When it comes to long term financial planning, my wife and I don’t really have one. We have some long term goals but we don’t have any dates pegged for those goals (which include starting a family, going back to school, buying a new home, etc.), which is about as useful as having no goals at all. That being said, it was about time we sat down and put pen to paper so we would stop committing the fourth deadly sin of personal finance – failing to plan .
The process for developing this plan has its roots in one of my MBA classes, one about financial management and analyzing new projects. Each of our future goals has a fixed cost and a recurring annual cost. When businesses analyze future investments, they go through very much the same exercise (though our plan is much simpler). For us, we will only need to consider how we’ll find the funds for each “investment” and how the various “investments” affect one another.
Step #1. Rough Draft
The first step in establishing your basic financial plan is to write a rough draft (some drafts are rougher than others). Draw out a timeline from now until you retire starting with this year. If it helps, you can separate them in five year increments starting in 2010 but the idea is you want a timeline to draw your plan on.
Next, write down every major expense you’ll have from now until retirement. Major expense is up to you but for our plan we put major as any expense above $5,000. It was entirely arbitrary, so you can make major be $500+ or $1,000. Mark down the date in which you’ll need those funds on your timeline. Example major expenses include buying a house, moving to a new house, buying a car, buying a new computer, major vacation, having children, paying for their education, subsidizing your parent’s retirement, your own retirement, etc.
Remember that this is a rough draft and not a final draft, so don’t obsess over getting every last detail right.
Step #2. Calculate Saving Needs
Now that you have each expense listed, you’re going to work backwards to establish a plan to help save for those expenses. This puts you in the mindset that you’ll be saving for thing before you buy them, rather than opening a loan or tapping a line of credit. In the case of some purchases, such as a house or car, you’ll be saving for a down-payment rather than the whole purchase. As a base, set the down payment at 20% and use that as the “purchase price.”
How do you work backwards and establish a savings plan for each expense? The easiest way is to use an online calculator, DinkyTown.net has a simple Java savings calculator  you can use to figure out how much you need to save each year on that expense (the calculator does not take into account inflation, but we have in using a conservative 5% figure). Repeat for all your expenses and you’ll have an amount for each year.
I like to use an annual rate of appreciation of 5% for the plan. Some experts will tell you to use 10-11% because that’s the average rate of return of the S&P 500, I think that’s a mistake because 10-11% is far too aggressive for funds you may need in just a few years. I arrived at 5% because I took the average return for US Treasuries (~4%) and the S&P 500 (~11%) and took off a few points for inflation. By including inflation in the rate of appreciation, we won’t have to worry about how $5,000 for a car down payment in 10 years isn’t the same as $5,000 today.
You may wish to exclude the retirement “expense.” For the purposes of your plan, you may want to exclude the cost of retirement and “assume” that your 401(k) and IRA contributions will satisfy that need. Establishing a retirement number is itself a difficult task and that figure could dominate the planning for your other expenses, to the point that you lose the whole point of establishing this plan. Ultimately you will want to revisit retirement separately (since it includes pre-tax and post-tax contributions, adding a wrinkle to the plan) because it’s not something you want to ignore.
Step #3. Adjust Your Plan
Now you how much you’ll need to save each year – is it a realistic number? If you find that your annual savings requirement is more than 50% of your take home pay (this is not your salary, this is how much you get deposited into your account after tax withholding, medical, and other deductions are taken), you will want to adjust your plan.
How do you adjust it? You can adjust your plan by pushing some events further out, such as having children one year later or driving your current car one year longer. You can adjust how much those expenses are by opting to buy a cheaper car or putting down a smaller down payment. And, if all else fails, you might have to scratch an expense.
Whatever you decide to do, this is where the value of the plan truly comes through. By seeing it all in one place, you can make these decisions now, years ahead of time, rather than at the breaking point. Wouldn’t you rather learn today, five years in advance, that you’ll have to drive your car an additional year or two in order to meet all of your obligations and get the car you want. It’s certainly better than when you’re sitting in the showroom floor working numbers with a salesperson.
Also, this plan focuses entirely on the expense side of the equation, one potential “adjustment” is that you add income. Maybe the plan tells you that you need to take on a second job (or a non-working spouse returns to work) to generate a little more cash flow to fund your expenses. Whatever the case may be, adding income is an option and the plan will tell you whether it’s necessary (and how much income you’ll need).
Step #4. Consult With A Friend
Time for a sanity check and a chat with a friend. If you have a spouse or a partner, they should have been part of the planning process from day one so this isn’t what I mean. I recommend that you speak with a third party, be it a friend or financial professional to see if your plan makes sense. It’s more important that the person understands you than it is for them to understand financial planning. This plan will only work if you follow it. Your friend could point out things you’re missing, things you’re being too optimistic or pessimistic about, or things that simply don’t make any sense (maybe you hit the wrong button on the calculator?).
Step #5. Revisit Annually
Now that you’ve gone over the plan, had it sanity checked, it’s time to implement it and revisit it annually (or more). My recommendation for implementation is to put savings for anything in the next five years into a high yield savings account  or laddered into CDs  (something safe) and then the rest into a mix of brokerage accounts based on the time horizon (target retirement funds might be a good option).
The revisiting annually, or more, is something you should do whenever you do your annual financial checkup. Check to see that you’re on track because if you slip a little (save less than you planned) or achieve a little more (save more than you planned), it’s important to integrate that into your plans. If you have any major changes (surprise!), then you’ll want to adjust your plan to cover the new information as well. Setting the plan once and then never looking at it again won’t be terribly helpful, you’ll want to revisit it annually.
Now start saving, a good place to put it is a high yield savings account !