I believe that the single greatest predictor of success, happiness and freedom is a successful cash management system. Once I had a client who came to us wanting to buy a house. We recommended building up a cash reserve first, and after 6 months he called to let me know that he had just quit his job. Initially I was alarmed, but he went on to tell me that it wasn’t until he had that emergency fund built that he realized how negative his job was to his mental and physical health. Rounds of layoffs and pay cuts left him working 12 hour days for less pay. So he quit—something he never could have done absent that pile of cash. And within a month he found the job of his dreams and bought that house about 6 months later.
The lesson I have learned after years of planning is that those who build the pile of cash and get rid of debt end up winning. The funny thing is that when they start building that pile of cash they usually don’t know the game they’re in or how it will turn out.
It was the same for me. After graduate school when I was working for an investment bank I treated saving like a game—a curious exercise to see how much I could squirrel away. I didn’t have anything that I was specifically saving for, but I tracked my money and learned to find alternatives to Starbucks (A coffee pot? Who knew?). Then one day I had an idea for a business. Two months later I left and started up my company.
After doing plans for over 250 clients, with an average income of $300,000, I can say with confidence that of all the important things I do from tax planning to investment planning, absolutely nothing is as important or life changing as cash flow planning. The challenge is that no one wants to be on a budget. Few people want to spend their lives typing in every expense into an app, saving receipts or carrying around cash envelopes.
We primarily work with young doctors who are transitioning from making a small amount of money in training to a whole lot of money. What we have learned is that if you make a small amount and can’t save there is little likelihood that you will save when you make a lot of money. So, while they are still in training, we encourage our clients to adopt a cash management system that works and allows them to save, even a small amount.
The first hurdle for young folks adopting a budget is to make a cash flow plan. Think about the plight of a young doctor graduating in June. They are mostly in the Income Based Repayment or REPAYE student loan repayment programs. The federal government calculates the repayment based on last year’s tax return, so it will be a year before they even see an increase in student loan monthly payments. Also taxes—since the first year they only make a lot of money for half a year they can withhold less in taxes. So without planning they might accidentally buy too much house or car and increase luxury purchases ahead of an easily anticipated headwind when they have to withhold a lot more from their paychecks the following January. And what if they don’t have kids yet? Without planning for the cost of childcare, private school or college savings they might spend those dollars that would otherwise be earmarked for their kids.
A cash flow plan takes all those things into account and figures out the best balance of spending on important things like education and travel while saving enough for an emergency fund, paying off debt and building up retirement savings.
Once the plan is in place, how do you stay within the plan? Our greatest effort at Aptus has been finding a cash flow plan that works universally for our clients. And we have it. The system that most of our clients, with incomes from $40,000 to $400,000, end up adopting is a pay yourself first system.
Here is how the Aptus cash flow system works:
Pay yourself first. We take our cash flow plan and make all planned savings disappear immediately. This includes 401(k)s, 403(b)s, 457s, traditional IRAs, Roth IRAs, Health Savings Accounts, Flexible Spending Accounts, emergency fund savings and debt repayment (yes, we consider debt repayment to be a form of savings).
The next thing we do is figure out the budget busters that wreck savings. We had clients who could stay within an operating budget but kept getting blindsided by “one time” expenses such as Christmas gift spending, booking a vacation, fixing an air conditioner, or paying for summer camp. But if you looked at those one time expenses, they were inevitable. To address this, we spend time with clients to think through all one time expenses that could hit each year, and we have our clients set up savings accounts for each one. Most of my clients have on average 5 savings accounts, and they find this to be a useful tool to avoid the inevitable budget wreckers.
One item that can hang people up is an insurance premium that gets paid annually or semiannually. If you can get a discount for paying up front then keep doing it, but think about making that one of your savings accounts that you fund monthly.
Ironically, our clients have remarked how much fun taking vacations have become since they have the money in an account for them to spend. Studies confirm this observation. Returning home debt free is part of vacation fun.
Bills don’t need a budget. From there we move to bills. The most difficult issue for young people who make a lot of money is feeling the “edge” of their money. What is the actual end of their means? And if you assume that you have two people spending from the same pot this is doubly challenging, particularly if they are spending on a credit card. It could be an entire month before they even find out they have overspent.
To address this issue we first take bills out of the equation. Think about that. They don’t need to be “budgeted,” because they just are what they are. The goal for bills is to carefully account for every bill from a mortgage to a monthly Spotify subscription and then levelize them. Did you know you can make your utility bills be the same amount every month? How much easier is it to keep a budget if you know your electric bill won’t swing from $30 to $300 depending on the season.
Let’s inventory what we have done. We have sent away our savings from long term important (aka boring) savings for retirement, college, and emergency fund. Then we sent our fun savings away from travel, clothes, new car, gifts etc. away. Then we took away our bills. So we are left with the edge, the end. Whatever is left is what we can spend on everything else. This is our discretionary budget.
And finally we arrive at the actual budget. Consider a client couple I am working with right now. They are 35 years old and between the two of them make $560,000. After we reduced their pay by $205,000 for federal, state and FICA taxes, carved out all those long-term and short-term savings and then subtracted their overhead, or bills, they were left with $36,000 to spend each year, or $3,000 per month. That’s a lot of money, but think of what trouble they could get into considering that they bring home $23,932 per month! They can spend that $3,000 on food, fuel, manicures, pedicures, babysitters, dining out, and random trips to Target. But how do they stay within that budget in light of how much actually hits their checking account?
Here is the secret. Our clients start a second checking account and then they fund it every Monday by the weekly equivalent of their discretionary budget. In my client’s case this comes to $700 every week, or $100 per day. They spend that down over 7 days, and once the money is gone it is gone—until the next Monday.
No saving receipts. No tracking money. It doesn’t matter how much they spent on food versus Target. They just had to keep their spending within that parameter.
This system is so simple, and it works. Our clients tend not to fight about money. It is a very different conversation to disagree on who is responsible for having no savings, for racking up credit card debt or splurging too much rather than the disagreements my clients have for when to cut off the emergency fund, whether to get the student loans paid off in 4 years versus 5 or whether to have $150,000 saved or $100,000 saved for college by the time the kids turn 18.
As a financial planner, I know that it seems more glamorous for clients who make a lot of money to talk about asset allocation, investment strategy and how to best game the tax code. We have those conversations and, while certainly important, in my opinion they can become a distraction.
Think about it—in order to invest, first you must save. Let’s get started.