)

As for the comments from others that I would be "bored" in retirement, I can only suggest that is likely to be a psychological projection. A lot of people basically vegetate when they're not working, and so if someone can only imagine watching television and lounging around the pool during off hours, it's not very surprising they would consider life without work to be boring. Under that paradigm, it certainly would be boring. However, I do find that, for me, almost every major activity outside of work is more intellectually challenging and fulfilling than the activities I perform at work. Note that I'm certainly not disparaging work. There can be intellectual stimulation and a certain degree of fulfillment in a corporate job, and I'll even admit that my daily work experience is not really all that negative from that standpoint. However, my current vantage point is that I most certainly would not be bored if I had to expand my "non-work" activities to encompass most of my time.

So specifically how do we handle these reactions? It depends on the particular response:

• Mindless disagreements. If someone continues to simply repeat the same criticism over and over without any true engagement of ideas, then it's time to move the conversation to a different subject. (There's no point in banging your head against the wall.)


• Lifestyle disagreements. When someone tries to understand our point of view, but can't understand how or why we would choose not to acquire a more "upscale" or "consumerist" lifestyle, I usually try to explain that everyone draws the line somewhere. Everyone has a point at which more acquisition and spending become simply waste and decadence. I don't usually criticise where others draw it for themselves, so I encourage others to agree to disagree on where the line should be for me.


• Financial disagreements. If someone understands your motivations and accepts your chosen lifestyle, but merely disagrees on the financial cost, then the conversation can actually be very useful. If you have friends who engage you at this level, consider yourself lucky. They can often poke holes in your arguments, force you to readjust your plans to reality, or at the very least, make you explain your assumptions and calculations in a clear and convincing fashion. This is a great thing, although it can sometimes involve some financial transparency if the conversation gets detailed.

In summary, disagreement and negative reactions can be helpful if they allow you to more fully explore and understand your own motivations or to engage in conversations with friends at a deeper level.

On the other hand, I would strongly urge anyone not to abandon their own ideas about what they hope to do with their life just to please someone else - especially if that person is not even a close family member. It is amazing to me how much we often crave acceptance from even the most casual of acquaintances. For many of us (myself included at times), we can be manipulated by a salesperson we have never met before and will probably never meet again. We may purchase or upgrade a product or service simply because we don't want to "disappoint" the salesperson or appear "cheap" or "unstylish" to him or her. Amazing!

Thus, when a friend or co-worker puts down early retirement as a losing proposition, it does affect me to a point. It sometimes does sting when someone says to me, "Come on! You could be making some serious bucks when you're 50! Think of your children! Do you really want to drop out of corporate life as a quitter? And if you stop working, you'll eventually run out of money, and then you'll end up flipping burgers or living on the street because no company is going to hire anyone with a big employment gap. Don't be irresponsible. And what's wrong with you, anyway? Don't you want to someday be proud to own a Lexus? Besides, I know you'll be much happier working. You'll be bored if you stop. Come on...everyone secretly aspires to be a Vice President. When you say you wouldn't want that, it only tells me you're either lying or you're content to do nothing with your life. Or maybe you just think you can't make it, so you pretend you don't want it."

Sigh... I'm afraid my desire to please only goes so far. Hence, I can't structure my life around comments like that. I just can't. If I really want to do something different with my life and my whole family is behind me, it would be the epitome of cowardice and underachievement to change that to please friends and acquaintances who think otherwise.

Reflections on the Nielsen's Early Retirement

"The trouble with retirement is that you never get a day off."
- Abe Lemons

Over the past few years, I've read many personal stories about early retirement. Unfortunately, in most cases the story details didn't resonate very much with me. Sometimes the person in question retired after a supreme event of good fortune, such as receiving a large inheritance or cashing out of a hugely successful stock option grant at one's place of employment. In other cases, it appears that a career change was redefined as "early retirement". (e.g. "I accumulated almost $100,000 and then retired early. Soon after that, I was bored so I started earning money in a different line of work six days a week, and now with that extra income, I'm really enjoying early retirement more than ever." Huh?)

Other articles describe an "extreme" lifestyle where someone lives on $7,000 a year or some similar number. Still other articles feature someone who does not have a plan but merely "hopes to retire early". And then there are the occasional self-serving articles where the person in question "retired early" by writing a book about how to retire early.

All these articles had some entertainment value for me, but they didn't resonate with me because I could not imagine myself in a similar situation or relate to them in any meaningful way. However, a recent Money magazine article about a military family who retired early really struck a chord with me.

