If you have ever run a businesses or worked in corporate finance, you are likely familiar with the concept of zero-based budgeting (ZBB) as an alternative to traditional budgeting.  The traditional form of budgeting – and the one most commonly used in corporate America – uses the amount spent last year in each category (or maybe the last 2-3 years) as the foundation for next year’s budget.  It is then determined whether next year’s budget amount in each category should be more, less, or the same. 

Alternatively, zero-based budgeting starts fresh each year.  The needs and operating costs of every function in an organization are assessed along with the strategic vision of the organization.  Instead of starting with how much was spent last year on an item like information technology to budget for next year, ZBB largely ignores this value.  Instead, ZBB considers the organization’s strategic vision and asks how much needs to be spent on technology next year to best achieve the strategic goals.

Those who have employed ZBB in a business or a non-profit organization will likely attest that it takes more time but delivers a far better result.  The status-quo bias that tends to drive budgetary decision making is minimized or eliminated in favor of what’s best for the strategic vision.  It is the classic tradeoff of putting in more time – whether it be violin practice, studying for an exam, or exercising – to get better results.

The concept of zero-based budgeting has plenty of application and benefit in the world of personal finance.  This is not to say that individuals need to create a brand new budget each year as that process may yield only minimal benefit for a large time commitment.  However, there are other personal finance decisions where most consumers can apply a ZBB approach with a limited time cost and meaningful benefits.  We highlight three items below where individuals tend to stick with the status quo rather than with a fresh assessment each year: 401k deferrals, the reinvestment of dividends, and health insurance/Medicare choices.

401(k) Deferrals

Evidence indicates that most people decide how much will be taken from their paycheck and how those retirement plan deferrals will be automatically invested when they begin a job and then rarely, if ever, make adjustments.  Given that 401k and other workplace retirement plans constitute a majority of retirement savings for many people, this status-quo bias can be very costly.

Employing a zero-based budgeting approach to 401k investments does not necessitate significant time devotion or constant monitoring.  Diligent savers would be well-served to sit down for a few minutes at the end of each year and determine three things with no bias to how things were done last year:

  1. What percentage of income should be deferred to a 401k or other retirement plan in each pay period?  There is compelling reason to reevaluate this percentage every year without the bias of last year, based on life changes or income changes.
  2. Assuming the Roth option exists, what percent of the deferrals should go to a Roth account versus a Traditional account?  This is a ratio that should likely change as income increases or decreases.
  3. How retirement plan investments should be allocated?  Rather than start this decision with how investments are allocated today, consider how the investments are ideally allocated if everything was in cash.  Once the decision is made, the investor can then reallocate the current allocation and update future deferrals to fit with the investment game-plan rather than relying on the roll-forward of a decision made years ago.

Automatic Dividend Reinvestment

When a stock, mutual fund, or exchange traded fund pays a dividend, most custodians like Charles Schwab or TD Ameritrade allow for the dividend to be automatically reinvested back into the position that paid the dividend.  The account owner can elect to turn this feature on or off.

Consider that ABC Stock Fund pays a dividend of $5,000 and this money is then automatically reinvested back into ABC Stock Fund.  The arbitrary presumption in this automated activity is that ABC Stock Fund is the best use of this $5,000 – not an investment in XYZ Foreign Stock Fund that is underweight its target allocation, not to paydown the mortgage, and not to be left in cash for an upcoming spending need.

Notably, the absolute worst form of automatic dividend reinvesting is when an investor owns a concentrated stock position with a low cost basis and the stock’s dividends are automatically reinvested back into the stock.  Why the worst?  In most of these situations, the concentrated stock is the very last place in the entire investment universe where the investor should be reinvesting new money.

An individual investor who chooses to automatically reinvest dividends for mutual funds and exchange traded funds is often just being practical.  However, a pre-established investment policy statement can help to quickly determine where the dividend proceeds are most needed and aid in a simple-to-execute ZBB approach for dividend reinvestment.  For advisors who get paid to manage a portfolio, there really is no compelling explanation for automatically reinvesting dividends.  Want to determine if your advisor is apathetic to the management of your investments?  Don’t look to see how often he/she trades – look to see whether dividends are automatically reinvested or whether the advisor is deliberate and thoughtful about how the dividends are used or reinvested.

Medicare Part D / Health Insurance

A whopping 87% of Medicare customers choose to roll forward with the same Medicare Prescription Drug (Part D) Plan each year.  Studies have demonstrated that this tends to be a poor decision for customers, resulting in higher costs and a plan that is unlikely to provide the best coverage.  The same status-quo bias exists in the private insurance marketplace where roughly 10% of consumers take the time to shop for a new insurance plan and 9 out of 10 apathetically auto-renew the same plan as last year.  This again happens, despite the fact that 70% of consumers can find a cheaper plan for the same or better coverage.

Insurance companies understand the propensity of consumers to maintain the status quo.  As a result, their profit-maximizing strategy is to roll-out attractively priced new plans to hook new customers and then reduce coverage and increase premiums in future years.  This makes what was a great plan for the customer to initially choose 3 years ago, a terrible plan for them to choose in the upcoming year even if their medical needs have not changed.

The zero-based budgeting approach to annual health insurance or Medicare shopping is what the insurance companies hope you will avoid.  They are counting on the fact that you’ll succumb to inertia rather than evaluating your annual insurance needs with complete indifference to the policy you had last year.  So do yourself a favor and start fresh each year in your insurance evaluation.



Questions, comments, or thoughts?  We welcome your comments below.

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