This is Part I in what will hopefully be a multi-part series on how start-up workers should best manage their financial planning. For more about me and caveats, see the intro. I obviously don’t know you (or maybe I do, but still…), so please think critically about your personal situation before making decisions with your money.
Step 1: Write down your goals
The cornerstones of all financial planning are your goals. Why, exactly, are you saving money?
For most of us, our goals follow the same general pattern. But small differences in what we want can make for wildly divergent steps that we need to take.
So before anything else, you need to think about what you are trying to accomplish. Write down your goals in roughly the order of importance to you. And by ‘goals’ I mean ‘anything that you have to save for’.
Here are mine:
1. I want to support myself and hopefully, a wife, through my retirement and not require resources from my family or the government
2. I want to be financially prepared for a situation where I do not earn an income for two years
3. I want to be able to support my immediate family if someone needs financial help
4. I want to be able to pay for my (potential) children to go to college wherever they want
Those are my goals. Yours may be different: they may involve starting a company, traveling around the world, leaving money to your alma mater, swimming in a giant pool of money, whatever. One thing that most people would as a goal is a down payment on a house: I’m not so interested in that myself though if I change my mind about the relative value of owning a house I may reconsider.
Once you have written down your goals, you want to estimate what each of those things will cost, in today’s dollars. This is fairly straightforward*: do it in two parts. First, everything other than retirement: these are modified from my actual numbers to be closer to averages for my age, and what college costs. Do this for yourself:
I’m pretty conservative here, especially with the college assumption, but in general I want to have about $630k to pay for these things (in today’s dollars). That looks like a gigantic number, but over a 20 year horizon, with two incomes and hopefully some investment gains, that’s not too crazy to hope for: if I have any luck at all investing, if we each sock away about $10,000 per year we’ll be in great shape.
The big issue, obviously, is retirement. How long will your retirement be and how much money will you spend? Standard estimates are 30 years and 75% of your income.
I’m not prepared to get into a really in-depth discussion of retirement, since it is so complex and certain issues (like: what will social security look like in 20 years?) are important and almost impossible to know. Investment lore is that you can spend 4-5% of your savings every year and it will last for 30 years in any market. Put another way, you should have 20-25x your annual expenses saved up. So if I think I could happily retire with $50,000 of annual expenses (for two of us, hopefully), I would want $1-$1.25 million (in today’s dollars, again) in my savings.
At least one Nobel Prize winner thinks the 4% rule isn’t great, and historical returns indicate that 4% is maybe being overly safe. As a simple rule, however, I think it is pretty reasonable**.
Regardless, a lot of this is very ‘big-picture’ and probably doesn’t help with your immediate decisions about: where should I invest? That will be in the next part of this series.
*Total lie- this is not straight-forward at all. A financial planner would consider the expected inflation, expected return, and time-value of money in these calculations. Of course, the planner doesn’t actually know what the inflation and expected return will look like. The additional complexity of their models, in my opinion, is not especially valuable at this stage of planning, so don’t sweat it.
**For finance nerds: I know there is a lot of math that can be done around optimizing savings, concerning relative returns and portfolios construction and how they relate to Roy’s Criterion or other decision models. My experience is that additional math here just turns into an argument about assumptions and isn’t very useful, though often fun to discuss.
