Pay yourself second

Question: My family and I try so hard to follow what financial planners preach and that is to budget savings before budgeting expenses. But time and time again, we end up with no savings. Is there something we are missing out on?—asked at “ask a friend, ask Efren” service at www.personalfinance.ph

Answer: First, let’s review the mantra of “paying yourself first” backwards and from the point of view of stockholders.

Stockholders can be paid cash dividends. Cash dividends need to be paid only out of the unrestricted earnings of a corporation.

Why would a company put restrictions on its earnings in the first place? It would do so only if it believes that earnings can be reinvested in its operations to further grow earnings in the future. Put another way, if a company sees no better use for its earnings, it would be best to just distribute them as cash dividends to shareholders.

Having a sizeable hoard of cash alone does not justify paying out cash dividends. A company that has collected a lot of receivables, sold huge inventories on cash basis or even borrowed from creditors and suppliers would for the moment have cash. But such cash may also be needed for the company’s operations. Again, the better measure would be unrestricted earnings.

Stockholders can use the dividends in any way that their heart desires. Similarly, a household, when treated as an enterprise, can pay out its earnings in the form of cash dividends to its members for discretionary spending.

However, such cash dividends can only be paid if the household cannot find a reason to reinvest the earnings for future growth. This is where the mantra of “paying yourself first” comes from, with the word “yourself” referring to your household treated as an enterprise.

But how can an enterprise generate earnings in the first place?

An enterprise always attempts to increase shareholder value by targeting ever growing levels of net earnings. Higher net earnings mean higher return on equity, high stock price and higher potential for cash dividends.

To get to the desired level of net earnings, an enterprise must first determine the optimum level of expenses, both variable and fixed to offset against the target level of revenues. This is called target costing.

Target costing is helpful if an enterprise operates in an industry where competition makes for little wiggle room in terms of pricing. The enterprise therefore just targets the maximum level of sales at the optimum level of costs to generate earnings.

A household where the breadwinners are employees normally cannot dictate what their salaries and wages would be. That is why for a household to have earnings, it will just have to operate within an optimal cost level. Now this is where the controversy lies.

Abraham Maslow did not say that people progress to the different levels of the hierarchy of needs in sequential fashion. In fact, the premise is that people could experience two or more levels of such needs at the same time, with one being in focus. This fact of human behavior muddles the issue of what should comprise the household’s target cost level.

Who is to say that the breadwinners should commute rather than take the family car to work? Is there a local ordinance on using the TV for a maximum of eight hours a day? What rule in economics dictates that the family should not eat out every weekend even if it be just a simple meal at a fast food chain? Where do you draw the line between buying children a great toy vs a good education?

These questions are best answered by objectively looking at the monetary equivalent of goals against what the household can afford as well as the risks it is willing to take. What risks? A household that cannot dictate the level of its salaries and wages will need to invest its earnings to supplement its revenues. The higher the targeted potential investment returns, the higher the risk that needs to be taken.

Only a household operating at an objective target cost level will allow it to have earnings. And only the unrestricted portion of such earnings can be paid out to the household members for discretionary spending. The restricted earnings need to be invested to afford future goals. In essence, before you can even pay yourself first, your household will have to operate at its objective target cost level. I leave it up to you to determine that cost level.

Thus, pay yourself second.

To know more about personal finance, visit www.personalfinance.ph. There is a wealth of free tools to allow you to hit the ground running with financial planning, whether you are a financial products consumer or a financial planner. You may also want to attend our Baguio EnRich™ cash, debt, risk and wealth management training run on Jan. 3, 2015. Details can also be found in www.personalfinance.ph.

(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, seasoned investment adviser and author. Questions may be sent by SMS to 09175050709 or e-mail to [email protected]. To learn more about the RFP program, attend a free orientation on Dec. 11, 7 p.m. at the PSE Center. E-mail [email protected] or text <name><e-mail><RFP> at 09173464126 to register).