We all know that the cornerstone of personal finance is setting a budget. It’s pretty much the first rung of the personal finance ladder. But do you know who are complete black-belt ninjas at budgeting?Yes, actuaries!
Have you read the important notes before proceeding further?
Budget Like An Actuary
If budgeting was an Olympic event then actuaries would have a monopoly on the gold medal. In fact all other competitors would be humiliated by their prowess. I would have lucrative sports sponsorship deals, my own signature brand of stylish (but efficiently moisture-wicking) signature apparel, and a legion of followers hanging on my every Instagram post.
I know what you’re thinking – this is a bold assertion. But look at the evidence.
- If you are running a pension plan and you want to budget the required cash contributions, then who do you ask?
- If you are running GEICO, or any other large insurer, and you need to budget how much you need to pay out in car insurance claims each year, who do you ask?
- If you are budgeting for future costs in dismantling a nuclear reactor, or budgeting what to charge travelers on a toll-highway who can help you?
An A.C.T.U.A.R.Y!
In fact many of these budgeting decisions are so important that they require an actuary BY LAW. As a society we have decided that there is only one person qualified enough to create these budgets, and it’s an actuary.
So I could drop the mike on budgeting and walk away now. But for you, my loyal readers, I’m going to let you into the tent with One Golden Rule.
Golden Rule – Money has Time Value
Wait, what do you mean?
Suppose I owe you $100. Setting aside for one moment your dubious judgement in lending to an actuary, it’s fair to say that you are going to want to be paid back, and probably paid back quickly. You want to put your $100 to work, don’t you? I’m sure you want to buy groceries, pay down a credit card or put it in your savings and investment to further feather your nest egg.
If I pay you back next year then that will piss you off and you’ll feel like you are out of pocket.
If I pay you back in three years’ time, you will be really pissed. Why? Because you have missed out on three years of investment returns.
So money has time value. $100 is worth $100 today, but $100 in the future is worth less.
You know how easy it is to pick up the phone, order a pizza, and very soon fill your home with delicious pizza aromas? Well, instead of delicious pizza aroma substitute blog posts from an actuary, and instead of picking up the phone substitute signing up for my email list or follow me on twitter @actuaryonfire. If you like this blog please share the love with others – I appreciate it!
An Example
So what does this mean for budgeting?
If I have a future obligation then I will set aside a budget today. But I don’t need to budget the whole amount today.
Let me explain….
Imagine I need to pay my child’s college fees of $20,000 in three years. I don’t need to allocate a budget of $20,000 today, since due to the time value of money I can set aside less money today in order to meet my payment in three years.
Let’s assume that I can achieve investment returns of 5% (in excess of inflation) over the next three years. Then my budget today will receive three years’ of investment returns between now and the time of payment. Three years of 5% investment returns is roughly 15%. So I only need $17,000 today in order to pay $20,000 in the future. My budget of $17,000 will grow to $20,000 in the future. I have now free’d up an extra $3,000 from my budget today that I’m sure I can put to work elsewhere. You’re welcome!
So the lesson here is that if you have to budget for things in the future then don’t think about setting aside the full amount today. Think about setting aside the amount today that will grow over time to meet your obligation. Makes sense?
Are you facing future payments that you are mentally budgeting for? Does it makes sense to you to set aside an sum now that is less than the future amount? Do you think you’re better at budgeting than an actuary? Want to challenge me to a budget-smackdown? Comment below.
Technical Notes
I know I was playing fast and loose with some of the math here, but I was using some artistic license to keep things light and breezy. Anyway, whadya gonna do? Send me to actuary jail? (Did you know actuary jail is unlike real incarceration; instead of menacing tattoo’d thugs sitting on the rec ground pumping iron and miming threatening ‘shank’ actions, there are bespectacled grey-suited individuals engaged in earnest discussion on the right risk-free measure of interest rates.)
If you are interested in the right math then google “discounting” or “discounted cashflows” and contact me if you’re having trouble.
Want to check out some of the other articles on this site? How about, Essential Insights from Karl Marx on Personal Finance or An Actuary’s Take on Longevity and Early Retirement
Budget like an actuary! I love it. Most people don’t understand the time/Money relationship.
Thanks DocG
Ooh I hope someone challenges you to a ‘budget-smackdown.’ Maybe that guy from Budgets are Sexy…
He’s going down!
Love this post AoF! As a complete novice I’ve blogged twice about the future value of a dollar so it’s nice to see someone with some actual chops throwing his weight around.
Thanks for stopping by Ty appreciate your comment.
The Mac Daddy of this budgeting is of course the retirement nest egg.
Example average value of a 2014 Honda EX with 58000 miles is $15000. Cost of a 2018 Honda EX is 30000. Differential $15000 To save $15000 @4% its $300/mo x 48 mos. So for saving $300 a month you can drive a new $30000 car every 4 years. The advantage over a lease deal is if something happens you own the car and can use 15000K as emergency money and save the lease down payment and fees which are not included in the lease fee.
I also put 15K into a UGTM gift trust for my kids at age 2. The UGTM can be used to pay anything not just school expense. The 15K grew to $35K 16 years later when college started. The money continued to grow as I started using the money to pay for college incidentals like trips home, summer abroad, cloths a monthly allowance etc. After 4 years of expenses there is enough left to buy a car, license, and a years worth of insurance upon graduation. Principal investment was about 37% but the interest was 63% so the interest paid the lions share of the cash flow. So in the end that 15K paid for 41K worth of benefit.
I can see AoF groovin’ on the rap.
Good examples of the time value of money. The trouble is that you have to suspend instant gratification… Thanks!
The “5% above inflation over 5 years” sounds like multiple big assumptions. Money looks magical with these conditions. What can go wrong ? 😉
Putting aside that these numbers were probably just meant for simple math (1% or 2% could have worked just fine and be as simple).
An interesting actuary perspective would be to explain how to account for the uncertainty and address the risks, i.e. do you invest more expecting a lower rate to avoid a scenario where you could have -5% of the amount and education cost have grown by 5% (think 2000-2005 or 2000-2008) ? Or other approaches accounting for risks ?
5 years is very short time horizon for assuming positive investment returns plus there is high real expected return but, on top of it, there is also an underlying assumption that beating inflation after taxes** is a given. Supporting this argument would also be very interesting 😉
Thank you for sharing.
** for the specific example in the article this problem can be mitigated by using a 529 plan but the article makes a more general argument. In the world of taxable accounts beating inflation after taxes is not a given (even TIPS get taxed)
You raise a good point, I was a bit cavalier with my assumptions. Reasonable people could disagree about 5% real return over the long term, but it’s probably not achievable over the next 5 years! So I could have chosen something lower for sure.
You’ve also called me out on taxes too! Again, I agree, beating inflation plus taxes is not a given, and something I just glossed over. Really this was a bit of a puff piece to float the idea of discounting with people. But when you unpick it, what are you left with…?
Thanks for coming by and commenting. I appreciate that, please come again.
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