Flexibility in a financial plan is a delicate balancing act: it is important to maintain enough flexibility that your financial plan can accommodate unexpected events that are out of your control. On the other hand, a sound financial plan needs to be firmly grounded by factors you can control.
When you develop a financial plan, you have to make certain assumptions, many of which are out of your control:
Taxes — 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 for those changes.
Income — We all hope, of course, that 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.
Health — Your health and your spouse’s health is a significant factor in your financial plan for two reasons: first, because health is a big determinant of one’s ability to earn income; second, because healthcare costs are often a large expense, especially for older people. As you age, it’s important to think about changing your assumptions about your health. Maybe you reduce the income you expect because you won’t be able to work such long hours anymore. Or you increase the healthcare-related expenses you plan for.
Life — 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.
Economy — 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 the relevant market indices.
That is not to say, of course, that these assumptions will always be correct; anyone with money invested in the stock market this year understands those assumptions can be turned on their heads in a few days. But given that we have to make assumptions, using historical returns is the best way to do it.
Be Grounded: Factors You Can Control to Keep Your Financial Plan on Track
It’s critical to know the factors you can control and to stay on track 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, for example, 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 that you can draw upon in the event of an emergency or unexpected situation. This fund should be set aside from all other savings and investments and only used for true emergency expenses — like in the 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 the factors out of your control that have changed, for better or worse.