Executive Summary
Getting a handle on client expenses is often difficult - and only exacerbated by the fact that most people don't exactly enjoy the budgeting process. Nonetheless, failing to accurately estimate ongoing expenses makes it almost impossible to plan. While in many situations, it's possible to get a reasonable estimate of spending by looking at ongoing household expenses, the reality is that many people have large expenses that occur irregularly throughout the year - or even interspersed across several years - and as a result, "just" focusing on recurring monthly expenses can lead to a significant underestimate of true spending.
The end result is that a lot of clients and planners may systematically underestimate spending by failing to fully take into account large irregular expenses, such that there is never as much money left at the end of the year to save as originally anticipated. Some planners adjust for this by trying to estimate every expense and convert it into a monthly amount, just to get a more accurate estimate of ongoing spending; others simply try to estimate the amounts of irregular expenses and when they might occur, and project accordingly. So how do you handle irregular expenses?
The inspiration for today's blog post is an Ignite session delivered by Jesse Meacham from YouNeedABudget at the Financial Bloggers Conference (FinCon). In the presentation, Jesse made the interesting point that most people misjudge and fail to properly budget for their expenses because they pay too much attention to the regular, recurring outflows and lose track of the annual, one-time, "irregular" expenses that arise. The end result - people underestimate, sometimes severely, just how much they actually spend.
Irregular Expenses In Annual Spending
For most people, an estimate of spending starts with an estimate of the big, recurring expenses every month - the rent or mortgage payment, perhaps a car payment, any loan payments, some other substantial recurring expenses like utilities, telephone, and cable, and then an array of expenses that are somewhat less consistent but known to occur on an ongoing basis like food and household supplies and necessities.
Yet the reality is that beyond these recurring expenses, there are often an array of other expenses that may be more irregular, but still have a material impact - if not on a standalone basis, certainly in the aggregate. This might include expenses like various taxes (not just income taxes during tax season, but property taxes, car taxes and registration, etc.), insurance costs (such as life insurance, disability insurance, etc., if not already paid on a monthly basis), as well as one-off expenditures like vacations or buying new suits/uniforms/work clothes.
The end result is that if we simply estimate our spending by remember the typical, recurring expenses, we may significantly underestimate total spending. And if recurring expenses consume most of the client's household income - with an assumption that the rest will be saved - then in reality there may not be much left to really save by the time an ongoing list of one-off expenses have been taken care of!
Irregular Expenses In Lifetime Spending
From the broader financial planning perspective, irregular spending is not just an issue on an annual basis; it's also a significant issue for planning lifetime spending, both in terms of managing expenses and savings during the working years, as well as estimating and then managing retirement expenses.
For instance, clients who don't maintain debt - including auto loans - will still have to buy a new car every few years as the old one wears out, but the expenditure may appear as a large single lump sum every 5+ years, not an ongoing expense. Nonetheless, buying a $20,000 car every 5 years is still ultimately comparable to a $4,000/year household expense for the car (give or take a little for the time value of money), although in practice most people who pay cash for cars don't account for the expense this way!
In a similar vein, other significant irregular expenses that could span many years include major household repairs (e.g., a replacement roof or deck), extended trips or special anniversary events, family weddings, and more. Arguably college would fall in this category as well, although we at least generally recognize that college is such a major expense that it needs to be separately planned for as an expenditure and saved for accordingly.
Planning For Irregular Expenses
In practice, I suspect that one of the reasons client plans often don't turn out as anticipated is that the budgeting/cash flow planning process often doesn't do enough to plan for such expenditures. The end result is that in many years, the money that was supposed to be left over to save after planned expenses just isn't there after all. "Something" came up and life happened; except in reality, while the expenses weren't part of the monthly recurring budget, many of those expenses are not perhaps truly as unexpected and unanticipated as we make them out to be.
