This Year is Not Average

Confession time. I had never calculated my annual spending before, until 2014. Which is weird, since I've tracked my monthly spending and savings for years. The prior years' data is still hanging out in old tabs of my budget spreadsheet, just waiting to be aggregated and put into nicely crafted formulas. But to pull all those individual spreadsheet tabs together, with all the organizing and copying and pasting...ain't nobody got time for that.

But then I remembered that I was trying to retire in about six years. Might my annual spending figure be important to figure out before then?

No one ever claimed that I knew what I was doing with money.

So, after many cuts and pastes, I finally had our 2014 spending figure: about $31,000. This will seem impossibly low to some people (note: we no longer pay a mortgage) and a little high to others. Travel was by far the biggest line item, weighing in at just under $7k. This is definitely higher than we normally would aim for, but we had a wedding trip to the big island of Hawaii, two trips to South America, and some domestic travel...a lot of it happening without travel hacking. Our second largest expense was groceries, followed by gifts, of all things. There's a sweeping criticism of our values in there somewhere.

For the voyeurs lurking on this blog, and those readers who miss Budget Porn, here's a taste, you pervs.

So we know we spent about $31,000 last year. My first instinct is to use the trusty 4% Rule and set a target value for our investments: $775,000. If we can stash away that amount (adjusted for inflation), we should have enough to cover our $31k in spending forever. Right? (Yes, so long as we ignore Jason Hull's advice for early retirees.)

As rules of thumb go, I suppose the 4% Rule a good one to start with. It gives us a specific target for our retirement nest egg to be achieved by a certain date, which we know is more motivating and effective than "just saving as much as we can".

But even if the 4% Rule is perfectly sound, there's already a problem with my approach: that $31,000 is not a true average of our household spending. It's just what we spent last year. And even if I spend the same amount next year, and the following one, it's still not going to be representative. Let me explain.

Planning for early retirement based on my annual spending does not account for those future costs that are rare, but are surely coming. Every so often (and fairly predictably, too), I will need a new roof. Every ten to fifteen years, I will purchase another used car. Some time in my life, I will suffer a major injury or sickness that forces us to actually spend to our deductible. Kids will need braces. And so on.

My amateur budgeting misses these costs entirely, since they are not in my budget most years. And because we are in an all-out sprint to "financial independence" it's possible that we won't see any of these rare events by the time I'm forty. But some day, those costs will come around, and I will never have accounted for them in my DIY 4% calculations.

While last year may account for all my spending down to the penny, and I might even repeat that process for the next five years...that's not a reliable average. My early retirement plan creates a too-small data set, and one that skews the data in the wrong direction.

This points to the need for some real financial planning advice...you know, from a financial planner.

For those of us committed to a DIY financial planning approach, we should at least utilize a replacement cost method: budgeting in 1/20th of a cost of a 20 year roof into my annual spending, along with 1/10th of a used car, 1/10th of our insurance deductible if we assume a major medical event every decade, and so on. While that only addresses those rare costs that we know are coming, it's better than nothing.

Accounting for just those three items (a roof every twenty years, a car every ten, and one major medical event a decade), our annual spending is really $1,500 higher than the $31,000 I calculated: a 4.8% increase.

Using the 4% Rule again, the amount we'd need for retirement is not just $775,000, but $812,500: a $37,500 delta. Saving that extra $37k will be no small feat, but it would be especially hard had I only realized I'd underfunded my retirement after I gave up my employment.

In general, my DIY, amateur financial blogger approach leads me to underestimate my true spending average. Worse, it leads me to severely underestimate the amount we will need to adequately fund our retirement. For someone planning to leave the workforce very early, in the hopes of living off a nest egg for fifty years, this is particularly stupid and dangerous.

Maybe we should budget in a few dollars for a financial planner this year.


*Photo is from kvanhorn at Flickr Creative Commons.