Daily, financial planners answer their clients’ heart-wrenching question: “Am I on track?”
The answer requires quantitative data that is accurate and up to date, complex probabilistic analysis, and realistic predictions on client behavior that is likely to support or derail the plan. In the absence of information, as many often experience, a skilled planner may “magically” populate what’s missing, or pinpoint the precise data needed before a wise decision can be reached.
Obviously, spending is a key input to a financial plan due to its current and long-term impacts. Current spending illuminates savings capacity leading up to retirement and provides the baseline for future retirement distributions. The consistent, predictable behavior that falls out of current spending and saving creates the foundation of the financial plan.
Yet, spending is often the figure that is most difficult to obtain with accuracy. Very few set and track according to a budget, and many have an estimate of expenses that is out of line with reality.
So how do planners determine the appropriate spending figure and savings capacity, whether to validate information provided or populate what is missing?
Below is a cash flow framework that can be used to extrapolate client spending. This “magic trick” impactfully allows planners to illustrate their knowledge of complex cash flow dynamics and reassure the client that we often know them better than they know themselves.
Underlying assumptions that may need to be adjusted based at the planner’s direction:
• Spending is client-specific, but can be broken down into two categories for planning purposes:
Baseline spending includes basic living expenses that recur yearly – food, household, entertainment, etc. This excludes savings and irregular expenses.
This must be monitored and requires a planner to know the client well. A pattern of irregular expenses means that it should probably be included in regular spending.
Irregular “lumpy” spending is layered on top of baseline spending because these do not occur every year, will not continue for life, or are aspirational goals to work towards. This may include travel, charitable giving, tuition, weddings, etc.
• Taxes are implemented at the discretion of the planner, specifically due to the various scenarios and complexities of each client’s situation. Income taxes are excluded from baseline spending for these purposes.
Cash Flow Framework:
1. Start with take home pay. A client spends the money that is deposited in their bank account from their employer.
2. Determine the change in bank account balances. Have these increased or decreased over the selected time period?
Ending bank account balance
- Beginning bank account balance
= Net change
3. Were there any significant additions or withdrawals that could distort baseline spending?
Take home pay
+/- Bank account balance decrease/increase
- Savings into other accounts that are not deducted from payroll
+ Irregular deposits: bonus, tax refund, additional income sources, gifts, etc.
- Irregular withdrawals: taxes due, debt payoff, large purchases (car, house, etc.)
= Baseline spending
4. Adjust for the appropriate time period.
If the time period is 12 months, the base spending figure is annual. If it’s longer or shorter, divide by the appropriate number of months and multiply by 12 to determine annual.
5. Determine the impact on the financial plan.
a. Saving – are realistic savings goals set?
b. Spending – is future spending appropriate? Is there a tendency towards wealth creep? Where does income/career growth need to be to support this lifestyle?
Consider the following examples
1. Start simple. A client’s bank account balance is $10K higher than one year ago. Income less withholding, deductions and retirement plan contributions is $100K. No extraordinary withdrawals or deposits:
Baseline spending = $90K
Additional savings capacity = $10K
2. It’s the first annual review with a young married couple, eager to make a strong start in their careers and a disciplined commitment to savings. Take home pay (after tax withholding, deductions, retirement plan contributions) is $400K annually. Target savings into their taxable investment account was set at $50K:
Bonus income was $100K
Bank account balances increased by $85K
High-interest car loan paid off for $30K
Tax bill for $5K
Baseline spending (total income less irregular expenses) = $400K+ $100K - $85K - $30K - $5K = $380K
This year’s savings capacity (bank account balance increase plus irregular expenses) = $85K + $30K + $5K = $120K
This year, they achieved the goal of $50K savings, but that was only possible by bonus income. If the savings goal was set in consideration of some bonus income, they are potentially on track. But if this income event is irregular, savings should be revisited, and long-term spending should be as well.
3. A client is nearing retirement, and there is concern about wealth creep given their recent job promotion and pay increase. Baseline retirement spending target has been modeled at $180K historically:
Bank account balances are unchanged over the past 13 months
Take home pay is $200K
Last year’s bonus was $100K
Home remodel expenses were $50K
Estimated tax payments totaled $10K
Taxable savings for $25K
Total Spending (income less irregular expenses and savings) = $200K + $100K - $50K - $10K - $25K = $215K
Monthly Spending = $215K/13 = $16.5K
Annualized Spending = $198K
Bank account balances are unchanged, so all deposits were directed towards spending and savings. While savings continued, baseline spending increased with the income jump. This could have been a one-off year where the client chose to celebrate career success, but it is a cautionary sign to address and monitor as retirement nears.
Emma is a Wealth Planner at Cadent Capital in Dallas, Texas, where she oversees new client onboarding and is a key associate for many of the firm’s top clients.
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