It seems that there are two primary approaches to address irregular but not unexpected spending needs. The first is to convert everything into a monthly or at least annual expense - regardless of whether it is actually paid monthly or not - just to get a better estimate of true spending needs. Thus, for example, a $3,000/year life insurance obligation might be estimated at $250/month and included as part of the monthly cash flow needs estimate, and a $3,000 vacation might similarly be budgeted the same way. A plan to buy a $20,000 car every 5 years can be estimated as a $4,000 annual expense, to ensure it's recognized as an expected annual cost "on average" or might even be broken down further as a $333/month cash flow obligation. To the extent that the money hasn't been spend - because the expense might not occur for a few more months or even years - the cash simply builds in the cash flow account until it is time for the expenditure to occur.
The second approach is to try to actually plan for and project the irregular expenses as they will occur. For instance, the plan projection might show a $20,000 expense every 5 years for a new car, a $30,000 expense in 25 years for the wedding of a newborn child, $10,000 for a new roof in 20 years, etc. In practice, this is often a difficult exercise, simply because it is data intensive - and sometimes beyond the constraints of financial planning software - to enter additional line items to expenditures in particular years going out for several decades. In addition, it sometimes feels arbitrary to assume something like a wedding expense 25 years out for a newborn; at best, the expense is considered small enough given the time horizon that it can be accomplished as a shorter term savings goal at some point closer to the event itself. Nonetheless, money that is saved for a future wedding is money that won't be available to be saved for other goals, so it remains an overall budgeting issue.
Either way, though, it's usually necessary to help clients with a prospective "budget" that lists both regular and irregular items, just to ensure that all expenses are accounted for in the first place, both annually and over a longer period of time. The reality is that many such expenses, because they're irregular, are not top-of-mind, and may remain forgotten and unplanned for unless prompted by the planner.
But the bottom line is that planning for irregular but not unanticipated expenses is a crucial part of both short-term and long-term cash flow planning. To exclude such expenses virtually ensures that clients will find there's never as much money left at the end of the year to save as anticipated - and in fact, this may explain why so many households have the trouble saving that they do in the first place!
So what do you think? How do you plan for irregular client expenses? Do you include them as they're expected to occur over the years? Do you convert them to a monthly estimate to try to get a handle on the overall ongoing cash flow needs? Do you have a cash flow or budget worksheet you use with clients to help them estimate these expenses? Do you have any kind of software to help the process? Or do you not separate plan and project irregular expenses at all, and instead simply handle them on an ad hoc basis as they occur and adjust accordingly?
(This article was included in the Carnival of Financial Planning on Planting Money Seeds, the Wealth Management Carnival #7 on Marotta on Money, and also the Carnival of Retirement on Making Sense of Cents.)
Michael,
This is a very real problem. Many clients that try to go it alone, and do not want help budgeting always seem to fall short when big purchases come up.
Here’s how I typically address this issue:
First, as you indicated, when planning for “annualized” budgets, it’s easy to figure in one-time payments each year (ie. insurance, taxes, etc.). For people that like a monthly budget, you can simply extrapolate it out into monthly budgeted payments.
Second, for the REAL problem purchases that are hard to quantify and put a date on, I address that with a savings contribution. For example, if you know that on average every 7 years you will replace your car, you figure out the amount of monthly savings you need for that (maybe with trade in value, you will end up needing $250/month in savings for 7 years). Same goes for a wedding, a new roof, a new boiler or furnace, etc.
The client just needs to know that if money is spent on items other than these, that they modify their plan accordingly.
It’s never going to work out exactly, but there will hopefully be surprises to the upside as well as the downside.
But to be honest, very few clients seem to be committed enough to actually follow through with this process, but rather just “wing it” as the time comes, pulling money from bonuses or tax refunds, or credit cards, or taking out loans, whatever.
Doesn’t the MoneyGuide Pro software do a reasonable job with the second approach described?
Good discussion on an overlooked issue. Purchasing cars for cash or taking an international vacation can be big budget busters (this I say from experience). Converting these expenses to a monthly amount makes the most sense to me. This maintains a “top of mind” awareness if not an actual commitment.
I focus on this especially with my retirees,as it is a big concern. Younger clients in accumulation mode will sometimes “wing it” as Robert states. Retirees won’t have the luxury. I address it with a savings goal for major purchases, usually funded with something upfront, separate from their emergency cash reserves. Some of my retirees have committed to sell other assets, such as their motor home, boat, cabin etc to meet a major unexpected expense. Regardless, I review their budget with them and have the conversation.