Tuesday, February 25, 2014

Little Money, Big Money

It is temping, once you start making big money - or accumulate big money - to stop thinking about little money.   But that would be a fatal mistake.

One weird thing about saving for retirement (as opposed to getting a pension) is that in order to retire comfortably, you have to save up this big pile of dough.   For a middle-class person hoping to maintain a middle-class lifestyle, this might mean saving a half-million to a million dollars.   And that is a lot of money - big money. 

Using the 4% or 5% rule, a half million to a million dollars will insure $25,000 to $50,000 a year in income, which with Social Security should be sufficient for most people to retire comfortably in most parts of the United States.

Thus, if you are getting a pension of $25,000 to $50,000, you have the equivalent of a half-million to a million bucks.   Yet most pensioners getting $50,000 a year don't think of themselves as millionaires.

And this is the interesting conundrum for the 401(k) generation.   For the first time in American history, a large number of people are starting to accumulate significant sums of wealth.   My parents' generation got by on a pension and social security - and maybe a small inheritance from their parents, and the money they cashed out from selling the family home, as well as what they managed to save during their working life.

Without that pension, our generation has to save at least double, perhaps triple, what our parents' saved, and it is a staggering amount of money.   And while many companies matched, dollar for dollar, 401(k) contributions in the early days, today few companies match at all.  So it is even harder for the next generation to save these huge amounts of dough.

But that was not the point of this post.

One problem that occurs when someone has a lot of money saved up or handed to them (particularly the latter) is that they think they are "rich" and stop thinking about the little money.  Businessmen have this same problem - they get a big check from a client, and think they no longer need to worry about small expenses (I know I fell for this, at one time, myself).

What do I mean by big money, little money?

1.  Take as an example Joe and Lisa.   Lisa inherits Big Money from her parents.   How much?  She won't say, but she says it is "a lot."   I suspect it is a lot less than she thinks it is.   A million dollars?  Perhaps.  But as I noted above, a million bucks isn't really a lot of money - just enough to finance the rest of your life - at a modest income.

But like many folks who get lump sum payouts, Joe and Lisa think they are "rich" now, and don't have to worry about little money - the daily expenses in their lives, which, when added up, come out to a lot of money, over time.

So they saddle themselves with lots of small expenses.   They buy a vacation home and a new car, adding thousand of dollars to their monthly expenses.  New smart phones, of course, and that luxury vacation.   They can afford it, right?   After all, they are millionaires.

Problem with being a millionaire is, once you start spending it, you ain't a millionaire anymore.

What will happen to Joe and Lisa is anyone's guess.  But I suspect, like with lottery winners, they will burn through a lot of money over the next few years before they realize that the amount they have isn't finite.  And when a million bucks becomes $400,000 or less, they will blame "the market" or the government or the welfare queens for "taking away all our money!" when in fact, they took it away from themselves.

2.  Another Example is the 401(k).   I am happy to say that I have enough saved up to retire on, fairly comfortably.   But checking the balance on it can be a nerve-wracking experience.  On a day-to-day basis, my net worth can vary by $5000 or more - sometimes as much as $25,000 or more.   When you have big money, small changes in the market result in big changes in your balances.   One day you can lose or gain enough to buy a brand-new car.   And your mind has a hard time wrapping itself around that.

And it is temping, having this much money, to think, "I don't need to worry about little money anymore - I can afford it!"   But that would be wrong.   Just  because you made $5000 in the stock market yesterday doesn't mean you can afford to be blasé about the cable bill or your cell phone bill.   It is these little expenses, that over time, can sink your rowboat.

For example, if we use the 5% rule for retirement withdrawals, and you have a million dollars saved up (that would be nice) you could have an annual income of $50,000 a year.   But if you increase your monthly expenses by 10%, you would need an additional $100,000 in savings to cover that additional $5000 a year.   And since you are retired, you really can't increase your savings at a whim.  The net result is, of course, that you are shaving a year or two off the duration of your savings, which could be catastrophic for you down the road.

Little money is still important - and in fact more important than Big Money, in terms of retirement lifestyle, no matter how much you've saved.

3.  A Third Example is the Small Businessman.   I remember when I started my own firm, I had nothing but an old desk and a laptop, and a dozen cases to work on.   Back then, we could charge $10,000 per case, and it wasn't long before I got a check in the mail for $80,000 from a client.   That's a lot of money - perhaps the largest check I ever held in my hand, at that point in my life.

And was tempting to think, "Gee, we're rich now, with checks like these!" and go out and rack up additional monthly expenses.   We need another phone line, a new desk, and maybe a secretary to help out with the docketing and filing.   With checks like these coming in, the gravy train has arrived!

But the truth is, of course, that there were already a number of expenses in running the business.  And once I got done paying the rent, the light bill, the phone bill, funding my IRA (which is an expense, just like the light bill, and should be treated as one) and also paying myself enough to cover my personal expenses, including the credit card debt accumulated in starting the business, well, not a lot of that money was left.

And the next check, was, well, months away.

And a lot of small businesses fall into this trap.  They let the little money expenses get out of hand, based on the premise that "we're making a lot of money" and suddenly the overhead overwhelms the business.  

Even big businesses fall into this trap.   You read, everyday, about some silicon valley or dot-com company that is making so much money that they provide all these "perks" to employees, like free day care, and a free latte bar.   And while this gets them on the "best places to work" lists in the media, it doesn't mean people are necessarily working harder.   Quite the opposite.   People take on the attitude that the company is so wealthy it doesn't matter if they slack off.

And pretty soon, the money stream dries up, as competition lowers prices or the fad dies off, and the first things to go, besides employees, are all these "perks."

As a small businessman, one of the mistakes I made was assuming those big checks would be coming in regularly.  I loaded myself up with overhead, in terms of employees and overhead costs, which did not generate the additional revenue needed.  As a result, I ended up squandering tens, if not hundreds of thousands of dollars, over time, on things that were not really necessary for my practice.  

I could have rented out unused office space and paid off the mortgage on the property.  But I thought at the time that "Hey, I can afford to leave this unused space vacant, as I'm making big money".

What I didn't realize is that watching the little money is the secret to success is most businesses.

* * * 

Big Money, Little Money.  It is a concept that affects us all.   We get a good job and think, "we're making big money now, I don't have to balance my checkbook anymore!" and of course, we are wrong.   We let our spending increase to accommodate our paycheck, kidding ourselves that we "deserve" a certain level of lifestyle.  But since we don't accumulate any of that wealth, we end squandering and not saving.

Keep an eye on the little money, and the big money will take care of itself.