Te Ara Ahunga Ora Retirement Commission recently released its latest survey into the financial capability of New Zealanders.
One of the key findings of the research is that a person’s overall financial wellbeing is not just determined by their financial knowledge. Their behaviour and psychology are also very important – even more so than how much they earn, their ethnicity or their gender. Knowledge is of little benefit unless we put it into practice. Most of us know which foods are healthy to eat and which aren’t, yet we still eat unhealthy food. It’s the same with money. In particular, while we know it is important to have a budget and to save money, in practice, only 1 in 4 people stick to their budgets. While most people aspire to being able to save and try to do so, they just can’t make it happen.
There are a number of good reasons why. To start with, budgets require a lot of time and effort to put together, especially if they are detailed. Next comes the difficulty of tracking actual income and expenditure against the budget and this requires either a very large spreadsheet and a lot of data entry, or software that takes bank account transactions and sorts them by budget category. All this is very time consuming.
Perhaps the biggest problem with budgets is they don’t change behaviour. They are usually constructed using previous patterns of expenditure as the starting point, so these patterns become entrenched. There is often very little correlation between budgets and goals. The approach is ‘bottom up’ with the focus on making sure the expense items, when added together, come to a sum that is less than income, rather than a ‘top down’ approach beginning with long term goals. The incentive to change short term behaviour in order to achieve long term goals is therefore lost or diminished.
Budgets are mostly about managing expenses, however it is managing the flow of income that is of prime importance.
There are only three things you can do with income. You can spend it now, you can spend it a bit later, or you can spend it a lot later; unless of course, you want to leave it behind at the end of your life for someone else to spend!
A money management system, which is not the same as a budget, starts by allocating the flow of income into each of these three categories. Money management is a ‘top down’ process that starts with a long term view of how you want your income to work for you. The key to successful money management is to direct the flow of income as soon it is received. For most people, that is on payday.
- making a choice about where to keep the three categories of money (spend now, spend a bit later, spend a lot later)
- deciding how much to put into each category
- setting up an automatic transfer of the income.
In general, money to be spent now will go into transactional bank accounts, money to spent a bit later (for example, emergency funds or money for short term goals such as holidays or home improvements) will go into a high interest savings account, and money to be spent a lot later will go into KiwiSaver or an investment fund aimed at achieving long term goals. The decision on how much to put into each category is a very personal one which depends on your current financial situation, your goals, and your preferences for when money is spent.
Having made choices at this level, the next challenge is to deal with the flow of money to be spent now, which needs to be broken down further. Daily living expenses fall into three categories
- Expenses you are committed to (for example, rent, mortgage payments, insurance premiums),
- Expenses which are completely discretionary (for example, entertainment or gifts)
- Expenses which are essential but over which you have some control of how much you spend (for example, food and transport).
Financial commitments are usually a known amount and easy to quantify. After deducting these from the amount set aside to spend now, it is simply a matter of deciding how much to put into each of the other two categories. Again, that is a personal choice.
For the money management system to work, each of these three categories of daily living expenses needs to be managed in a separate bank account, one of which will be the main account into which income is paid. Funds should be transferred from the main account into the two other accounts each payday.
Ideally, financial commitments should be paid by direct debit or automatic payment. Because they are known amounts, it is easy to set aside sufficient funds to cover them, and with the payment systems in place, they will take care of themselves with only the occasional review when the payments change due to price increases. It is important that this account does not have EFTPOS access so as to ensure funds are always available for bill payments. The remaining two accounts, covering discretionary expenses and essential expenses should be accessible by EFTPOS. Within a relationship, the essential expenses account can be joint and each partner should have their own discretionary expenses account.
Managing your money in this way will help you stop living from payday to payday and ensure you make proactive choices about how you want your money to work for you in the long term.