How Do You Calculate Household Cash Flow: Expenses are Critical
Key takeaways:
1. Understanding net household cash flow, which includes income and expenses, is crucial for financial planning and investment advising.
2. The ability to save significantly affects investment strategies; higher savings allow for more aggressive investments, while lower savings necessitate lower-risk investments.
3. Life events and personal circumstances, such as divorce or sudden financial responsibilities, can drastically impact one’s financial stability and investment options.
4. Investment advisors need to have a comprehensive understanding of their clients’ financial situations, including a detailed cash flow report, to tailor the investment risk level appropriately.
5. Regular updates and communication between clients and advisors are essential to adjust financial plans and investment strategies as clients’ situations evolve over time.
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How Do You Calculate Household Cash Flow: Expenses are Critical – Transcript
Welcome back to the podcast. This is episode number 476. I am your host, Tom Mullooly.
We tell our new clients that we need to know your net household cash flow, which has two parts: income and expenses. We need to know what kind of income you’re bringing into your household.
More importantly, in many ways, we need to know what your expenses look like, and I will share two “fictitious” examples. I say fictitious because we’re not going to use names, but these are real-life examples.
Couple number one makes $300,000 dollars a year combined. They are a married couple.
Couple number two, also married, makes $300,000 dollars as well, combined. Both have good household cash flow.
Now, I’m going to simplify some numbers just to make the example clear, but let’s say both couples, couple number one and couple number two, both net after taxes about $200,000 dollars a year. This is after paying federal taxes, state taxes, benefits, any medical costs, and their 401(k) contributions.
So, they’re both bringing home, we’ll just ballpark it, at $200,000 dollars a year. I know they bring home less in both situations.
Regardless, still good household cash flow.
But to make the story work, we’ll keep this number at about sixteen thousand dollars.
They’re both bringing home, let’s just say, a little over sixteen thousand dollars a month.
Couple number one has monthly expenses of $11,000 dollars. They try their best to trim their expenses and keep their costs down, but their monthly expenses are just around $11,000 dollars a month.
Couple number two brings home the same money, but their monthly expenses are $15,000 dollars a month.
Both couples are saving for retirement. Yes, both of them.
Are both couples paying their taxes on time? Yes.
However, from a financial point of view, these couples couldn’t be more different.
Couple number one is able to save an additional almost $5,500 dollars every single month. That adds up over a year to be around $65,000 dollars a year that they’re just funneling away into the bank or into different investments.
Couple number two, netting a little over sixteen thousand a month after taxes, with expenses of fifteen thousand dollars, can still save – about $1,000 dollars a month or about $12,000 dollars a year.
So, from our perspective as the planner and investment advisor, the investment picture for these couples looks vastly different.
The reason why is, well, I’ll just throw some numbers out.
If you want to replace the bathroom, if you need to – or want to, the opening bid starts around $25,000 for a new bathroom in New Jersey. If you want to replace the furnace and air conditioner in your home, depending on the size, it could start at $10,000 and escalate pretty quickly.
You want to pay for college? Well, we could do a whole another series of podcasts on that.
So couple number one and couple number two make the same income.
They both have different expenses per month.
They both have different rates of savings per month.
However, I will tell you that the investments that couple number one owns are vastly different from what you’re going to see in couple number two’s account.
Couple number two has to own different investments because they need to take less risk. The reason for that is because they may need this money in the short term.
It’s very possible that couple number two could call us up and say, “we had a pipe break over our bathroom. We need to replace everything in the bathroom, and we’re going to need twenty-five thousand dollars.”
That represents two years of savings.
We’re not judging them. We’re not making any kind of statement about them. That is fine. They take vacations, they do what they want, they own a beautiful home here in Monmouth County. This is the life that they have chosen, and that’s fine. We’re not judging them.
But we want to make sure that their investments are in lower-risk, lower-volatility types of investments. Because we don’t want to be in a situation where we need to sell something for them to raise money and the markets are down, and they’re going to lose money on that.
Likewise, we also don’t want to be in a forced position where we have to sell, and that’ll trigger some capital gains taxes.
So, keep in mind when we’re talking about capital gains taxes, most people directly assume that we’re talking about long-term capital gains where you may be taxed at, in some cases, zero percent. But in many cases, fifteen percent, and in some cases, twenty percent. This may be less than your ordinary income, your marginal or your effective rate.
But if you are just socking money away, and then you suddenly need to reverse course and take it out, you’re probably going to have (if you have a gain at all), a short-term capital gain, which is taxed as if you earned that – at ordinary income tax rates.
Again, we don’t judge people on their income or their expenses. But we need to have a handle on what their expenses look like so that we can better allocate their investment dollars.
Now, I want to tell you a true story of a client that I worked with who was divorced in 1994. She was my client back then. This woman never worked. She had side jobs and things. Her husband was the breadwinner. They got divorced, now thirty years ago, in 1994. Her settlement included some cash, but the main asset that she received in the divorce was a retirement account that was worth a little more than $250,000 dollars.
So when I sat down with her in 1994, she was traumatized. This was going to be a whole new life for her that she really wasn’t expecting. And I told her “we need to get this money in this retirement account invested so that you can live off of this in the future.”
