Balancing ≠ Budgeting ≠ Anticipating Cash Flow with a Sinking Fund(s)
You must control spending in retirement. A sinking fund (or funds) is our secret sauce to a budget that works by managing cash flow.
If you haven’t figured out how to live within your means and manage a budget during your working life, it is essential in retirement. It’s not so easy to solve shortfalls with the, “I’ll just have to make more money,” excuse. In retirement, expenses are more variable than income. It’s hard to increase your income after retirement because so many things are beyond your control. You may want to work forever, but bosses and health may intervene. Even professionals often find that post-retirement pay scales or consulting don’t pay as well as they enjoyed in peak earning years.
For more on the challenge of earning income in retirement see our review of Dr. Teresa Ghilarducci’s book, How to Retire with Enough Money: And How to Know What Enough Is. Ghilarducci warns that 65 is the new 16 when it comes to available pay. It’s too often like starting all over again at the bottom of the ladder, regardless of your prior experience and despite age discrimination laws.
So, that leaves budgeting as an essential retirement skill. Here’s what finally worked for us.
Balancing the checkbook is necessary but not sufficient
Okay, confession time. For a person with smart credentials, I haven’t always been practically smart with money despite Granddad’s best advice. My spouse is better. Much better. We struggled to find a system that worked for both of us. The royal Us. That means me.
Looking backward just didn’t work for me. I can’t tell you how much time I wasted getting last month’s checkbook to balance to figure out where the money went.
It turns out balancing the checkbook isn’t enough. A checkbook balance is just the current snapshot in time of your available cash. It doesn’t tell you if you’ve got enough to cover your future expenses. Nor does it force you to answer, “Where do I want to spend my money?”
You must still reconcile your account especially given the prevalence of fraud and identity theft. But balancing the checkbook is not an effective control point for your own spending. It’s too late. The money is already spent.
Budgeting, looking backward at last month’s spending, doesn’t work
I tried traditional budgeting techniques. How much does it all add up to? In a month or a year? The month matched the regularity of bank statements. The year matched satisfying the IRS with tax filings. Can’t say that budgeting by looking backward at the last month ever worked well for me either. Why? I was still treating it as a snapshot in time in the rearview mirror. It was more about what I spent last month than what I was going to spend the next month. And it still didn’t answer that question, “Where do I want to spend my money?” A backward looking budget wasn’t enough.
Planning where the money is supposed to go is different than figuring out where it went.
The basics of budgeting, Dave Ramsey’s “Baby Steps”
Now we’ve done some things right to build a nest-egg for retirement. We tended to pay ourselves first for savings and investment so at least that was in order. But the monthly budget always felt a bit of mystery or even out of our control with emergencies or “unexpected expenses.”
We took Dave Ramsey’s Financial Peace University class. http://www.daveramsey.com/fpu Highly recommended. Ramsey is pretty, “Keep it simple, Stupid” (the KISS Principle), because, as he confesses, he’s paid the “stupid tax” before. That’s how he learned the hard way. Dave’s baby steps helped a lot. Having an emergency fund reduced the frequency of emergencies. Turns out most unexpected expenses weren’t that hard to anticipate if you turned around and looked forward. Next month’s expenses are not necessarily the same as last month’s spending. For most “surprises,” they are now at worst a one-time surprise. Fool me once. We no longer make the same mistake twice.
Ramsey emphasizes answering where you want your dollars to align with your priorities. Giving every dollar a name and assignment makes spending more conscious. This also includes planned savings.
It’s also when, not just how much — Cash flow
But it still wasn’t perfect. The step that really made the budget effective was understanding, it’s not just how much but also when income and expenses hit each month. It’s cash flow that counts not just the beginning and ending balance.
And managing cash flow requires anticipating expenses and reserving cash in advance of anticipated expenses. You can’t spend the same cash twice. Holding cash in the checkbook register doesn’t mean it’s available for just anything. A lot of it is already spoken for if you plan ahead each month.
Great software tools for forward-looking cash flow based budgeting
Since we started using YNAB, Dave Ramsey offers a conceptually similar online budgeting tool, Every Dollar. http://www.daveramsey.com/everydollar/ Similarly, YNAB has itself gone with a cloud-based app versus the old desktop model. (We’ve stayed with the desktop because it works for us and it was already paid for.) Both are well reviewed and follow the principle of giving every dollar of income a job. YNAB makes it easy to think of future expenses by categories and create sinking funds that carry over unused balances month-to-month until a payment is due.
