Ever walk out of a restaurant and see a fishbowl at the entrance, filled with business cards? The sign next to it would say “Want a free dinner? Meet with a financial planner!”
When I was younger, I put my business card in one of those fishbowls because who doesn’t want a free dinner?
It turns out that I would have to pay for my dinner with an hour+ meeting with a “financial planner,” who was more sales person than actual financial planner, and I didn’t have a financial plan. I did have a better understanding of how those fishbowls worked though!
A financial plan is important, we all know this, but very few of us have one. It’s because we think that we need to meet with a financial planner to get one and who has the time or the money to pay someone for a “plan?”
The reality is that you don’t. A financial plan is quite simple and today I’ll explain exactly how you can build one all by yourself.
To be clear, I’m not a financial planner. I have no certifications, no formal training, but I’ve met with several and currently work with one. When you work with a financial planner, you do more than just come up with the financial plan, you also execute it. A plan without execution is just a piece of paper!
What is a financial plan?
In its most simple terms, it’s a plan of your current (A) and future (B) financial states and a strategy for getting from A to B based on your income, assets, and expenses.
In other words, if today you are a single professional who rents an apartment and in five years you want to be married homeowner, a financial plan is your way of figuring out how to get married and buy a house in five years. When you create the plan, it’ll be based on your financial realities, which might tell you that getting married and buying a house in five years isn’t possible!
With a plan, you’ll know. Or at least have your best guess.
To that end, there are three parts – getting your current financial state, mapping out your future states, and then building a plan to get you from current to future.
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Mapping out your current state by financial planning
This is a simple listing of your assets and a good understanding of your income and near future income potential. Every month, I keep track of my net worth in a spreadsheet. This gives me a good sense of where our finances are right now.
Every month, I update those figures and maintaining that a monthly snapshot is important because it’s also a check-in on our finances. I review my credit card statements, my bank statements, and double check everything is accurate and correct.
The second piece of your current state is a high level understanding of your expenses. Your financial plan is about charting a path for your future and how you’ll get there through a mix of saving and asset growth. How much you save will depend on how much you earn and how much of it you spend – understanding that today is crucial.
Planning your future state(s)
This is the hardest part of the process because human beings are notoriously bad at predicting the future. Working with a financial planner gives you the opportunity to talk out loud about your future plans, something that is difficult to do on your own. I recommend speaking with someone who cares deeply about you, is able to have a frank discussion about money, and is able to give you honest feedback.
Also, don’t think about a single future state but a series of future states. I like to think of our financial future in a series of 5- and 10-year blocks. What do I hope to accomplish in my 30-35 year old block? What do I hope to accomplish in my 50-60 year old block? I want to buy a house in 5-10 years, vs. in 5 years. I want to have kids in 10-15 years, not in 10 years.
I like the idea of blocks because it gives me flexibility and builds that flexibility in the plan. Many people set a goal of “I want to buy a house in five years.” The goal is perfectly fine, but you won’t buy a house in exactly 60 months on the dot. In a few years you’ll start looking on Redfin for houses in the neighborhoods you like. You’ll find a broker, get pre-approved, and go through long and drawn out home buying process which culminates in your new home whenever that process is done. The “five years” timeline is merely guidance, it’s not a finish line.
I like to capture that flexibility by putting it into blocks, instead of setting a date.
Of those accomplishments, what are the future funding needs of those blocks? That’s the real question because the financial plan is about money.
If you are buying a house in five years, how much of a down payment do you need? Your financial plan needs to know because you will want to start saving money.
Let’s think about the hardest savings goal — retirement. If you plan on taking the traditional career arc of work full-time for 40+ years and retire at 65 to a life of leisure, you’ll need to amass a nest egg.
For this, I like to keep it simple. For something 40+ years into the future, you’ll have plenty of time to work on course corrections in 10, 20 and 30 years, when you have a better understanding of your finances. For now, rely on the 4% withdrawal rule, which states that your retirement nest egg needs to be 25X your expenses each year. If you only withdraw 4% of your nest egg each year in retirement, its own growth will support itself until you die.
The math is simple, for each $1,000,000 you save, you will have $40,000 a year to spend. If you believe your retirement lifestyle will require $120,000 a year, aim to save $3,000,000 for retirement.
Let’s keep it modest and say our retirement will cost $80,000 a year – that’s $2,000,000 in retirement savings.
If that number looks big, you can adjust it for any pension or Social Security benefit you expect to receive in retirement. For example, I used the Social Security Quick calculator and learned that I’m trending towards a benefit of about $2,450 a month in benefits. That’s $29,400 a year in benefits, so of the original $80,000 I now need to come up with just $50,600 – or a nest egg of $1,265,000.
Planning on Getting from A to B
You’ve done the hard part, now time for the math part.
Your plan is a series of future funding needs – house in 5-10 years, kids in 10-15 years, etc.
Your plan will now help you 1) set how much to save and 2) where you will be saving it so you meet your funding needs.
Let’s take our example retirement goal – $1,265,000 in 45 years.
How do we get there in 45 years? For that, we’ll need a calculator.
I kept the base assumptions (8% investment returns, 3% inflation, retire at 65 and 20 years of retirement income) and it told me that I would need to save $822 a month towards retirement to reach a total retirement nest egg of $1,505,733.
For retirement, I need to earmark $822 a month.
Now I need to do this for all the future funding needs. If I want to save $20,000 for a house in five years, that’s an additional $333.33 a month because I’m going to assume I put that in a savings account, not the more volatile but potentially more rewarding stock market because I intend to use it in 5 years.
If those are my only two needs, I need to save about $1,155 a month. $822 into the stock market for my retirement and $333 a month into a savings account for my house.
Is that doable? That depends on how much breathing room you have in your income and expenses. if you can’t save $1,155 then you may need to find ways to earn supplemental income, cut expenses, or adjust your future plans.
If you are willing to wait an extra year on your house, then your monthly saving needs drops to just $1,100.
If you reduce your down payment, your savings need to meet your goals will also decrease.
By creating a plan, you can now make intelligent choices about your future with hard numbers.
Review and Update Annually
Every year, review your plan. The numbers you used from a year ago will have changed. Everything from your funding needs to your income to your expenses to the investment returns, your plan should be adjusted too.
Remember, the goal of all this is to think about your future and to formalize a plan. Accuracy is important but not paramount. If things change, adjust the plan accordingly.
Perhaps you were given a larger than expected raise or received a windfall like an inheritance or a bonus, financial events that can accelerate your timeline. On the flip side, if you experience an accident or emergency that required you to dip into savings, those can affect your plan too.
Don’t over-react, especially on numbers like your volatile investment returns (it won’t be 8% exactly!), but adjust the plan accordingly, especially for funding needs that are within the next 5 years.
Having a plan is important because it helps you make informed decisions. Without a plan, you’re relying on your gut and you will rarely make a good decision with perfect information.
Jim Wang has been blogging about money for over 10 years and most recently writes about personal finance at WalletHacks.com. To get exclusive bonus material and weekly updates, please sign up to receive his email newsletter!
Do you have a financial plan? Why or why not?