Replacement Cost Budgeting

By Henry K. (Bud) Hebeler

10-29-04

 

Everyone should have some savings set aside for unforeseen emergencies. However, few people think about setting aside a reserve for long-range things that they could foresee if they looked. The fact is that things wear out or become obsolete.

Replacing worn out or obsolete items can be painful for anyone, especially retirees. Unfortunately, conventional retirement planning programs donít provide much help with expenses that are irregular or may occur at uncertain times. The best way to cope with these is to set aside a reserve for replacements and budget an annual wear-and-tear contribution to that reserve. Then you will have the cash in your savings to buy large value items outright instead of having to borrow. With the possible exception of real estate, retirees should never buy anything on credit.

In order to do this, you need to make an estimate of the number of years the expensive things around your home will last. When the time comes to replace something, its cost and your trade-in value will be somewhat different than your assumptionsóas will the amount of time it lasted. However, in the long-run, youíll be much better off than all of those people who donít understand how to do replacement cost budgeting. Youíll be paying yourself the interest instead of paying someone else the interest! The difference is huge.

If you are able to invest the money you would save for replacement items at a return that keeps up with inflation, itís easy to calculate how much you need to save each year and how big your reserves should be at this time. For example, consider that you expect to replace your automobile every six years, and that you would have to pay $24,000 (in todayís dollar values) after trading in your old vehicle. This means that the vehicle capital cost (not its operating costs) will be $24,000 divided by six years, or $4,000 a year for a wear-and-tear contribution to your reserve. Every year you would make a new calculation and make a new deposit.

The total of the annual wear-and-tear contribution can be alarming, but probably not as much as what the size of your replacement reserve should be today. Suppose that your automobile is four years old. That means your reserve should already be 4 x $4,000 = $16,000. Very young people consider this kind of computation to be absurd. By the time they add up all of the items requiring existing reserves, they have nothing left in their savings for anything else, much less retirement. If you are a retiree in this situation, you are already in real financial trouble, because the replacement reserve cannot be used as the part of your investments that will contribute to your normal living expenses.

Items you should consider for replacement cost budgeting are things like your automobile, roof, furnace, water heater, carpets, furniture, exterior painting, interior painting, drapes, and electronics like computers, large screen TVs, etc. If you belong to a home ownerís association that doesnít have a replacement reserve and an annual budget for wear-and-tear savings, you will very likely have large assessments in the future. Youíll have to include your share of this omission as part of your own reserves because those assessments will be inevitable. Competent home owners associations have very detailed replacement cost analysis and significant reserves.

It is a good idea to keep replacement reserves in a separate account that is liquid, not something like a stock fund or real estate which might be difficult to get as much as you want when you need it. Alternatively, this account can be a theoretical part of the rest of your liquid investments as long as you remember to subtract this theoretical amount from the investments used to determine how much you can otherwise spend for normal retirement expenses. In addition, your normal retirement expenses budget should include the wear-and-tear contribution even though you may not spend any of it in this coming year. When the time does come to replace an item, the larger part of it will come from the reserve.

See the Free Programs in www.analyzenow.com for computer assisted help with this subject. Even if you donít use the programs, itís likely that the table formats will be useful.

RETURN