And she was like, “absolutely not. I can’t do that.” She was terrified at the idea of putting money to work. She was 53 years old at the time. She had said to me on several occasions through that year and the next year, “This is all I’ve got. I can’t afford to lose it.”
Maybe you know someone that’s in a situation like this — where they’ve suddenly been thrust into a new phase of their life and they’re paralyzed. They can’t make decisions. They can’t see what the future is going to look like because they think their whole world has changed.
The best this account got invested was about ten percent of the money got invested for the long term. Ninety percent of this money sat in treasury bills, short-term bond funds, CDs, basically earning nothing more than the current rate of inflation. There really wasn’t much in terms of earnings.
So that was in 1994. Fast forward fifteen years to 2010.
This woman has really struggled to make ends meet. At some point along the way, she moved in with her daughter and son-in-law and their family. Her life completely changed. She said that she “was poor.” She felt poor. She “had no money,” she said, so she pinched pennies.
She stayed home, sat on the couch. It was sad to see, and her health started going downhill pretty quickly.
But she still had money sitting in that retirement account, which wasn’t really growing or doing what it could be doing.
And now she’s turning seventy years old. She starts to withdraw large chunks from this retirement account. And she starts to see the balance in the account going down pretty rapidly. At one point, she was pulling out about five thousand dollars a month.
You do the math. She’s got two hundred and fifty thousand dollars, and she’s taking five grand a month out. She’s getting taxes withheld, but she is now at the point where one year of withdrawals at five grand a month, is sixty thousand dollars.
You can see the money isn’t going to last very long.
So she is starting to drain huge chunks from this IRA on a monthly basis. And it’s only then, when she can start to see the finish line, in the sense that she’s really starting to run out of money. She goes from a terrified fifty-three-year-old where “this is all I’ve got, I can’t afford to lose it,” to now asking, “Do you think we can do something with this money? Can we invest a portion of it to grow this account? I’m going to run out of money very soon if I don’t do something.”
There really wasn’t anything we could do. It was absolutely the wrong time to get invested at that stage of the game, because she was in the drawdown phase. It’s a situation where she should have invested years back in the 1990s.
It was just far too late for her when she finally came around to understanding what I had been trying to tell her.
Now, should she have gone all in, into stocks in 1994? Probably not.
I think that would be too drastic of a shift for her. And the volatility, even in the 90s, would have been very hard to stomach.
But she held zero percent in things that can grow. She had very little exposure to stocks and to the market.
So maybe something in between, maybe a fifty percent allocation, would have made the situation a little better. The money could have lasted a little longer. It’s too bad when you look back over a thirty-year window to see what could have been done.
But this is what shapes our process today at Mullooly Asset Management.
We had a couple in to meet with us recently. It was early in the first quarter of this year, 2024. We told this couple that we need to start with the basics. We want to build a balance sheet for them and put together a net household cash flow report that shows their income and their expenses.
The couple, both of them in the finance industry, were astonished when we told them what our process was. The actual quote that we heard was, “Why do you need to know that for? What do you need to know our expenses for? No one else has ever asked us for this information like our household cash flow.”
Take our word for it. It’s not to pry. It’s really to get a good understanding of where you’re at; so that we can take the proper amount of risk for your situation. I still think there’s this overhanging belief that people are going to work with an advisor and they’re going to have outsized returns.
But they don’t realize that will usually come with outsized risk that needs to come with it.
We want to right-size the amount of risk that we’re taking for each person’s situation.
There’s also… and this came up in the conversation as well… when I was a stockbroker, there was a New York Stock Exchange rule called Rule 405, which is “know your client.” And this is a very good policy to have as you’re getting started with a new client.
If you’re working with a fiduciary, it’s imperative that they know your situation. That they know what’s going on in your life, not just the numbers in your brokerage account, but also what this money is for. And how this can be used to support your lifestyle.
And if you’re working with a fiduciary, you should want them to know as much as possible about your situation.
So I’m still (personally) stunned when people come in to meet with us for the first time, we tell them that we want to build a balance sheet and a net household cash flow report for them. And then we want to project that into the future with inflation to try and right-size the amount of risk that we should be taking. I’m still stunned when people tell us that “no one else in our industry is asking for this kind of information.”
Their advisors are required to know this.
I’m kind of surprised that people aren’t asking, or at least asking for the information like household cash flow and updating that as we go forward.
We tell people all the time that when we build a net household cash flow report, this is just “a snapshot in time.” This just tells us where you are in 2024.
Your situation in 2025 could be drastically different, and we want to know about that. Because we will update the numbers and rerun the scenarios to show you what impact that’s going to have on your investments and some of the investment decisions that we’re working on together with you. So this is super important.
And I’m a little surprised that more and more people in our industry just skip over this part. They just want to talk about their different investment ideas and their opportunities. We have to get through some basic stuff first like household cash flow, before we can even start talking about investments.
Sad to say, this was true in the 1980s when I got started in the business.
And it’s still true in 2024. We need to know your situation very well. That’s true for any advisor.
That’s the message for podcast 476. Thanks, as always, for tuning in.
Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.
