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?
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!
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.
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