Considering the dramatic financial impact of institutional and governmental decisions in the past few years (such as the sub-prime mortgage bubble, financial bailouts, and Federal Reserve monetary policies), it seems a bit harsh to say the key to economic recovery is getting American households to clean up their personal finances. But there is also some truth in this perspective; on the whole, American households don’t manage their finances very well.
Between 1951 and 1992 U.S. household savings rates as a percent of disposable income were consistently between 7% and 11%. When income growth slowed in the mid-90s due to global competition and down-sizing, American households maintained their spending habits by increasing debt and decreasing saving. By 2005, the savings rate was below 2%, and personal debt ratios were at an all-time high. Since the recession, there has been some improvement, both in debt reduction and saving. But compared to other countries, U.S. households are underachiever savers.*
The Organization for Economic Co-operation and Development (OECD) is a global think tank sponsored by democratic nations with free-market economies. According to the OECD, the estimated savings rate for the United Statesin 2013 is 4%, which ranks 18th among the 26 countries listed in the report. Yet citizens with greater economic challenges – higher unemployment, lower economic activity, heavier taxation – save significantly more than Americans. The French save 15.8% of disposable income, while Germans save 10.6%. In Spain, where unemployment is approaching 20%, the national savings rate is estimated to be 13.6%! Belgians have a higher tax burden, yet save 9.5%. In light of these numbers, you can’t lay all the blame for a poor U.S. savings rate on governmental or institutional policies. There’s more to Americans not saving than difficult economic conditions.
Enter the Financial Behaviorists
In simplistic theoretical models of economics, consumers make rational financial decisions based on their self-interest. But in the real world, people make irrational financial decisions based on their frailties and ignorance. This is where financial behaviorists enter the picture.
Financial behaviorists attempt to explain irrational financial behaviors by understanding how our attitudes and habits regarding money influence our decisions. From this insight, they develop strategies to make it easier for us to do what is best, or at least avoid mistakes. Behind the scenes, financial behaviorists exert considerable influence in the marketplace, attempting to encourage “paternal libertarianism,” i.e., allowing us to do what we want, but “nudging” us to the “right” decision. Default enrollment in retirement savings plans, automatic deposits, electronic payments, and lifestyle funds all have the imprint of behavioral engineering.
Spurred by a proliferation of free on-line programs and the ability to integrate data from multiple financial institutions, a trending “new idea” from financial behaviorists to encourage saving is…are you ready?...
ESTABLISHING AND MAINTAINING A PERSONAL BUDGET.
Why a budget? (And can you make one?)
The dictionary says a budget is “an itemized summary of estimated or intended expenditures for a given period along with proposals for financing them.” In theory, establishing a budget will help you see the reality of your financial circumstances, understand where your money is going, leading to an “Aha! moment” that motivates you to better decisions.
The concept seems plausible. An April 2013 Gallup survey of households with annual incomes of $75,000 or more found that 39% of respondents “prepare a detailed written or computerized household budget each month that tracks income and expenditures.” The $75,000 income level is a pretty accurate marker for middle class households that typically have the financial resources to save and invest, so 6 of 10 households that could be saving are operating without a monthly budget. Seems like budgeting would be a beneficial activity. Except…
Assembling and maintaining a budget can be a data-heavy, time-intensive activity – the devil is most certainly in the details. That’s why most businesses rely on professional assistance. In theory, technology promises to make similar budgeting assistance affordable for individuals. But no matter how “easy” technology makes the process, financial behaviorists admit some people aren’t going to prepare a monthly report – written or computerized. Their personality type just can’t handle details, even for “important” issues. A budgeting process can’t make people change if it never gets done.
Instead of starting with the daunting task of monthly reports, a little simplification may be in order. John Savage, a well-known late-20th-century financial counselor, distilled budgeting down to a simple two-circle illustration:
Person A added up monthly expenses and saved what was left over. Person B saved a specific amount each month,
then spent what was left over. Savage asked a simple question: Which person will save the most money?
In theory, the pictures represent equal amounts of saving. But people intuitively understand Person B will save more, because saving is declared a financial priority – it happens first. Yet Person A is more likely to be preparing a budget!
Savage’s illustration is financial behaviorism at its finest. In one simple illustration, it clarifies and connects priorities with behavior. If saving is important to you, you will save first and spend the rest – no details required.
Is budgeting really that easy? Maybe.
People who commit to saving first tend to adjust their spending to accommodate their priorities. Any household that works toward consistently saving 15% or more of annual income will almost certainly achieve long-term financial stability. If this minimal budgeting process achieves these results, what else is needed?
There are reasons to consider a full-fledged, detailed budget – at least once. Some households need a detailed budget to find the money to save. For others, a budget can discover inefficiencies and “turbo-charge” existing allocations. As a one-time project instead of an ongoing process, even individuals with an aversion to details should be able to get through the task, especially since making a budget doesn’t have to be a do-it-yourself project; financial professionals who want your business should be available to help you.
In this format, a “budget” need not be comprehensive, just focused on the critical elements of your financial life (saving more, eliminating debt, etc.). If necessary, a select number of important financial accounts can be connected in an on-line financial program to provide simplified updates when needed.
The value of a budget is measured by its results. If two circles work, fine. If it takes a monthly written or computer-generated statement, do it. If you need expert assistance, get it. But the process only works if the priorities are clear: You must be a “save first” household for a budget to improve your financial condition. By extension, American households, particularly those earning more than $75,000, must establish a “save first” priority. After all, U.S. economic growth depends on it.