Successful Saving: Building a Plan
We're back with some insight on how to build a robust savings plan, so you can make that next big purchase. 💰
Successful Saving: Building a Plan
In this edition of the Personal Finance Project Newsletter:
Recap from The Beginning
Fixed versus Proportionate
Risk Mitigation
Prerequisites
April 1st 2023 - Successful Saving: The Beginning
Where we left off…
In Successful Savings: The Beginning we quickly looked at what it takes to accomplish any savings goal. We only explored the topic at a high level - this is where we dive in.
I introduced a character named Jerry, whose initial savings plan is as follows:
“To reach $2500 by September 1st, I will need to save $500 every month for five months.”
We then quickly realized that, though this plan is better than nothing, it may not be as robust as necessary to face the complexities of life. So I asked you…
How can we craft a plan for Jerry that ultimately increases his chances of success?
The first consideration looks at the fixed “$500 per month” part of the plan, followed by a look at incorporating risk.
Proportionate versus Fixed Savings Targets
One option to increase Jerry’s chances of success is to write it in proportionate terms instead of fixed terms.
Jerry’s Proportionate Savings Plan Statement
Instead of, “To reach $2500 by September 1st, I will need to save $500 every month for five months.”
How about, “To reach $2500 by September 1st, I will need to save 84% of my disposable income every month for five months.”
(If you forgot, disposable income is your available money after taxes, PYF, and all necessary expenses).
Instead of fixing the amount that MUST be saved every month, Jerry can design a proportionate target that allows him to more easily achieve his savings goal, given fluctuations in his income. This change reflects that, with generally constant expenses, it’s easier to save when income is high and harder to save when income is low.
So how does Jerry figure out what proportion of disposable income to save? Here’s how:
Calculating a Proportionate Savings Goal
Estimate his average monthly DISPOSABLE income for the duration of the savings goal (say $600).
Estimate his desired monthly savings by dividing his savings goal amount ($2500) by the number of periods until his desired deadline (5 months). $2500/5 = $500/month. (The same logic was used for the original savings plan statement above).
Now, divide desired monthly savings by the average monthly disposable income to find a proportionate monthly savings rate. ($500/$600 = 0.8333).
Multiply the decimal by 100 to find the rate as a percentage. (0.8333 x 100 = 83.33%)… then round up to 84%.
Jerry should save 84% of his monthly disposable income.
Here’s a theoretical example of Jerry’s 5-month income and savings goal progression.
To see the full excel sheet, feel free to download here:
Let’s break it down.
First, notice that the proportionate monthly savings target (top table) of 84% allowed Jerry to reach his goal in time, whereas the fixed monthly savings target (bottom table) of $500 fell short. Specifically, the fixed savings target fell short in May and August because Jerry didn’t have enough disposable income to cover the $500 (the red numbers in the “Savings Goal” row were all he could afford to save in those months). The proportionate savings target, however, ensured that Jerry made up for the low-income months by making higher savings contributions in the high-income months.
Now, the success of the proportionate savings goal is not always guaranteed, and here’s why.
In the example, Jerry nailed his estimations. His gross income averaged $3,500/month, and with constant necessary expenses of $2,900/month, his average disposable income was $600/month. Jerry’s plan is very dependent on correctly estimating his income while keeping his expenses under control. A successful estimation will not always be the case.
A gross income below the $3,500 monthly average or necessary expenses above the $2,900 monthly average would result in a disposable income below $600/month. The plan would ultimately fail, as the 84% goal wouldn’t be sufficient to reach $2,500 in 5 months.
Overall
Using a proportionate savings goal can be an effective way to save when your income fluctuates. If saving is harder in some months than others, consider using a proportionate goal instead. Understand that it's not guaranteed, but can ultimately help relieve the pressure of savings.
This possibility of failure introduces an element of prioritization… along the path of failure, can Jerry cut back on other expenses? Can he make an exception to his 84% target by contributing more next month? Can he put the expense on a credit card and pay it off next period?
These are real-world questions that can make-or-break Jerry’s success. Realistically, the risks associated with income and expense uncertainty will always exist, and the secret to success is risk mitigation.
How can Jerry protect himself from these risks when crafting a savings plan? How can he dramatically increase the likelihood of success?
Success Through Risk Mitigation
Risk mitigation is always possible, regardless of the decision to use a fixed or proportionate savings goal.
Four handy risk protection strategies are:
Infusing time into your savings plan.
Saving more than you need.
Considering situational probabilities.
Specific budgeting.
These four simple (and tightly related) strategies are foundational to risk mitigation.
By infusing time into your savings plan, you give yourself a buffer zone in case you cannot reach your monthly target.
In Jerry’s case, depending on what he is saving for, he could plan to achieve his goal by October 1st, adding one month to his plan. By keeping the 84% target, he will theoretically reach his goal by September 1st, and that extra month is the buffer zone in case he needs extra time to make that final savings contribution.
Saving more than you need also gives you a buffer zone - but in a different way. The time infusion strategy assumes some flexibility in the savings goal deadline, whereas the extra saving strategy assumes flexibility in your ability to save.
In Jerry’s case, if he must meet his savings goal by September 1st, he could save 90% of his disposable income (6% above the initial 84%). By keeping the 5-month timeline, he will theoretically reach his goal before September 1st, building a time buffer in August.
Outside of the actual savings calculations, considering situational probabilities is a great way to think critically about a savings plan. Ask yourself:
How likely is it that my income decreases (or my expenses increase) so low (or high) that I will be unable to meet my savings target?
What is the chance that both of these happen together? Has this happened before? When and why? (Pro-tip: use the PFP Financial Tracker and start building your financial history).
What specific amount of increase/decrease would cause this “default”? A mere $100 or a lofty $1000?
Lastly, build a specific budget if neither fixed nor proportionate targets seem feasible. The PFP Budget Table breaks down monthly cashflows, which you can use to make a legitimate month-by-month savings plan based on specific income and expenses.
And lastly, a combination of all four strategies is encouraged! Considering the above strategies, you are well protected when your projections don’t play out exactly how you thought.
Embed these strategies into your savings goals to reach your targets on time and with pride!
Next Time
Check your inbox at 9 am on May 1st for the next edition of the Successful Savings series, where we will look further at disposable income.