Some may say that if you have 6 month’s worth of expenses in a bank account, you are safe. Financially assured. Possessing a buffer capable of absorbing all but the severest of emergencies.
Maybe even true.
Some may say that if you have accumulated and invested 25 times your annual expenditure, you are done. Financially Independent. Have won the game. Need no longer be motivated by money.
Maybe even true.
Yet few may say that the difference between weathering a financial storm and never worrying about money again is a simple factor of 50.
Maybe even true.
These bite-sized morsels of fortune cookie wisdom and t-shirt slogan financial planning are based upon assumptions.
It is an inconvenient truth that limitations such as these are true of all projections and plans. No matter how slick the presentation. Nor how expensive the advisor making them.
This raises some interesting questions about the assumptions those rules of thumb are built upon.
What if today to never ends?
Which year should form the expenditure baseline for those rules of thumb?
The most recent year?
For many of us, that covid disrupted lap of the sun was the most unusual in living memory. Wings clipped. Social lives curtailed. Dry cleaners and season tickets substituted for t-shirts and sweatpants. Overpriced gym memberships and store-bought sandwiches replaced by jogging and home-cooked meals.
We spent less.
We saved more.
Far from being representative of normal.
How about an average calculated over several recent years? Plausible. Smoothing out one-off shocks and distractions. Sensible for those comfortably settled into the boring “middle” part of our financial journeys. Less so for those nearer the beginning or the end.
Imagine basing your sums on the lifestyle you led as a broke student. Living in a group house. Subsisting on a diet of beer and ramen. Fun at the time, but a phase of life that most of us soon outgrow.
Predicating all your plans on the premise that lifestyle costs would never exceed those experienced when you were young, certain, and immortal. Nothing to lose. Not knowing any better.
Now imagine locking those assumptions in. Reaching that mythical 25x accessible liquid net worth figure, then hitting eject on the daily grind and its endless pursuit of “more”.
From a planning perspective, the assumption that spending shouldn’t exceed an annual expenditure amount becomes a cold hard reality. Baked in. By design.
To be sustainable, the naïve happy path where everything is awesome and nothing unpredictable occurs becomes the only viable path. Any divergence or random life happens event would invalidate the premise upon which those plans were based.
Forcing adaption. Change. Evolution.
Reprioritising and tightening belts, if possible.
Returning to the workforce, if not.
A fragile existence, made so by the mistaken belief that today will always represent your everyday.
Which raises a troubling question: at what point in our lives could a year ever be considered “normal”?
When is life ever normal?
There are numerous transient phases of our lives. Where our expenditure then would not provide a representative long term baseline of “normal”.
A person living alone incurs a higher cost burden than when that same person cohabitates with another. Economies of scale. In the context of a whole lifetime, which would be “normal”?
A couple without dependent children have a vastly different spending profile to that same couple should they become parents. Equally true for young couples just starting out as it is for empty nesters. In the context of planning for a financial lifetime, which would be “normal”? The ~20 years with dependent children, or the ~40 years without?
Eye-watering nursery fees can consume more cash flow than a monthly mortgage payment. Yet before long the child ages out, graduating to “big school”. Are those early childhood years expenses considered a brief aberration from the norm? Or will nursery fees give way to equally expensive private school tuition, an expenditure pattern potentially lasting 20 years or more?
But here is the thing. All those phases of our lives felt perfectly normal at the time. Yet in hindsight, the pace of change and volume of uncertainty we experience throughout life is astounding.
Few of us as children knew what we wanted to be when we grew up. Most adults still don’t know.
If you were to travel 20 years back in time and tell your younger self about your current life, how would they react?
Nodding along wearing the self-satisfied smile of someone who loves it when a plan comes together?
Or would they goldfish in disbelief at how differently things turned out from their current hopes and dreams?
Hopefully, they wouldn’t immediately burst into tears or run away screaming in horror at the mess you had made of their promising future!
