Everyone likes a quick simplification of something that otherwise requires a lot of thinking. A “rule of thumb”.
When it comes to planning what to do with your money, odd are that you’ve likely heard some recommendations floating around in articles, podcasts, videos, and the occasional blog post. Some of these recommendations are:
- Save at least 10% of your income
- Invest 15% of your income for retirement
- Pay yourself first
- 50/30/20 rule (Spend 50% on needs, spend 30% on wants, and save 20%)
- Track your spending
- Don’t buy fancy coffee
- Automate your savings
- Wait 7 days before buying anything
- Follow a budget
- Have an emergency fund
- Don’t have an emergency fund, use credit cards or a HELOC
- And plenty more
Turns out we need a rule of thumb to cut through the rules of thumb.
One of the more popular rules is the 50/30/20 budget. I want to destroy the rule. Here’s why.
Despite what I assume were good intentions when someone devised the 50/30/20 rule and the likely good intentions of everyone since then who have repeated it, I sincerely doubt it’s efficacy in the real world. In reality, saving 20% of your take home pay to cover everything from a rainy day or big purchase to retirement investments is not enough.
More importantly, justifying the expenditure of 30% of your pay on “wants” because it fits in an easily repeatable saying like 50/30/20 is in my opinion only serving to enable wasting money. Somehow many of the big voices in media only suggest investing 15% of our income. At that rate of saving, you would need to continue for 51 years before you could retire and have enough invested to cover your costs of living! 51 years! Reference this article by the infamous Mr. Money Moustache to see the math behind this claim:
Even if you started diligently following that advice at age 20, that means you have a 51 year career ahead of you! Better not relax and take your foot off the gas! Plan a wonderful 71st birthday party because that’s how old you will be when you can finally retire! MADNESS. I don’t know what your hopes and dreams are around working and retirement, but even a foggy and ill-defined view into my future doesn’t show a 71 year old Brendan hard at work at the same full time job!
Even if you somehow had enough cash savings to allocate all of the recommended 20% of the 50/30/20 rule directly to investments, it would STILL take 37 years to replace your average spending with investment income! This is believed to be “not bad” considering most people start working in their early 20’s and the retirement age is people’s early 60’s. But why is retirement age all the way into our 60’s? Because the government sets those dates for penalty-free withdrawals from our tax-advantaged retirement accounts? Or because it’s impossible to do otherwise? To be honest I have no idea. It feels like surrender to just accept 4 decades of work to one day have hope of achieving “work optional” status. This is something we need to force to change at a grassroots level.
My baseline proposal is to flip the 50/30/20 rule around and recommend spending 50% of income on needs, 20% or less on wants, and 30+% to save and invest.
My baseline proposal is to flip the 50/30/20 rule around and recommend spending 50% of income on needs, 20% or less on wants, and 30+% to save and invest. To regularly save cash for future purchases or to replenish an emergency fund that’s been tapped, we have to create a margin. 5-10% of income going to cash savings is likely needed to save for that next car, that home renovation project, that vacation, or a similar expense. These kinds of things are foreseeable, predictable, and are therefore “save-for-able”. Having the cash to pay for these kinds of things keeps us out of debt and in the long run easily saves tens of thousands of dollars. The fact that a large purchase is always around the corner means that we should perpetually be saving cash for these kinds of events. You can either make payments to yourself interest free or you can make payments to a lender and get absolutely destroyed by interest. I choose the former.
The common practice of taking out a home equity line of credit or second mortgage to pay for a big project or other expense seems especially appealing in 2020 because interest rates for this kind of loan are at record low levels. I am with you in feeling this temptation. I even called our mortgage broker to discuss refinancing to take advantage of these incredibly low rates. But the response I got back was basically, “Your rate is already so low and your mortgage balance is also so low, that I won’t write the loan and the banks likely won’t be interested in it.” Translation: we can’t make enough money off of you so we’ll move on to someone else who WILL make us a lot of money. (No hard feelings on the broker, the guy has to eat.) This is somehow a compliment and a rejection at the same time. Because we took out a 15-year mortgage 4 years and 1 month ago, we’ve aggressively paid down the principle on the loan. That’s just the way a 15 year mortgage works. In the same 4 year period we would have paid off far less of the loan balance and far more toward interest (i.e. making the banks richer) had we opted for the far more common 30 year mortgage. Anyway, all that to say, the only way the banks would be interested in allowing us to refinance would be if we did a massive 6-figure cash-out refinance to do something like fund a home renovation project. As a result they would make many thousands of dollars on us, just because we wanted it now and would not wait and do the same work over a period of years.
