I have had a few conversations over this past year regarding extreme frugality, with a few people I know as well as a few in the media. Some examples that I see are inspiring, many are entertaining, and some just way out there and over the top. Some, as I have alluded to, cross the line by taking advantage of others or causing one to lose self-respect. So, there is a spectrum when it comes to extreme frugality, ranging from very good to very bad.

That said, stripping away the inspiration, entertainment, and morality issues related to some of these tactics, a key question remains: Is it worth the time? Is it worth going to extreme measures to save money – even pennies – when it costs time to do so?

This is where it appears many people are not fully thinking through the value of their time. I have certainly fallen into that at times, and I’m guessing we all have at one time or another. Its important to keep in mind the value of our efforts in terms of the precious time we spend on such time saving efforts.

To illustrate, lets take the example of a person with the following hypothetical employment situation:

Wages: $50,000 annual salary

Work Day: Standard 8-hour day.

Days Worked: 250 days per year (factoring in 5-day workweek, plus holidays/vacations)

For this person, his total imputed hourly rate is $25 ($50,000 / (8*250)). Thus, before taxes and other deductions, this person sells time to an employer at a rate of $25 for every hour on the job.

Lets say that this person’s employer came back to him and said that they wanted him to work overtime on a special project. This project would not lead to a better performance review, nor would it provide a leg up for promotion. Additionally, it wouldn’t provide experience that could benefit your career, nor would it impact his job security. All this said, the employer would pay him $5 if he spent an extra hour working on this project each week.

Would this employee, who normally gets paid $25 per hour, jump for joy at the possibility of making $5 more if he works that additional hour on this non-value added special project? I suspect that this employee might evaluate this, and think: “Why should I get paid $20 less – or 20% of my regular pay – to do this? It’s not worth my time!“

Its something to think about as we spend time devising ways to save money.

Is it worth $5 to spend an hour round trip, to shop at a cheaper grocery store?

Is it worth $5 to spend an hour driving to buy that printer that’s cheaper at the store which is a 20 mile drive from here?

Is it worth $5 to use that coupon to buy a new pillow at the store in the next town over, when I could spend just buy it at the store right around the corner?

Is it worth $5 to hunt for bargains online for an hour, when I could just go to the site I know and buy my product in a matter of minutes at the price offered?

When you frame these “savings” in terms of opportunity cost such as in these examples, it provides another perspective on frugality: Sometimes its just not worth our time to focus excessively on extreme frugality. Perhaps it’s often better to spend that extra time on improving one’s capacity to earn?

Back to the topic. Of course, I’m presenting this as a purely dollars and cents argument here. Sometimes people feel great pride in finding a bargain, and take on frugality as hobby – the thrill of the chase. In that way, if it works for someone, so be it:) Its also understandable that if frugality becomes a habit – a way of life – then this mindset can provide benefits in other decision scenarios.

I’m all for sensible frugality. It’s a great practice! That said, on an individual case-by-case basis, its worth thinking about the value of time when trying to save money. Every little bit helps, but if it costs us all of our time, it makes sense to re-evaluate that investment of time. Because while money can always be made, new time can’t be made!

Note: I originally posted this piece very soon after Squirrelers was launched. Given the blog’s increased readership, I wanted to revise the post a bit and revist this topic to get everyone’s thoughts

There are many ways that we measure wealth, and many ways that we can fund our retirement through our wealth.

One way to measure to determine where we are in terms of our savings is to look at months of covered expenses. For example, if a couple had $600,000 in net worth (assets minus liabilities), and $4,000 in monthly expenses, then they are 150 months wealthy in terms of savings.

Covered expenses is a simple, practical way for many of us to assess where we are financially. I’m a big fan of this personal finance diagnostic tool. It tells us how long we can live on what we have saved. Most of us are not multi-millionaires who can live off interest income and not touch our principal. Some folks reading this might be in that position, but if the rest of us stopped working, we would have to use our savings. This approach tells us how long our savings will last.

Stretching our minds and looking at things differently, perhaps we can save money with the intent of accumulating year in, year out, and never spending your savings. Keep on saving it, even when your months of covered expenses exceed your estimated remaining lifespan.

Why? Well, not touching savings is not just letting money sit there. Rather, it’s repurposing the money to be used as a source of more money.

This is where portfolio income comes into play. Instead of consuming your savings, you preserve your savings and let your money work for you. It becomes your faithful source of your own personal social security check.

Lets say the couple with $600,000 wants to live off an income stream without touching the principal. One could look at the required rate of return to see how how hard this money needs to work in order to satisfy their expense needs.

