Many people find budgeting tedious and boring. That’s not to say it isn’t important. The worst thing you could do is stick your head in the sand when it comes to your spending habits and hope for the best. But I believe there’s a simpler and more effective method to ensure you are saving enough to meet your financial goals while enjoying the rest of your money, guilt-free.
Traditional budgeting involves tracking all your expenses and reviewing them regularly against spending targets that you’ve set – and saving the rest. But what if we flipped this around? What if we first figured out how much we need to save and invest to reach our goals, and could worry less about how we spend the rest?
It’s called reverse budgeting, and it’s remarkably effective.
First, you determine the goals you want to meet, and when. Are you saving for retirement, a child’s education, a vacation, or a new car? Map out your goals, when you hope to achieve them, and how much they will cost.
Next, work backward to figure out how much you need to save to meet your goals on time. This part is a bit trickier and will require some number crunching on your part. You’ll need to consider your capacity to save, inflation, your tax rate, and an expected rate of return on your portfolio. There are many online calculators that can help you with this, such as this handy tool from Fidelity.
Shorter-term goals, such as buying a car in a few years or planning for a vacation, are easier to calculate. Longer-term goals – such as funding your retirement – are more complex because the impact of inflation and taxes over a long time can be significant. You can use a common rule of thumb here as a starting point: the “25x” rule states that your portfolio at retirement should be 25 times the income you want in retirement, adjusted for inflation.
For example, if you think you’ll need $60,000 a year, you should aim for a portfolio of $1,500,000. Using the calculator above, you can vary the inflation rate to see how it affects your goals and savings strategy. And while this is no substitute for a professionally designed financial plan, it’s helpful as a starting point.
Once you’ve figured out how much you need to save, set up an automated savings plan that makes regular contributions to your investment accounts, timed with your paycheque. This not only simplifies the strategy but also helps you avoid the temptation of spending money that should be saved for your future self.
Lastly, spend the rest! You’ve already taken care of the most important bill, which is paying yourself first.
While going through this exercise, keep in mind that there are several variables that will affect your outcome, most of which are unknowable in advance. Things such as the inflation rate, your future tax brackets, the return on your portfolio, and other sources of income, such as CPP and private pensions, will all be important factors in your long-term financial plan.
For reverse budgeting to be effective, your income needs to at least exceed your fixed expenses such as rent, food, clothing, and utilities. If it doesn’t, then focus on traditional budgeting to get a handle on your expenses. And if the amount you need to save feels unreasonable, start small. Part of the benefit of this strategy is getting into the habit of automating your savings.
Monitor your plan and adjust it to life’s inevitable changes – the birth of a child, a change in your income, or a change in your goals. Over time, look for opportunities to increase your savings rate. If you get a pay raise, ensure you don’t fall victim to “lifestyle creep” – take a portion or all of your raise and increase your savings rate instead.
While you may still want to audit your spending occasionally to make sure you aren’t going overboard in some categories, if you follow the reverse budgeting strategy properly, you will be well on your way to achieving your goals.
Mark McGrath is a Squamish, B.C.-based certified financial planner and associate portfolio manager with PWL Capital Inc.