The other extraordinarily common way to get what we want RIGHT NOW is just to put it on a credit card. It’s truly amazing how common this is and how common it is for people to carry a balance on their credit cards. The average American carries $5,700 in credit card debt. The average interest rate on credit cards in America is about 17%. If someone with this “average” situation pays $150 per month on their credit card, it would take them 55 months to pay off the balance! Almost 5 years! That would also mean they paid an extra $2,541 in interest! That’s 44.6% more than that stuff should have cost! Those $200 earbuds? They actually cost $289. That $1100 phone? It actually cost $1590! And this is all assuming the credit card spending stopped and no additional charges were made! Most of us keep using the cards for the next emergency or the next impulse buy! The amount of money that credit card companies profit from our lack of saving and impulse control is truly staggering and depressing. Let’s just say it’s in the hundreds of billions of dollars. (In 2016 it was about $163 billion and odds are that number has only risen).
Especially if someone is already in debt using some of these methods (which aren’t even the worst or most predatory kinds of debt available), allocating at least 5-10% of all income to save and/or use for debt repayment is crucial. In fact, as part of the new 50/30/20 rule I’m proposing here, I think if someone has high interest debt, which I would classify as anything above 6%, the vast majority of that 30% number allocated toward saving and investing should be spent on debt repayment. If you are losing money at a high rate, you won’t dig yourself out of the hole by investing and hoping to earn it back at an even higher rate. Paying off that credit card balance that’s costing/losing you 20% interest is triage. Stop the bleeding! Until then, postpone investing and get the wounds stopped.
Paying off that credit card balance that’s costing/losing you 20% interest is triage.
After paying off that high interest debt, let’s say you’re saving that 30% total, with 5-10% of that going into a high yield savings account or CD ladder. You’re preparing for future expenses both expected and unexpected! Bazinga! You will avoid the debt woes mentioned above and will have ample cash saved. I agree with recommendations to have about 6 months of living expenses in cash, more if you have greater volatility in income levels or spending levels. I.e. you are paid on commission alone and have variable medical expenses etc… Or even if you just want to be prepared for anything and not have to think about going back into debt, having a larger cash emergency fund available is great.
The traditional 50/30/20 budget is oriented much more toward immediate satisfaction than my proposed swap. Planning to spend 80% of your money makes sense in the moment because there are SO many things to buy and so little money to buy them. I think it also serves to make people feel better about “only” saving and/or investing 20% when they could actually do considerably more if they set their mind to it. For higher earners or people with simpler lifestyles, it’s a relatively low bar. In my suggested 50/20/30 budget, spending 70% (or less) and saving or investing the other 30+% positions a persons finances with a hugely increased level of security and future hope.
The remaining 20-25% of that 30% total left after saving in cash should be allocated to investing. The reality is that many people are forced into involuntary retirement through job changes or medical challenges. Perhaps your company closes and you aren’t able to find a similar job in another company. Maybe you’re injured and can’t perform the physical duties your job called for. There are any number of ways this happens. Sometimes it’s not even something that happens to you specifically, but a choice you feel is right. Taking care of someone close to you make become a higher priority than work. Being financially secure could allow you to stop working or cut down the amount of work greatly to care for them. Only investing a small amount now does not allow those transitions to happen with any degree of smoothness.
But the fact is that over 47% of Americans aren’t investing at all, let alone to the degree recommended above. And less than 20% of Americans are saving for retirement specifically in 401k or IRA accounts. Since the 401k and IRA are tax-advantaged accounts and are the most popular ways to save for retirement, we can postulate that the vast majority of people simply aren’t prioritizing their retirement.
But the fact is that over 47% of Americans aren’t investing at all, let alone to the degree recommended above.