Which raises the question of what makes us think that receiving a similar visit today, from our future selves 20 years hence, would go any more smoothly?
But probably not evidence!
The unknowable unknowns
The reality is we are all just guessing. Placing bets on the future and hoping for the best.
Some will undercook their numbers. Their rose coloured worldview paving the way for future disappointment. Hopefully content to enjoy the ride, despite their eventual destination falling short of where they originally sought to end up.
Others will be so scared of the unknown they can never have “enough”. Pessimism and uncertainty keeping them chained to the grindstone. Stopping only once they are physically or mentally unable to continue. Risking life passing them by as they endlessly seek out more.
The rest of us fall somewhere between those two ends of the spectrum. Adjusting the dials of risk and reward until we find a unique balance that works for us.
Some will chase higher returns or huge saving rates to reduce their timescales. At a price of increased uncertainty or reduced quality of life.
Others will adopt a slow and steady approach. Trading scarce precious time for a more certain outcome.
Anticipated rates of return, timescales, and withdrawal rates play a huge part in determining the outcome.
Nominal or real?
Before or after tax?
Current or historical averages?
Local currency holding its own or anticipating changes in relative purchasing power?
Local market returns where we live, or bubbly exuberant markets on the far side of the globe?
Assumptions all. Only verifiable in hindsight.
Which, after the fact, is about as helpful as somebody performing the “I told you so” dance!
The humble state pension might play a role in your planning.
Today, the English “new” state aged pension pays out the princely sum of £179.60 per week.
Which may not sound impressive at first glance. However, if we think of the state pension as an inflation-linked annuity, we can then calculate an approximate value for those future cash flows.
If we are fortunate enough to live for 5 years beyond the state pension eligibility age, the pension will have been worth the equivalent of nearly £45,000 in today’s money.
Live until we’re 80, and that value increases to more than £115,000 in today’s money.
Make it to 90, and our state pension “asset” would be worth over £180,000 in today’s money. That is more than 60% of the current median household net worth!
Which could make a major difference to how we meet our future cash flow requirements. Potentially reducing the net worth required to cover our expenditures earlier in life, as the state pension might help out during our elder days.
But only if a state-funded age pension continues to exist. In a form we qualify for. At some point in the future, potentially decades from now.
An unknowable unknown.
Quite the assumption.
We all make assumptions in our planning.
Some are obvious, yet seldom discussed.
That you will live long enough for any of this to be a problem.
That the gap between your income and expenditure is large enough for savings to be a possibility.
That your assets won’t be frozen, nationalised, seized, or otherwise lost to civil disturbance, corruption, or conflict.
Others are hidden in plain sight.
Purchasing a home with a repayment mortgage is based on the assumption that you will be able to consistently generate an income sufficient to service the loan throughout its duration. Enjoying potentially 25-30 years worth of good luck or good management to maintain job security and skills relevance, all while avoiding serious illness or disability.
Borrowing on an interest-only basis assumes that asset prices will appreciate, or at least not decline. Inflation is our friend here, keeping more leaky leveraged investment boats afloat than their owners might care to admit.
The oft-quoted “my property is my pension” approach to financial management relies upon the assumption that a ready buyer will be waiting in the wings to purchase your old family home. That the price they are willing to pay is sufficiently high that, after clearing your mortgage, the residual amount is sufficient to both cover your new housing costs and support your lifestyle.
Which might even be true, assuming the factors upon which local housing prices are based remain constant. Unaffected by changing employment prospects, commuting patterns, or technology improvements. Yet consider what happens to property values in a soulless commuter town, if remote working became the default rather than the exception, and workers no longer needed to commute? Where would the buyers come from then? Who would be the next generation of greater fools?
We all make assumptions in our financial planning. What are yours?
- Gov.uk (2021), ‘The new State Pension‘
- Office of National Statistics (2020), ‘Household wealth by ethnicity, Great Britain: April 2016 to March 2018‘