[Editor’s Note: Today’s WCI Network post is from The Physician Philosopher and is about his system for making budgeting less of a chore and more about executing a plan for financial independence.]
Daniel Kahneman, a Nobel-winning psychologist, holds that there are two systems in the human mind that are responsible for the decisions we make. He calls them System 1 and System 2. System 1 is the intuitive, fast-thinking portion of our brain. It is what we use when someone asks us to solve 2 + 2, or you hear a loud noise and immediately locate the source. It’s also responsible for quickly recognizing when someone is angry with you. System 2 is the slow, methodical, and painstakingly rational side of our minds. Thoughts performed by System 2 require a lot more time, effort, and energy.
Kahneman’s work was eventually discovered by Richard Thaler, the founder of behavioral economics. You’ll hear much more about their story on this blog through the Behavioral Finance Series.
You aren’t here for a history lesson, though. You clicked on this post to figure out how to make budgeting a process that you don’t hate and one that works.
In this post, we will discuss why traditional budgets usually fail, the advantage of a backwards budget, a step-by-step process for making your backwards budget, and a case example of part of our budget when I finished training.
Transitioning a Budget from System 2 to System 1
Building a line-by-line budget requires a lot of System 2 work. It is labor-intensive, time-consuming, challenging, and requires a lot of mental effort.
Unfortunately, spending money often involves System 1 instead. See something you think you need? You buy it. Amazon even offers one-click purchasing options to make the thought process more automatic. This is the sort of stuff that can absolutely destroy a line-by-line budget.
The truth is that most people pick out their house, cars, and designer clothes/gadgets before they ever consider their monthly savings and debt repayment goals. This is not the way things should be, and spending before these goals are taken care of is a sure-fire way to end up broke.
What if I told you that—with a little work—we can transform budgeting from a boring and slow System 2 process to a fast-twitch and effective System 1 process?
We can make our wealth building and debt destroying ways automatic, and reign in those spending habits that seek to destroy our future.
An Intro to Backwards Budgeting
Let me give it to you straight.
The reason that most people fail at budgeting is that they don’t have the dedication, passion, and discipline it takes to keep to a budgeting routine month after month. We can make excuses, but if we can find the time and discipline to do a monthly line-by-line budget, we will find financial success.
But, the reality for most is that we don’t find that required discipline. We hate the “B” (Budgeting…) word and all the arguments that it brings. I am not making excuses for others, I am simply a die-hard realist who practices pragmatism to the core.
Some of us (myself included) are not detail-oriented. My message focuses on the big picture of personal finance, and my attitude towards budgeting fits this to a “T”.
If you—like me—cannot stand the detail and monotony that comes along with line-by-line budgeting processes, let me introduce you to something that gets the job done without forcing us to get stuck in the weeds.
It is called a backwards budget, and here is the premise:
If you are accomplishing all of your big-picture financial goals,
you don’t have to focus on the rest of your spending habits.
Yes, I just said that. Online. For everyone to see. Your spending habits do not matter if you are achieving your financial goals.
Meet your goals FIRST, and spend what is left… in whatever way you want to spend it.
Steps in Making a Backwards Budget
Now that I have convinced you that there is a way to find financial success without the terribleness that is a typical budget, let me walk you through the process of a backwards budget.
Hopefully, by the end of this, you’ll be able to sit down and make a budget that works for you.
The goal is to figure out the big picture first and then to distill that down into a short term picture in order to fill up a monthly budget. It takes a bit of upfront System 2 work (the slow, thoughtful, and intentional system), but once it is set up it becomes an automatic System 1 process.
Step 1. Define the Big Picture
The first step in making a backwards budget is to figure out what your big goals are in this life.
How soon do you want to rid yourselves of your student loans? At what age do you want to reach financial independence? Retire? Are you going to pay for college for your kids? Do you need to protect your assets? When do you want to get rid of that mortgage?
If you don’t have answers for all of these questions, I’ve already suggested a tool for this step: The Three Kinder Questions.
Make a reservation at a restaurant. If you have kids, get a babysitter. Grab a bottle of wine (or a coke for those that don’t drink). And then go through the Three Kinder Questions.
Once you do this, you’ll have a better idea of what is important for you to accomplish. Only after this step can you start to set monthly goals that will achieve your long-term goals.
Step 2. Attack Each Goal Starting with the End in Mind
Now that you have an idea of the goals you’d like to achieve and by what age, this is where the backwards budget starts to work.
For example, say you finish training at age 32 and your goal is to be FI by age 50. After you’ve spent some time determining how much you need to reach financial independence (25-30 x your annual spending), you should be able to determine how much you need to save each month to get to that goal.
For example, say I start with no savings at age 32 and want to retire by age 50 as described above. I’ve determined that we want to be able to spend $10,000 each month in retirement ($120,000 annually). Well, that means that we will need 25-30x this number to be “financially independent”.
In other words, we will need between $3 to $3.6 million. That’s “our number”. Using this as a goal by age 50, we can calculate backwards our annual and monthly savings goals.
There are a lot of online calculators you can use to determine an annual savings goal. I prefer to use this calculator.
Using the calculator linked above, I can start plugging in some annual savings goals to see how much I need to save each year to get to that goal by age 50. The answer for this couple (who wants between $3 to $3.6 million by age 50) is that they need to save around $90,000 annually to reach that goal.
