I was talking to a friend yesterday, and she mentioned a relative who was a highly-paid consultant, had ALL the right toys (cars, boats…), but still had a mortgage on his house, and had nothing set aside for retirement.
The timing of her mentioning this was kind of noteworthy – because for the past week or so I’ve been considering writing a post on the topic of Personal Financial Management for people with variable income (small business owners, commissioned salespeople, entrepreneurs, consultants…)
So, as I was thinking about it this morning, it occurred to me that the story of Joseph was kind of relevant. In case you haven’t read the Old Testament any time recently, a brief summary of the story is :
Pharaoh had a recurring dream, in which first there were seven fat healthy cows, and then seven skinny ugly cows walked up and ate the fat cows (or, in another version of the dream, there were seven healthy heads of grain on a single stalk, and then seven more heads of grain appeared, thin and scorched, and they swallowed up the full healthy grain).
Joseph, an accomplished dream-interpreter, explained that the dreams meant that there were going to be seven years of plenty, when harvests would be good, followed by seven years of famine, when all the land would suffer.
Joseph (also an early financial planner) then suggested that 20% of the harvests from the coming years of plenty should be set aside, to carry the land through the subsequent famine.
So – how’s this relevant to YOU?
In fact, I’d say it’s relevant to everyone (including the federal government), depending on the degree of variability in your income. The recommendation was :
When times are good put away 20% of your income, so that when times are bad you’ll have something to fall back on.
There are a few different ways in which this can be applicable in your life:
1) You have an income that varies substantially from month to month (eg. you work on commission, or you work short-duration contracts, or you own your own business…)
2) Even if you earn a consistent salary from month to month, you have less than 100% job security (which is true for pretty much everyone) and if you were to lose your job you might not be able to find a new one (paying at least as well) right away
3) If you have a consistent salary AND incredible job security (seldom true, except possibly for tenured university professors or unionized government employees), there still may come a day when your income drops – after you retire (although people with steady salaries and incredible job security often also enjoy solid defined-benefit pensions)
Starting with (3) : saving for retirement.
Say you start work when you’re 25, and work for the next 40 years until you retire at age 65. And then you live another 30 years before dying in a spectacular sky-diving accident when you’re 95. You’ve earned money for 40 years, and you have to live on it for 70 years. If there were no inflation, and you were going to put your retirement savings in a shoe-box under your bed, then you’d have to save 43% of your income during your working years in order to be able to live on your savings until you died. In fact, there IS inflation, and you’ll probably see an increase in your earnings over your life-time, which would mean that you actually have to save MORE than 43% – except that you’re also going to invest your savings in a prudent way that will consistently beat inflation. AND the government will kick in a bit after you retire. Given which, if you consistently put aside 20% of your income towards retirement, you’ll probably do just fine (note that if your job comes with a defined benefit pension, you’re already doing this).
Continuing on with (2) : creating an emergency fund.
Say you’ve got a great job which pays really well, but you happen to be employed by the ONLY company in town that hires people with your qualifications (risk factor – may be difficult to fine a comparable job if for any reason you have to leave this one). Or you’ve got a high-paying job in an industry that has its ups and downs, like the oil industry (risk factor – you and a lot of other similarly-qualified people may suddenly be competing for jobs). Consider the likelihood that you will have to leave your current job, and the length of time that you may be between jobs. That’s what should determine the size of your emergency fund. The standard ‘rule of thumb’, which is 3-6 months of income, can be a good start, but what you really want to do is figure out how many months you may need to survive on your emergency fund, and how much ($$$) you’d need each month (assume for the moment that you’d probably be willing to cut back on some expenses while unemployed and looking for a new job).
And finally (1) : creating an income buffer
Say you’re a commissioned salesperson, and your income varies depending on how much you’ve sold during the month. In a good month, you rake in a load of money; in a bad month, not so much… Take a look at your earnings over the past 12 months (or, better still, over the past 5 years). What’s the least you’ve earned? What’s the most? What’s the average? What’s the longest period you’ve earned fairly little? Arrange your life so that you can live on somewhat less than your average income. On months when you earn above-average, put the excess into a ‘buffer’ account (ideally something paying a reasonable interest rate). On months when you earn below-average, make up the difference by withdrawing from the buffer account.
Now, back to my friend’s relative, who is currently earning loads of money, with a fair amount of variation from one month to the next, and a very real possibility that economic change could impact his earnings. Ideally, he should be a) putting aside 20% toward retirement, b) putting aside another 20% until he has enough to cover 6 months of expenses, and c) putting aside some more into his ‘buffer’ account on months when he does well.
What would this give him? Financial security. Which in turn provides choices. If his current job ends, he’ll be in the relatively comfortable position of being able to look around and find something that he’ll enjoy doing (as opposed to desperately seeking anything that will pay the bills). If his current job changes in some way so as to make him HATE getting up every morning, he’ll be able to leave it, knowing that he can live without it for a while. And if at some point he gets tired of working and retirement starts to look kind of appealing, he’ll have that option.