Financial Margin Revisited

In February 2009, I wrote a series of articles about creating financial margin in our life. During the preceding years, the economic and market environment was euphoric and everyone was feeling optimistic about their finances – and extending themselves accordingly with buying decisions and debt.

Fast-forward seven years, and we are beginning to see a similar sense of optimism driven by recent increases in the markets, housing and employment. Based on the number of margin-related discussions I am having one-on-one with clients, I think it is time to revisit the concept of creating financial margin.

Those who created financial margin prior to 2009 were able to weather some pretty incredible financial storms that followed the euphoria, and many were able to radically increase their wealth by having the capacity to invest significant sums of money while others were engaged in panic selling.

The greatest impact on the success of any investment strategy will be how you manage your personal finances in terms of savings, cash flow and debt in the coming year.   – 2/2/2009 Client Letter

In a minute, I’m going to share with you a rule of thumb about financial margin. But every client’s personal finance situation is unique, so it is often difficult to make blanket statements about what you should do with your finances. Attempts to do this usually result in clients responding, “That is a really good idea, but should we still do it even though [insert unique circumstance here]?”

Rules of thumb too often assume everyone has the same thumbprint. I think these few stories will better convey the important big ideas. How you implement the big ideas in your own life will be unique to you, which always makes for a great discussion with your financial planner.

A young couple with room to spare…

I recently received a phone call from a young couple with elementary aged children. They were excited to talk because they now have some excess cash, which they want to begin systematically investing. The husband described their savings account as now being sufficient to cover multiple catastrophes, they were both participating in and maxing-out their employer retirement plans, and they anticipated being completely debt free before the end of this year. They have also been setting aside additional cash for the husband to purchase a business in the coming few years without having to borrow significantly. And even with all of this, they have now found that they have excess cash flow.

Surviving extended unemployment…

Another client that comes to mind hasn’t been as fortunate as the couple above. Their household has always been funded by two salaries, until the husband became unemployed for over a year. Then, within a few months of the husband finding a job, the wife became unemployed. During these successive periods of extended unemployment, the family was able to continue funding their various retirement accounts, did not need to downsize or otherwise sell their home, and was able to continue providing a private education for their teenage children.

Retired and not concerned during a market crash…

One last story is from a retired executive and his wife. In 2009 we were discussing the economic and market downturn, and the noticeable effect it had on some of their investments and income sources. Our conversation covered everything from the history of the credit crisis to the current actions being taken in Washington, D.C., investment strategies, medical updates, and a healthy dose of laughter. Missing from our conversation was any hint of concern on their part about having enough income for their needs, paying for the expenses of a second home, or other fears that are common for retirees during a market collapse.

These three families, each with a very unique set of personal circumstances, have one very important thing in common — margin. Room around the edges of their financial lives.

When I prepare a document on letter-size paper, I generally set up a one-inch margin on all sides of the paper. Even though this margin doesn’t look very large, in reality I am only using about 63% of the available space on the page – the rest is margin. This margin leaves me with plenty of room to take notes, make changes in the main document, write a handwritten message to the recipient, or for my children to draw a picture. Without this margin, the document would be cluttered and overwhelming.

It surprises me that such a visually modest margin results in using only 63% of the available space on the paper – the margin is 37%. The implication for financial margin is that a margin of 35% to 40%, which seems far too big in percentage terms, actually looks quite reasonable since it only affects the edges of our life. But it has a huge impact on how cluttered and stressful, or how organized and flexible our life is.

Here is how I would propose calculating your own financial margin:  Savings and Discretionary Expenses divided by Net Income After Taxes. You’re looking for a result that is at least 35% or higher.

The formula looks like this…

financial margin formula

Net income after taxes is pretty simple. Just take your total annual income and subtract the federal, state, local and employment (Social Security and Medicare) taxes you paid. Other taxes, such as property and sales taxes, are ignored since they are part of expenses and not tied to your income level.

Determining savings is also simple and usually limited to retirement plan contributions, education plans, and other long-term savings. Savings does not include money that is temporarily set aside but later spent.

Discretionary expenses are more difficult and subjective, with some gray areas. An easy test is to ask if a given expense can be stopped quickly (within 30 days), then not resumed for an extended period of time, and doing so wouldn’t cause you undue stress…these would be discretionary.

If you started shaking at the mere sight of a math formula, just let me know and my office can discuss the components with you and calculate your financial margin. You’ll need to have already begun tracking your finances to figure out your margin.

I am aware that targeting 35% to 40% financial margin may seem ridiculous to some. But keep in mind that we are only talking about a one-inch border around the edges of the page. I am also aware of the difficulty of creating this margin from a life that currently has zero margins – but it is worth it. I have reviewed the finances of well over a thousand families in the last seventeen years. Many of them have this kind of margin and are successfully building sustainable wealth, while others are feeling the personal and relational stresses that occur when margins are too narrow or nonexistent.

Not everyone has the option of creating financial margin – there are plenty of families that struggle just to provide food and shelter, and living with margin is not possible. But those of us that do have the option, and take it, will benefit during periods of economic growth, and during economic downturns.