Hopefully, they have a matching/contributions program through their employer or they are self-employed and can tuck away $56,000 each year through their 403(b)/401(k). This will do a lot of the heavy lifting to get to their goal.
[This serves as an example, and might be different than your goal. Use your conversations from Step 1 to come up with an annual savings goal that works for you!]
Step 3. Rinse and Repeat for Other Goals
You should repeat the process from Step 1 and 2 as many times as is necessary for your big goals.
For example, you might go through this for other important financial goals, such as your student loan repayment plan, paying down your mortgage, or saving for your kids’ college.
Say, for example, you had $300,000 in student loans and that you wanted those paid off in five years after training.
An excel spreadsheet formula or calculator would tell you that (if you had a 4% interest rate), this would require a monthly payment of $5,525.
Combining this with our annual savings goal, you might start to see more of your monthly paycheck vanish. But, you’ll be using that System 1 quick-thinking process to create automatic wealth.
Step 4. Put It All Together
Once you have gone through Step 1 and Step 2 for all of your important financial goals, you have to add all of this together to figure out your monthly backwards budget.
For example, you’d add your monthly savings goals + your student loan repayment plan + the mortgage pay-off plan + your kids’ college savings + your monthly disability and insurance premiums, etc.
This would form your monthly budget. These things must happen FIRST before you spend money on anything else.
If you make these things automatically happen from your paycheck and bank account each month (i.e. before you see it and spend it), you will have found the best practice of “paying yourself first”.
This is how people build wealth. It’s not complicated, but it’s also not easy unless you create an automatic process like this one.
Step 5. Track Your Goals
While we don’t utilize a line-by-line budget, my wife and I do track our goals.
To track our progress towards many of our financial goals, we use Personal Capital. This software has free tools that allow you to track your spending (which is different than budgeting), and also allows you to follow your net worth progress.
This is really helpful when you feel stuck in the grind. Watching your progress can motivate you when you feel like your tires are spinning in the mud.
Note: If you sign up for Personal Capital, they will call you if you have more than $100,000 in assets. They want to manage your money. And they use an AUM fee to do that. I don’t recommend using their paid services, but I absolutely do recommend their free tools.
A Backwards Budget Example
Let’s look through an example for my wife and me when we finished fellowship.
Here were some of our big goals:
- My wife and I wanted to tithe 10% of our paycheck.
- We wanted to pay off $200,000 of student loans in 24 months. (And we weren’t buying a house until this happened).
- Financial Independence by age 50 at the latest (goal of $3 million, initially). This requires an annual savings of $91,000.
- $150,000 in 529 for each kid by age 22 (when they graduate)
Based on these goals, here is what we needed to be doing each month through our various retirement plans and student loan repayment options.
Monthly Student Loan Budget
We needed to be paying $9,000 in student loans on average each month.
So, we paid $4,500 each month (which was quickly increased to $5,500 after we saw our first couple of paychecks). We planned for the other portion to come from the bonuses I knew we would receive each quarter from picking up extra shifts.
In fact, 90% of the money from my bonuses for the first 18 months went into paying off my student loans.
Monthly Savings Goal
Our annual savings goal meant that we need to save $7,584 each month ($91,000 annually).
We accomplish this in a pre-tax fashion through my matched 403(b) (~$45,000 annually, which includes my $19,000 contribution and the employer matching/contribution) and my wife’s governmental 457 ($19,000) and 401(k) ($15,000). We then break our annual savings goal with a $12,000 backdoor Roth IRA each year.
Any additional money placed in here after our student loans are gone is gravy. It just gets us to our goal faster. Alternatively, we could also use the extra money to pay off our mortgage faster.
Kid’s College Education
Everyone has a different view on this one. I’ve written extensively about saving for your child’s college education previously.
My wife and I want to provide a large amount of money to our kids for their college education expenses. To get to our $150,000 goal for each of our three kids by age 22, we need to save about $1,100 each month for our kids’ 529.
We didn’t start saving for this until we finished training. So our oldest obviously needs more placed into her account each month (~$600) while the other two kids need substantially less ($300 and $200).
Putting the Case Study Together
Putting all of this together, our monthly budget started with the following coming out of our paycheck before we ever even saw what was left:
- $1,750 tithe to the church
- $5,500 for student loans
- $4,416 pre-tax dollars coming out for our two 403(b)s and my wife’s governmental 457
- $1,100 each month going to kid’s college
Add that together, and we have already set up an automatic path to achieve four of our big financial goals.
Half of our paycheck was gone before there was even any chance to determine how to spend what was left.
Of course, I am giving you a bite-sized example of our goals. We have others, and those factored in as well, but hopefully, you get the point from the examples I’ve provided.
The take-home here is this: Make sure you have created a path for success towards your long-term financial goals before you spend the money you see in your bank account.
Do this by automatically sending money from your paycheck towards these endeavors. Create automatic bank drafts the day you get paid, or allow them to come directly from your paycheck, when possible.
If you learn the art of naming your goals and then creating a backwards budget to get there, then you will make budgeting—which is normally a painful slow-thinking System 2 process—into a fast-twitch automatic System 1 process.
You’ll get to wealth very quickly, and you will also get to spend whatever is left however you want.
Do you use a backwards budget? Or are you an old-school line-by-line budget kind of person? Leave a comment below. I’d love to hear people’s thoughts on this!
The post Budgeting That You Won’t Hate: Backwards Budgeting appeared first on The White Coat Investor – Investing & Personal Finance for Doctors.