When it comes to flexibility in a financial plan, it’s a delicate balancing act: it is important to maintain enough flexibility so your financial plan can accommodate unexpected events that are out of your control (like the loss of a job, unexpected illness, market downturn, or tax rate increase). On the other hand, a sound financial plan needs to be firmly grounded by factors you can control (like how much you save and spend) so even in the face of unexpected events, following your financial plan gets you to where you want to be.
Be Flexible: Assumptions Will Need to Be Made about Uncontrollable Factors
When you develop a financial plan, you must make certain assumptions, many of which are out of your control:
The notoriously complicated U.S. tax code will affect your financial plan in a number of ways. For one, your effective tax rate will change as your income changes. Also, changes to the tax code itself can affect your financial plan, often dramatically. Fortunately, changes aren’t typically made every year; and because Congress sets tax policy, most changes in the tax code are announced in advance of taking effect — allowing you time to plan how those changes might affect your financial plan.
We all hope our income will rise as we move forward in our careers. Typically, those kinds of income changes are predictable — maybe it’s a 3% raise every year or a 10% raise every three years. More dramatic yet still predictable income changes can happen when one spouse voluntarily stops or starts working. The loss of a job or dramatic decrease in work hours can cause unexpected changes in income.
Your and your spouse’s health are significant factors in your financial plan for two reasons: first, because health is a big determinant of one’s ability to earn income; and second, because health care costs are often a large expense, especially for the elderly. As you age, it’s important to think about changing your assumptions regarding your health. Maybe you reduce the income you expect because you won’t be able to work long hours anymore. Or you increase the health-care related expenses you plan for. You can also take steps to mitigate the impact of health changes by saving for medical expenses in a tax-favored health plan like a health savings account (HSA) or flexible spending arrangement (FSA) and by buying disability and long-term-care insurance.
Beyond job losses and health events that can impact your financial plan, other major life events may have a big impact as well. Whether it’s good or bad, expected or unexpected, events like the birth of a child, marriage or divorce, a spouse’s death, or a relocation will impact your financial plan. Some you can plan for, some you can’t; the point is to be aware that these kinds of events typically require a review of your financial plan.
For most of us, our financial plans are based on the assumption that our investments will earn a certain average return in the market. Those assumptions affect decisions we make about our plans. For example, the amount you need to save every month to retire at age 70 is larger or smaller the higher or lower your assumption about investment returns. The best way to make these assumptions is to base them on long-term historical returns in relevant market indices. That is not to say, of course, that these assumptions will always be correct; anyone who had money invested in the stock market in the fall of 2008 understands that the stock market can turn those assumptions on their heads in a single day. But given that we have to make assumptions, using historical returns is the best way to do it.
Be Grounded: Controllable Factors to Keep Your Financial Plan on Track
Because there are so many factors affecting your financial plan that you can’t control, it’s critical to know the factors you can control and stay on track with your plan in those areas.
Live within your means —
When you keep your expenses (including savings and investments) less than your income, you give yourself more flexibility to accommodate unexpected changes that you can’t control. If you have some breathing space in your budget every month, you can more easily accommodate a higher tax rate or economic downturn without having to alter your financial plan.
Have a rainy-day fund —
Have at least 3–6 months worth of living expenses in an easily accessible, liquid fund you can draw upon in the event of a rainy day — an emergency or unexpected situation. This savings should be set aside from all other savings and investments and only used for true emergency expenses — like in case of a job loss or illness. With an adequate rainy-day fund, you can deal with unexpected events without having to dilute or erode your financial plan.
Revisit your plan regularly —
The number-one key to achieving your financial goals is to review and, if necessary, revise your financial plan regularly — at least once a year. That way you can make adjustments for all factors out of your control that have changed, for better or worse. If you haven’t revisited your financial plan in the last year or need to develop one, please call.