We all have irregular and unexpected events that adversely impact our finances: Your hours are cut back. You are widowed. The car breaks. You need to go to the emergency room. The roof leaks. You need to fly to a family funeral. Your daughter gets married. Lightning strikes a hole in your roof. In economics, these are called financial shocks.
Financial shocks are not rare events. In fact, according to The Financial Advisor Magazine’s article “Unexpected Expenses Are The Rule In Retirement, Not The Exception,” 83% of households experience at least one financial shock annually.
What is more: financial shocks are experienced throughout life. They do not end when one retires. Sudden, unexpected, large expenses are a part of life and should be taken into account during retirement planning.
As article author Jennifer Lea Reed explains:
When a shock does come, lower-income retirees are typically far more devastated. The annual expense, on average, represents 13% of their retirement income, while their well-heeled counterparts would see the greater expense representing just 7% of their retirement income.
Unexpected expenses ironically tend to increase with income (since those with higher income can afford them). However, “the share of these expenses relative to income tends to decrease for those with higher income,” the brief said, adding that the average works out to 10% of annual income per household.
This study agrees with our lived wisdom.
None of us can anticipate all of our expenses. Every stage of life brings a whole new set of unanticipated needs. Even after identifying every outflow you think you might have, there will still be significant unexpected costs.
For these reasons and more, we recommend constantly budgeting for surprises by setting aside at least 10% of your budget each month into an “Unknown Budget.” We call this budget the Unknown Budget because the question everyone asks is, “Like what?” and that is the point. You do not know how you will spend this budget.
Such unknown expenses may include any of the shocks in our “How to Budget for Emergencies” series, including major car repair, major home repair, trip to hospital, pay cut, divorce, separation, widowing, or another large expense. Even if you can anticipate that you will experience one of these expenses, often their timing can’t be anticipated. It may be years until you need a new roof or a new heat pump, but when that time comes there is little to do except pay the expense.
Other expenses may be completely unanticipated such as a child’s wedding, a death in the family that causes you to travel unexpectedly, or perhaps even being the one who can write a check that will save a Christmas Lodge.
If you are using the Automatic Millionaire technique, we recommend only taking 90% of your standard of living as regular monthly payment. Reserve that last 10% for unknown unknowns and keep those funds in your long-term savings. Then, when you encounter a financial shock or emergency which cannot be paid for out of your regular living expenses, you can transfer funds from this unknown budget without exceeding your target standard of living or annual safe withdrawal rate.
If you are using a Schwab Bank Account to stay more fully invested, the full 100% of your standard of living can be maintained in the same location with the excess which you are not spending seamlessly invested according to your asset allocation. Then, you or your financial advisor can simply monitor the outflows to make sure that the total — both unknown budget expenses and regular expenses — stay below your annual safe withdrawal rate.
Whatever implementation you choose, reduce your lifestyle expenses and set aside 10% of your budgeted standard of living for unknown expenses even in retirement.
Photo by Manu Mateo on Unsplash. Image has been cropped.
