This article was written by Sara Freitas-Maltaverne, a French to English translator. She specializes in high-quality translating, training and copywriting and works with a team of translators to provide the same service in the major European languages. You can find her blog here. This is part two, of a four part series.
Three Basic Concepts
Before we get into the nuts and bolts of personal finance and retirement planning, there are three basic concepts that should apply regardless of where you live.
1. Pay yourself first. This is the golden rule of personal finance. Whatever your current goals are (building up your emergency fund, saving for a medium-term goal, or growing your retirement nest egg), paying yourself first means setting aside a given percentage of your income and putting it away where you can’t get at it before you even start to budget for other living expenses. The opposite of this is waiting until the end of the month to see what, if anything, is “left over” and then saving (sound familiar?).
Automatic transfers or direct debit from your checking or current account are great tools for achieving the goal of paying yourself first. Of course, as freelancers, we don’t have a weekly/bi-weekly/monthly paycheck like employees do. I used to take money from my business account on a very irregular basis “as needed.” This made it impossible to stick to any kind of a savings plan. Now that my business has been up and running for a few years, I pay myself a regular monthly “salary” based on the previous year’s business income. Because my income has gone up steadily, this has two benefits. I have a steady “salary” to facilitate budgeting and savings and, if my income is higher than last year, I end up with a “surplus” at the end of the year that goes to my emergency fund, medium-term savings, or retirement savings. Estimating how much your “salary” should be will depend on the tax and social welfare systems in your country. In France, contributions to social welfare programs are high, as are income taxes. I base my monthly “salary” on 50% of the previous year’s total income divided by 12. This leaves me with more than enough to pay my social contributions and income tax. If your income drops from one year to the next…well, that’s what your emergency fund is for (see below)!
2. The magic of compounding. For the mathematically inclined, this is rate of return x time. For the rest of us, the earlier you start saving, the longer your money-and the returns on your money-will work for you (rather than you working to save money). If you are under 30, this is excellent news (even if you feel that you are too “broke” to start saving). Here’s a good example of compounding from the Morningstar Investing Classroom:
When compounding, the earlier you start, the better off you’ll be. Let’s consider the case of two investors, Joe and Sam. Say that Joe put $1,000 into the market at age 25 and earned a 10% after tax return. Sam also put in $1,000 and earned the same return, but waited until he was 35 to do so. When both were nearing retirement at age 60, Joe ended up with $28,102, while Sam only has $10,834 from his investment.
For a fun illustrated (Flash) example of compounding, visit Vanguard’s Investor Education Center.
3. People first, then money, then things. This is Suze Orman’s “First Law of Money” as explained in her book The Courage to Be Rich.
People first. Those things that are created by and kept with love must always come before anything else. Family, friends, your partner, your children, yourself […]
Then money. Can you imagine going to someone’s house and having them proudly show you a room filled with thousands of dollar bills and telling you the history of how all that money came to be? You would be appalled at the vulgarity. At the same time, you would think nothing of it if you were to go to someone’s house and be given a tour of a room they had just redecorated. What did it take to redecorate that room? Money. […] In either case you are being shown a room full of money. The difference in your perception was the value system that you applied-a room full of things is okay, whereas a room full of money is not. That is because you value things more than you value money.
Then things. When your financial priorities are in order, things come last.
If you are feeling overwhelmed by debt or are just disorganized and don’t know where to start, I would recommend reading The Courage to Be Rich as the first step to planning for your future. While the investment advice is geared to US investors, there are a number of universal life lessons in this book that can help anybody to face their financial future more effectively.
If, on the other hand, you feel that you are ready to take the plunge, the following three guidelines are the foundation of any personal financial plan and will help you get started. I will try to keep these guidelines as general as possible, but I encourage budding investors to seek tax and investment advice from qualified professionals in their country to see what options are available locally.
1. Emergency cash reserves. Most financial advisors recommend saving enough to cover six months’ living expenses (rent, food, utilities, etc.). This emergency or “rainy day” fund should be in an account that is risk-free or low-risk, accessible, that charges no penalties for withdrawing funds (such as a money market account or a savings account) but that is ideally separate from your checking or current account (the account you use for your month-to-month living expenses). If you do not have an emergency cash reserve, this should be your first savings priority. It will cover unexpected medical expenses, car repairs, and living expenses if you suddenly lose work or are too sick to work (you might also look into the option of a private insurance policy to cover long absences from work due to illness). Once you have built up your emergency fund, you can get started on the next two savings goals (medium-term savings and retirement savings). Again, pay yourself first. Set a goal for building your emergency fund (aim for 15% to 20% of your income each month), open an account to hold this money for you, and automatically transfer the funds to this new account each month until you reach your goal.
2. Medium-term reserves. This is money you have earmarked for goals such as vacations, a down payment on a home or home renovations, a new car, or a career change. It may be placed in term accounts, CDs, or other low-risk investments that will enable you to withdraw the money when needed (but not before, or at least not without dissuasive penalties). You can work on this while you build your retirement nest egg.
3. Retirement savings. These are long-term savings that you will not withdraw until retirement. Right now, even if you do not know where or how to invest, do not have the time to get started, or are simply afraid to invest, the important thing is to save regularly every month, even if you are just putting the money into a savings account until you can figure out what to do with it (although a savings account is not a good long-term solution as inflation will erode any earnings). Once you do figure out how to invest your savings, investing regularly is important as it will “smooth out” the effects of market fluctuations over time (for instance, it is better to invest $100 per month than $1,200 all at once each year). This is also known as “dollar cost averaging.” In some countries, there are tax considerations to factor in when saving for retirement. See a professional in your country for tax-related investment information. Saving for retirement may be a way to significantly reduce your taxable income. So, by saving, you are doing yourself a favor now that will also pay off in the future (unfortunately this is not the case in France where I live, where such tax breaks are limited!).
Most financial advisors suggest saving 10% to 15% of your income for retirement. This estimate is often geared towards employees and takes into account employer-sponsored pensions and state pensions. For freelance professionals, I am afraid that this is not enough. To secure a comfortable future, 15% to 20% of your income is a good starting point. Remember, pay yourself first and then base your monthly budget on what is left. If you don’t feel that you can live on the remaining 80% to 85% of your income, then it is time to take a look at how you can cut spending or increase your income. Learning to live within your means and within a budget is a whole topic unto itself, and I would encourage you to read Suze Orman for more on how to achieve this.
Now, the 15% to 20% figure can vary depending on a number of factors. I consider this a minimum. The closer you are to retirement, the higher the percentage will be. In order to refine your investment plan, you will have to assess your retirement needs in greater detail and get to know yourself a bit better (your investor profile).