What is your burn rate and is it resilient?
In the start-up world, or the business world in general, one of the critical questions for investors is “what is your burn rate?” This can refer to how much of the cash funding a start-up uses in a year, or how many shares of stock the company is granting to employees per year. Basically, burn rate is the percentage of your cash reserves you are “burning” in a year. What could this possibly have to do with personal finance? A lot.
Burn rate is just as important in your personal finances as it is in corporate or small business finance. Burn rate is basically knowing what your outlays are each year, and some quick division can tell you how long your savings will last you if you need to start tapping it. By example, let’s say you know you spend $30,000 per year, and you have $100,000 in invested assets or savings. Your burn rate is 30%. If you had $350,000 in savings, your burn rate would be 8.5%, which means your “funding” will last 11.5 years.
The first step in getting a handle on your burn rate is measuring your cash outlays for each year. I track all of this information, but I’m always surprised that many of my friends don’t. The key is to simplify your financial accounts so that you have funds going out through two accounts – a checking account and a credit card. Wherever possible, paying on the (rewards) card allows you to track your spending by category on your credit card’s website, and any other payments can be tracked with the checking account.
Then next step is to add up various accounts to determine your liquid assets, or your “funding.” This is pretty simple; just add up all of your accounts – checking, savings, investment, health savings, etc. Now, the simple division: annual cash spending / total assets = burn rate. With this number, you can get a firm understanding of how resilient you are and how much financial security you have. If your burn rate is 20%, you can last 5 years assuming no investment returns. Of course, invested assets earn 3% to 4% in real returns each year on average, so burn rates of 4% should last 30 years or more, and burn rates of 3% should last nearly indefinitely. You can test scenarios at firecalc.com, which simulates burn rates and draw-downs of financial pools over time.
Many people use this concept to determine when they have reached the point where they can retire, with the typical goal being to retire early. This may be your goal, or it may not be. However, I think the most powerful role for tracking your burn rate is to have a strong understanding of how resilient your financial situation is. You don’t need to be completely financial independent (e.g., able to survive without a job for the rest of your life) to gain more autonomy from your financial situation. If your burn rate tells you that you can survive and/or life well for 10 years without a job, that can change the way you approach your relationship with work and money dramatically. You can take more risks, be more choosy, or just make a change in your situation. I describe one way to get to a 6% burn rate in 10 years here.
I think the topic of resiliency bears a bit more discussion. Using the burn rate calculation, we can see that one way to lower your burn rate is to save more and increase your assets. However, the other way is to “lower the numerator” or the actual “burn” part of the burn rate. The reality is that the “burn” is the part that we really have control over. If you want to make your money last longer, you need to spend less. Likewise, if you want to increase your assets, you can either earn more (sometimes easier said than done), or “burn” less. This is why all early retirement websites stress the importance of frugality, because it has dual impact: when working, it allows you to grow your assets more quickly, and when retired it reduces your drawn down.
One part of financial resiliency that I think is important is the flexibility of your burn rate. Some people have very fixed burn rates that would be very hard to lower if catastrophe hits. By example, say you lose your job or want to quit because of a bad situation. How quickly can you cut your cash outlays to make your unemployment benefits and/or savings last longer? If you own a single family house with a big mortgage, two 5-year car payments, high utility bills, and a $100 cell phone bill on a contract; it is very hard to lower your burn rate. However, if you live in an urban apartment, rent cars when you need them, have low utility bills, and a month-to-month pre-paid cell phone; you can cut expenses very quickly. Even if the person in the latter situation spends openly on entertainment, clothing, or travel; those are not fixed costs and can quickly be cut back in a crisis. Further, the person can instantaneously cut back on car travel, and step down to a lower-use cell phone plan like one from airvoice wireless, and within a year can move to a lower cost apartment or even a lower cost neighborhood or city. This is called financial resilience, and the more quickly one can respond to a crisis by cutting back means the longer one can live comfortably and keep options open. They key is in keeping fixed necessity costs like housing, utilities, and transportation flexible.
Understanding your burn rate is really about having a very easy/quick reference for your financial resiliency, and financial resiliency is one way that you can live at a higher plane of existence.