Laura Rowley Money & Happiness

Susanna Donato, a 37-year-old Denver-based writer and editor, has been working for herself for a decade.

She's enjoyed flush times, when her income soared 60 percent year over year, and lean years -- like this one, when it's fallen 35 percent. Her husband Mark, a sculptor, went back to school part-time three years ago and recently became a fifth-grade teacher. They thought that would mean more income stability, but that didn't quite happen.

"He is on a pay-for-performance system where he gets a bonus periodically if he meets certain objectives," explains Donato, who has an 8-year-old daughter. "We know what his baseline is, but don't understand when (bonuses) are going to come through. We were surprised at how much (his paycheck) varies even though it's a steady job."

Is income volatility the new normal? And if it is, how do you adapt your household budget to stay whole?

Clearly the recession has taken a brutal toll on household income. Since the start of the recession in December 2007, 7.6 million people have lost their jobs, and the unemployment rate has doubled, to 9.8 percent. Another 2.2 million workers who are out of work were not counted as unemployed in the latest Labor Department report because they didn't search for a job in the last four weeks.

Moreover, some 9 million workers were classified as "involuntary part-time" in September, meaning they want a full-time position but can't find one. The average workweek continued to decline, edging down to 33 hours.

A More Common Problem?

Even those who are fully employed face uncertainty: Two-thirds of employers are using variable pay bonuses or performance-based rewards that have to be earned each year, according to a study by the consulting firm Hewitt Associates.

Economists disagree over how severe and widespread income volatility has become. In his book "The Great Risk Shift," Yale sociologist Jacob Hacker suggests volatility has roughly doubled since the 1970s. By contrast, studies by Wharton's Shane Jensen and Stephen Shore argue that volatility has increased sharply only for about 5 percent of the population, largely the self-employed.

Nonetheless, when even the most secure paychecks -- those of government workers -- are reduced by mandatory furloughs, it's a sign that income volatility is a growing problem. 

Freelancers like Donato are well-versed in the rules of volatile income. Number one: Create a huge reserve fund. "Paying yourself first is so much more important when your income is fluctuating," she says. "You have to put safeguards in place so you have money for lean times. I've been in that panicky place where the income tax bill is higher than I expected, lying awake thinking how I'm going to come up with money."

Lori Nixon, a coach with the online budgeting firm Mvelopes.com (a site where I have worked as a contributing editor), has her clients create a baseline budget using an average of past income as a guide, and save the excess in a virtual "reserve" envelope during the boom times.

Add up a year of income and divide by 12 (or better yet, two years and divide by 24). Set your monthly expenses at that level, and in good months, save the excess so you can maintain your lifestyle in the bad months (versus alternating between filet mignon and Ramen noodles).

"The person either has to take the worst-case scenario and budget conservatively based on that, or an average of spending over some period of time and set middle ground," Nixon says. "There will be months when you earn way over that. Most people get into trouble because they don't take the overage and set it aside to take care of months that can't be funded."

Susan Lannis, an Oregon business consultant who works on productivity issues, follows a percentage-based formula: She lives on 70 percent of her income (which includes retirement savings); saves 20 percent as a buffer; and budgets 10 percent for charity. "In this economy it's a little tougher. I'm not putting away as much in savings because there's not as much left over when I've paid the bills," she says. "But when the model works, everything feels in balance."

Steps to Take

Logistically and psychologically, it helps to create a "buffer" account where your income goes, which is separate from the account you use to pay the bills, says Matt Wallaert, lead scientist at the online money management site Thrive.

"You have to have someplace where the money sits and is paid out to you at a steady rate," says Wallaert, a behavioral psychologist. "The classic analogy is the reservoir -- very early on humans realized it doesn't rain in a predictable way -- so you dig a big hole and collect water and let it out at a constant rate throughout the year."

Having income and monthly expenses flowing in and out of the same place creates "a huge mental accounting issue," Wallaert says. "You look and see $5,000 in there, and that's a big temptation, when it really represents money you are supposed to set aside for a lean month. Psychologists are not immune by the way. I find myself saying, 'hey I have a lot of money in checking' and then buying a TV or something."

Charles Farrell, a Denver-based investment adviser, agrees that "the hard part is the good years, because the good years can run for a period of time that makes them look a lot more stable or permanent than they really are. And if you have ramped up your lifestyle and have lots of monthly cash-flow commitments, it can really be a problem if your income drops."

Households with large income swings get in trouble if they adopt the prevailing "monthly mentality" -- taking on fixed payments that are too high. Extracting oneself from those fixed expenses is no easy matter.

"People also think they can just trade down in their lifestyle if times get tough," Farrell writes in an email. "But they fail to recognize that if times are tough for them, they are probably tough for a lot of people. And that means it will be hard to unload your big house, or your vacation home, or your Cadillac Escalade. So the things you don't want to own anymore because they are a big drag on your finances are also the things that not many other people are going to want to own either in a recession."

Households with low fixed expenses have the flexibility to adjust their lifestyles if cash-flow evaporates. Paul Glen, a Los Angeles IT consultant who has worked for himself for a decade, started using Quicken software to track his spending after college so he could quickly pay off his graduate school loans. That made it easy to determine his baseline expenses when he went on his own.

"Instead of a fancy car, I'd rather have an old car and a year of cash in the bank," says Glen, who is married with a 6-year-old son. "I try to keep my lifestyle fairly consistent. I think that's especially important if you have kids, to give them a sense of security."

Finally, in a household with fluctuating income, there's no room for revolving debt. "The only debt I carry is a mortgage and when I need something I save up and buy it," says Glen. "There are always the feel-good stories of people who financed a movie on a credit card -- but the vast majority who finance businesses on credit cards probably end up bankrupt."