Mr Micawber said this about making a budget in Charles Dickens’s book David Copperfield:
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
For those too young to remember old money, nineteen nineteen and six is £19.97½. And twenty pounds ought and six is £20.02½.
This maxim illustrates a deep truth about money. Riches won’t necessarily make you happy, but being able to live within your means can.
A budget for the long term
Making a short-term budget is relatively easy. Taking Mr Micawber literally, you’d save 5% of your income every year. Nowadays, that’s very little to buy a comfortable future.
So just living within your means is not enough. During your working life, you need to live well below your means. Anything you don’t spend on consumables becomes your retirement fund. But once you stop working, what you’ve saved will need to support you for the rest of your life. You may have a future guaranteed pension (for example your state pension). But anything more will need to come from your savings. So how much or how little should your budget be?
This sounds like a complex problem, and it is. And to make it harder, there’s no guaranteed right answer to it. That’s because there are many uncertainties.
The biggest uncertainty is how long you’ll live. A budget based on living for 30 years after retirement may well fail if you live any longer. You might remove the uncertainty by buying an annuity to cover all your expenses. But in that case your budget will need to be very modest, and you may not be able to leave a legacy.
Then there’s the uncertainty of investment returns. You might eliminate most of this uncertainty by choosing very low risk investments. But in that case your investment returns will most likely be very low, as will your budget.
Inflation is another uncertainty. Maybe your budget will fail to keep pace with increasing prices. But predicting inflation is an uncertain science.
The right balance
It’s only natural to adapt your standard of living to your income. But it’s less natural to adapt it to your long-term financial situation. That’s because understanding your long-term financial situation is difficult. To adapt sensibly you need to understand your attitudes and motivations. You also need to take into account how all the present and future uncertainties interact. Ideally you should get professional and independent financial advice; and certainly before making important investment decisions.
As the first step to understanding your financial future there’s no better place to start than EvolveMyRetirement®. This intelligent app will give you an unbiased steer towards what discretionary spending you can afford now and in the future. It bases this on a unique analysis of your current financial position. From this it creates a strategy that’s optimised to achieve your goals.