Budgeting isn’t just for retirees: Tips for young professionals

One of the hardest parts about being a financial planner is convincing people to do things they’d rather ignore. When times are good, it’s easy for people to avoid putting strategies in place that create some short-term work and discomfort, even if it provides long-term benefits and financial security.

Changes in the economy and job market mean that young professionals earn about 20% less* than their baby boomer parents did at the same stage in life, despite having higher education levels. They can also expect far less of a retirement cushion than their parents got, with the uncertainty surrounding the future of social security and company pension plans largely a thing of the past.

Add in student debt, rising healthcare costs, and the difficulty of getting on the homeownership ladder, and it’s easy to see why many who are under 40 feel overwhelmed and helpless when it comes to saving for retirement. Some 62% of young professionals say they’re living paycheck to paycheck, according to a 2019 survey by Charles Schwab.

The good news is that there’s a simple, highly effective way for young adults to get a grip on the situation and take back control of their finances. Unfortunately, it’s also quite dull, making it a hard sell to a generation that’s very busy and wants to enjoy life to the fullest extent. 

The solution: Budgeting

Making a budget taps into a powerful aspect of human nature that we all know — that writing down your goals makes them more likely to happen. It also reveals insights into self-destructive spending habits that would otherwise go unnoticed.

This is an effective tool for people of all ages, but it’s particularly essential for young professionals because of their spending habits and the length of time they have to accumulate savings.

It’s no secret that younger individuals have a greater affinity for eating out and traveling than their parents’ generation, especially with today’s easy access to travel startups and food delivery services. That same Charles Schwab survey showing that younger people live paycheck to paycheck also found that they spend an average of $478 a month on nonessential items, like dining out, entertainment, and vacations. Baby boomers only spent $359 on those items.

Even small spending cuts can have a big impact on savings over time. Switching from that $100 per month gym to the $10 per month gym can create more than $1,000 in annual savings and your muscles won’t know the difference!

Time is on your side

There’s clearly room for some belt-tightening. Budgeting enables young professionals to pinpoint where to do that and funnel cash toward the essential goals of building up a three- to six-month emergency reserve, as well as contributing to investment accounts like 401(k)s and Roth IRAs.

Those investments create wealth over decades through the power of compounding, and the younger you start saving, the better. Starting a regular investment habit early in life is particularly crucial because, in addition to their other disadvantages, younger people are facing the prospect of lower market returns. A 100% equity portfolio, represented by the S&P 500, has returned an average of 10.3% from 1926–2020. The same portfolio is expected to earn slightly less than 7% on average over the next 10 years, according to Callan LLC and Dimensional Fund advisors.

Having enough cash to make it through at least six months allows young people to feel a much higher level of comfort at a time of job and pay cuts, furloughs, and a generally uncertain outlook. It also avoids the need to dip into investment portfolios during a down market or, worse, take costly early withdrawals from pretax retirement funds.

Beyond security, extra cash also holds possibilities

That much is fairly obvious. Less well understood is how a healthy cash reserve also provides opportunities to gain during volatile times. Clients with significant cash on hand are generally hesitant about deploying their cash all at once into the current market. As a result, we have helped them develop dollar-cost averaging strategies over 6–18 months to reduce their vulnerability to an immediate market downturn and potentially take advantage of lower market entry points.

The advantage of having cash reserves is about peace of mind and the flexibility to invest in a way that takes advantage of opportunities in line with your risk tolerance. Having cash on hand gives an additional element of malleability to build strategies around dollar-cost averaging, asset allocation, and risk exposure.

Keep everything in perspective

Anything that encourages stricter budgeting and more investment opportunity is positive in my view, but people also need to be realistic about how much they need to retire. It all comes down to spending habits.

I’ve had conversations about “running out of money” and budgeting with clients who have over $20 million in investment assets, and I have many clients who can live comfortably for the rest of their lives on well under $1 million. Spending is the most important variable, and that’s why it’s hard to have a rule of thumb for how much in investments the average person needs to retire.

None of this is to gloss over the very real financial challenges that younger people are facing. But disciplined budgeting and smart investing are simple ways for them to regain control and build the freedom they want both today and in retirement.