Looking at this issue objectively, I completely understand why this is the case. The realities of today and the next month are pressing. Retirement happening someday feels like an eternity away. It is both distant and vague. We know what we need this week to pay bills, buy a new fun thing, or eat at our favorite restaurant. We don’t know exactly what we need or even when we will need it in terms of retirement savings. Human nature is to focus more on the immediate payoff, so we do. And this is one of the main reasons (in my opinion) why we are in dire circumstances when it comes to most people’s personal finance situation and especially in the case of retirement savings.
Part of my motivation to both do this and encourage other people to do this is the potential for something to happen between now and “retirement age” that knocks us off our feet. I’ve known people personally and read numerous stories online about otherwise healthy, active, relatively young people being struck down with cancer, covid, accidents, or other unexpected events. These are catastrophic financially because not only is that person not working, but their partner is likely working less or not at all to take care of them and to top it all off, they are racking up obscene medical bills along the way! This is not a commentary on the American healthcare system, but we all know how crazy expensive these bills can be. No one has died, and in fact the expectation is for a slow but full recovery. Let’s look at a hypothetical example:
Let’s say you’ve been working on this flipped 50/20/30 plan for 10 years. You started at age 35 and now you’re 45. You have paid off your debt with the exception of your mortgage and have 7 months of living expenses saved in cash as an emergency fund. You also have $5,500 saved for a home repair you expect to happen in the next year. Solid work! Not only that, but you’ve been investing 25% of your income every year for the last 10 years and the occasional small pay raise at work has helped create quite a nice nest egg between your tax advantaged retirement accounts and a taxable brokerage account you opened on the side. The retirement accounts have about $125,000 in them total and the taxable brokerage account has about $20,000. Out of nowhere, you feel a tightness in your chest on the way to work. You make it there but walk inside only to feel worse. You call 911 and are taken to the hospital when you find out you’ve had a very mild heart attack. The doctors recommend spending 3 nights in the hospital for monitoring and tests then taking at least a month off work. During the second night, you have more chest pain and have yet another heart attack! The doctors rush you to surgery and implant a stint. You end up spending a total of 4 nights in the hospital.
After that you’ll likely need regular checkups and daily medication to mitigate future problems. As a result you end up missing over a month of work, have $11,300 in medical bills, and now pay $267 per month for the prescription medication. Your old financial self would have been crushed by this. Missing over a month of income alone would have pushed you to visit the dealer of debt known as “credit card”, let alone the huge medical bills and increased living expense of the medications. You would have been paying off the balance of the new debts for years. Instead, you dip into your emergency fund to pay bills while you are away from work. It’s annoying but not a stress-inducing exercise. Then you negotiate a bit with the medical billing people and find out that not only can they reduce the cost of the bills by $1100 down to $10,200, but they can also break up the cost into an interest free 6 month payment plan for you. Nice. You use the cash in your emergency fund and the $5,500 earmarked for home repairs to fairly easily pay off the entire balance in the 6 months. You end up with 2.5 months of living expenses remaining in cash in your high yield savings account and begin to quickly replenish it now that the bills are paid. Your credit card remains at a $0 balance since it wasn’t needed. Before long, you’ve gotten the cash savings back up to the previous levels and didn’t even need to touch the money you had invested, but knew if you needed to you could pull the $20k out of the taxable account at a moments notice. The biggest difference throughout the whole scenario was your lack of stress brought on by the financial burden of this. You had a plan and were not very burdened at all. This left you with more mental and emotional bandwidth to focus on your physical health and recovery. Quite the win-win!
This is the kind of real life in-between scenario that I expect to happen to many if not most of us. The point of saving and investing far more than is common isn’t to “get rich” or even to have a plush retirement. Despite current popularity in early retirement, I would argue it’s not even about that! (Though the potential of work becoming optional before all of my hair turns grey does sound pretty awesome.) It’s about the peace of mind all along the way. Getting away from the regular stress of debt and cash shortages along with a total lack of preparation for the future is priceless. It frees us up to spend more of our limited time and attention on the people around us. It prevents big nasty financial catastrophes when unexpected costly events unfold. It prepares the generation after us to change the “norm” to something much better. Our kids watch us, including what stresses us out and what causes fights. Let’s pave a new road toward financial security and health for ourselves and for them!
Abacus Fitness and Money 