Sinking Funds – Save in advance for anticipated expenses past the current month
The secret sauce for us was creating sacrosanct sinking funds within the budget for known, anticipated expenses that recurred annually or semi-annually or otherwise less frequently than the paycheck. A sinking fund is like a dedicated reserve fund for a particular expense. Rather than financing big expenses like a new car and paying someone else interest, you can save up in advance of the anticipated expense and earn interest. (Sinking Fund is derived from the financial markets, where bond issuers create a sinking fund to assure payment to bond holders of interest due on specific future dates.)
This isn’t necessarily a separate bank account (though it can be and is for some of our categories). It is a category within YNAB we don’t touch for any other purpose. It means our checking account tends to have a good cushion. Our bank rewards us with better interest and terms for the higher average balance. Overdrafts are a thing of the past.
YNAB’s unique value is in guiding you to build up that buffer, breaking the living paycheck-to-paycheck cycle.
We also use SmartyPig to save for longer-term savings like our Christmas fund, our vacation/travel fund, and our new used car fund. www.SmartyPig.com. SmartyPig is great for setting savings goals and has a better return than most commercial checking accounts. CapitalOne 360 Savings has similar tools to divide the account into smaller goals for specific purposes. www.CapitalOne.com We use our CapitalOne 360 Money Market account for our emergency fund and separate out the savings funds into SmartyPig. We don’t make it easy to get to some of these designated funds. They are reserved for long-term goals.
In any case, there are tools out there to help you plan and look ahead.
Sinking Fund Example – Auto insurance annual premium
With the internal sinking fund for auto insurance, we pre-fund the annual payment due every November. Rather than a shock expense in November, we’ve already saved a twelfth every single month leading up to November. We know what the annual premium for our automobile insurance is – $980. Divide $980 by 12 = 980/12= $81.67. Every month we budget $81.67 for auto insurance, even though we only pay the premium annually. We also earn a discount from our insurance carrier with an annual premium over paying monthly or quarterly. Auto insurance is a fixed expense. Shifting dollars around wouldn’t reduce what we must eventually spend on insurance. Therefore, these dollars are untouchable for any other purpose.
Fixed Expenses vs. Variable Expenses
We do the same for other fixed expenses like tithing (charity), life insurance, health insurance, real estate taxes, and more.
We do have some variable expense categories that may vary month-to-month or which we may shift within the month. For instance, if we increase the restaurant budget for a month, the increase is balanced by the grocery or personal spending categories. Variable transportation expenses are perhaps the biggest headache. We have two cars and miles driven and repairs/maintenance can vary considerably month-to-month. We use the past (trailing) annual average to set monthly allowances for fuel and oil changes, for regularly scheduled maintenance, and for repairs. These accumulate in sinking fund fashion again to assure we have cash available when tires need replacement. But we can and do shift dollars around within the transportation category.
Problem Areas – You need some flexibility month-to-month
We live in a rural area where transportation is a major expense. Nothing is close. We’re debating whether we could get by with a single car. We certainly plan to in retirement. But for now, we have enough days where we each need to travel for work or family obligations that two cars make sense and we’ve got mid-size to full-size vehicles, at least partly for safety in the Snowbelt. Every place you choose to live has some tradeoff like that.
Your problem area may vary from ours, but the difference between anticipated fixed expenses and month-to-month variable expenses will help you figure out where you have slack in your short-term budget and where you can’t steal from the future.
A forward-looking cash flow budget that gives every dollar a job is the solution to monthly financial emergencies. Use a sinking fund to set aside cash for each future known expense. Sinking funds in your budget are tools you must use in retirement even if you managed without planning ahead earlier in life. It’s a tool you might need to refine in retirement, even if your budget operated with machine precision in your working life. Retirement is such a major change. It will change your budgeting. Anticipate expenses. Plan for them. Get out of debt. Pay yourself interest, not the bank. It’s amazing how few emergencies or surprises we have now compared to previously. Finances won’t be a personal or relationship stressor. And you will feel more in control. Make your money work for you. Don’t let financial disorder run your life or your retirement.