Taking a conservative view of returns, however, one could try to backsolve for the required nest egg size they would need to accumulate in order to live on their income stream.

For example, if the couple wanted to live on $4,000 monthly – $48,000 annually – they would have to amass quite a nest egg. If you took $48,000 and assumed a 3% rate of return to match inflation, it would take a next egg of $1.6 million for them to live on that $4,000. If they reduced their expense needs to $3,000 per month, it would take a nest egg of $1.2 million for them to accomplish the same goal.

This specific example doesn’t factor in the idea that your principal will reduce in purchasing power every year due to inflation. Remember that a dollar today is worth more than a dollar tomorrow. That said, portfolio income is cash flow that you can rely on without directly touching the principal. The good thing is, if you need that, you can eventually tap that as well. It’s another layer of conservatism is making sure you have enough to live on.

Ultimately, my take is that by working toward portfolio income, while trying to leave the principal intact as much as possible, you’re taking a big step toward financial freedom.

You will have worked hard to save and grow your money. Allow it to reciprocate and work hard for you in return!

Any thoughts? Do you look at retirement savings in terms of income streams, or in terms of a lump sum to tap into?

One note: I am personally a long, long way from retirement. Not going to stop me from dreaming big though:)

This article was included in Carnival of Personal Finance #264 at My Journey to Millions

Have you saved enough for retirement, and your future financial needs?

As much as I would like to say that I have done so, I’m a long way from that point. In fact, I’m not even remotely close. I’m actively working on it though, day by day, focusing on growing the income minus expense gap. I’m guessing that if you’re reading this, then you’re probably somewhere on that same journey as well. 

Since we know that we aren’t there yet, just how close are we to actually being able to retire? What is health of our portfolio, and how do we measure that? 

One could take the traditional approach, and focus on net worth, calculated as assets minus liabilities. I have advocated taking this a step further by calculating months of covered expenses, to determine just how long you can survive based on your current net worth and expense needs. 

I often look for different ways to answer such questions, with the hopes that some additional insights could be gained by viewing a situation through a different lens. In this case, determining where we are with respect to being able to retire, I suggest that we also consider our current required rate of return.

So, what is the current required rate of return? 

In essence, it is the rate of return that we will need to earn, in order to survive with our current nest egg. 

Let’s assume a couple with the following financial profile: 

Assets: $800,000

Liabilities: $200,000

Monthly Expenses: $4,000 

Further, let’s assume the following additional information:

Tax Rate: 25%

Rate of inflation: 3% 

To calculate their required rate of return, let’s first subtract liabilities from assets to obtain net worth: 

Net Worth = $800,000 – $200,000 = $600,000 

Then, let’s annualize their expenses: 

Annualized Expenses = $4,000 x 12 = $48,000 

Next, calculate percentage return on net worth:

$48,000 / $600,000 = 8.0% 

So, this means that the couple needs to earn 8.0% on their nest egg to meet their expenses. Or so it seems. 

The 8.0% figure is an interim step. There are two more factors that need to incorporated:

1)      Inflation

2)      Taxes

 To account for these factors, let’s take these steps: 

1)      Rate of return adjusted for inflation = 8.0% + 3.0% = 11.0%

2)      Adjusted rate of return, pre-tax = 11.0% / (1-.25) = 14.67%. 

Thus, on a pre-tax basis, the couple’s portfolio must return 14.67% annually in order to meet their annual expenses. 

Here’s the formula:

1)      Return on net worth = annual expenses / net worth

2)      Required return = (return on net worth + inflation) / (1 – Tax Rate)

What insights can we get from this calculation? 

1)      The ability of the nest egg to meet income needs. In this case, when you see a required rate of return at 14.67%, it tells you that you likely don’t have enough saved!

2)      Direction on reallocating our investment mix. In this case, with this type of required return, one might want to consider a mix of assets that is more likely to obtain a higher return. With higher potential return comes higher risk. And closer to retirement age, that might not be such a good thing. But it’s something to consider.

3)      Information on how we can improve our balance sheet and cash flows. Taking this formula, we can make changes to net worth and expenses to see how increasing/decreasing these measures can help us meet our goals. For example, in this case, reducing expenses to $3,000 per month and boosting assets by $200,000 changes the required rate of return to 10.00%.

It’s interesting to view the health of our portfolio using different calculations. What I like about this one is that it incorporates taxes and inflation, which many more basic views don’t.

Any thoughts? Do you have any other measures for assessing the ability of a portfolio to meet future cash flow needs?

This article was included in Carnival of Personal Finance #260 at Rainy Day Saver.