On the surface, the family in the article seems much different than my family. They live in the midwest. We live in the Northeast Corridor. They worked in the military. We have always been civilians. Their primary source of retirement income will be their combined pensions. Our primary source of income retirement income will be stock dividends. They will have lifetime medical benefits provided by the government. We will need to pay for medical expenses. On the other hand, it appears they are starting retirement with many years on their mortgage, while we will probably be mortgage free when we start retirement. We also have a sizable sum earmarked for our kids for college, while this is still a big concern for them. Additionally, we don't share the same family backgrounds, the same occupations, or even the same hobbies.

Yet a closer examination reveals a whole host of financial and lifestyle similarities between our two families:

• Early retirement was a conscious, but evolving, plan over 15-20 years.


• The success of the plan mainly depended upon consistent execution.


• Frugality was important, but was never taken to extreme levels. Consistency in all areas for long periods of time was more important than a few spectacular penny-pinching maneuvers.


• They adhered to a budget for long periods of time.


• Their spending level is in the general ballpark of what we are planning.


• Interestingly enough, upon discussing the possibility of early retirement with friends, we have also experienced the same two negative reactions from many people: (1) You're going to be bored. (2) You're being quite irresponsible.


• Career success was a reasonably large factor, but their strategy did not require an extensive climb up the ladder.


• They saved about 35% of their income at first, and even more as retirement approached.


• They invested mainly in equities.


• They felt like quitting many times, but ultimately persevered.

In addition to a modest $400K in savings, they can also draw about $60K / year from their military pensions, which are adjusted up for inflation each year. While a pension seems intangible to many people, a pension is just an annuity stream and one can easily calculate its value. Using publicly available annuity quotes from Vanguard, I attempted to put a value on their military pensions. Here are the results:

• Male; Age 44.5; Missouri resident
  
• Annuity income = $36,900


• Paid monthly ($3,075/month)


• Adjusted for inflation (yearly to CPI)


• Value of annuity:
  
• $955,982 (Single Life)
• $1,044,396 (Joint / 50% survivor benefit)
• $1,132,810 (Joint / 100% survivor benefit)



• Female; Age 40.5; Missouri resident
  
• Annuity income = $36,900


• Paid monthly ($1,800/month)


• Adjusted for inflation (yearly to CPI)


• Value of annuity:
  
• $629,494 (Single Life)
• $646,343 (Joint / 50% survivor benefit)
• $663,193 (Joint / 100% survivor benefit)
  

Depending on the survivor benefits chosen, the total value of both annuity streams is worth somewhere between $1.6 to $1.8 million. Again, just as our projected spending level is similar to theirs, our projected necessary wealth accumulation is (perhaps unsurprisingly) also in the same ballpark.

Congratulations to the Nielsens. If all goes well, we hope to be joining them in about 5 years.

Net Worth Update 2007

"Your net worth to the world is usually determined by what remains after your bad habits are subtracted from your good ones."

- Benjamin Franklin

I've calculated our net worth at the end of 2007 and appended it to the previous ten years of data I posted last year. I was perhaps hoping for a bit more progress last year, but I'm nonetheless satisfied with the results.

You may also wonder why I only update our net worth statistics once a year, as I've noticed a number of personal finance blog authors provide monthly or even weekly updates. In our case, we have a portfolio consisting primarily of equities, and the total portfolio dollar amount size has grown to dwarf even our yearly savings. Thus, I'm afraid that a monthly net worth update would merely be a reflection of monthly market fluctuations, which I don't think is a useful thing to calculate and post.

Year	Net Worth At Year End
1997	$80,641
1998	$134,135
1999	$224,502
2000	$300,710
2001	$337,281
2002	$401,199
2003	$477,903
2004	$549,144
2005	$684,813
2006	$864,380
2007	$950,346

TIPS Rates Too Low

"I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime."

- Jim Rogers

In June of 2007, I posted an article describing why TIPS rates were very attractive at the time. How things change in seven months! Back then we had a rate of about 2.7% to 2.8% (plus inflation) across almost the entire yield curve. Now the entire curve is well below 2% and the short end is below 1%.

The total return on 10-year TIPS has been about 11% or 12% since last June. To me, this figure represents the excess over typical bond returns that I originally hoped to achieve over several years by entering at an attractive price. Looking to exit here...

Most Viewed Posts Of 2007

"Popularity, next to virtue and wisdom, ought to be aimed at..."
- John Adams

According to Google Analytics, the following are the most viewed pages for this site during 2007. Thank you for reading!

1. Retire At 45 [main page] (7,085 views)


2. Financial Autopilot (5,422 views)


3. Early Retirement and Social Security (590 views)


4. Roth IRA Conversions as a Tax Timing Tool (275 views)


5. Why I Won't Need 80% (218 views)


6. My Mutual Fund Holdings (207 views)


7. The Record Thus Far (149 views)


8. Mental Accounting Errors (144 views)


9. Detailed Social Security Calculations (119 views)


10. Reframing The Question (95 views)