People have lots of questions about saving for retirement.
“Am I saving enough?” is a really common one. As my colleague Amy Arnott
explored in “Do You Really Need to Save That Much for Retirement?” the hardest
part for many people may simply be scraping together enough of their paycheck
to make regular contributions. Many planners recommend investing 15% of your
pretax salary, which is no easy feat. (But remember that any employer
contributions also count toward that number, so if your employer matches up to
a certain amount, contribute enough to get the full match!)
Beyond your savings rate, though, you also have some control
over how much you will need to save. That’s because, to some extent, your
choices determine how expensive your lifestyle is. In effect, by being mindful
of how much you spend and ratcheting up your savings/investing rate as needed,
you will be able to save more--and you will ultimately need less--money for
retirement.
Fred and Sarah
Here’s the tale of two retirement investors, Sarah and Fred.
They’re starting out in the same place--they each make $50,000 and save $5,000
per year (10% of their salary, which is taken out of each paycheck, a bit at a
time). But just because they started in the same place does not mean they’ll
finish in the same place.
For one thing, we don’t know how these two investors’
salaries will grow. If their 401(k) contribution is set up as a percentage of
salary, it will adjust upward as they make more money. But that shouldn’t stop
them from investing more if they want to and can afford to--employees can
contribute up to $19,500 to a retirement account in 2021. And if those over 50
can contribute $26,000 per year.
What else determines whether they’ll have saved “enough”
come retirement? In addition to how much Fred and Sarah are able to save,
there’s another big variable that’s within their control: how expensive their
lifestyles are.
If you’re not following, I’ll help connect the dots. Think
of them each having the money they saved for retirement in a big pool that will
eventually replace their salaries. Right now, they work and get paychecks. But
someday, when Sarah and Fred stop working, the money they've saved in their
individual pools for retirement, along with Social Security payments, will help
provide the income needed to pay their mortgages, buy their groceries, and take
vacations.
Don’t Get 'Creep-y'
Because you are one of the main architects of your own
lifestyle, the choices you make along the way help determine how expensive your
lifestyle is and, therefore, how much you are able to save in your pool and how
much you need to save in your pool.
The more income you earn, the more money you spend
(usually). It’s not strictly a bad thing; you work hard, and when you get
rewarded with a raise, you might be able to afford a bigger apartment closer to
work or a house in an area with a good school district, for example. But these
lifestyle upgrades add up and have consequences, in terms of both how much you
are able to save while working and how much money will be required to fund that
lifestyle during your retirement. For example, maybe your housing costs jump to
$4,000/month from $2,000/month. That’s an extra $24,000 per year. The more
expensive your lifestyle becomes, the more you'll need to save to fund its
continuation. But the more you’re spending, the less money you'll have
available to save.
I interviewed financial-planning expert Michael Kitces about
this phenomenon--which a lot of advisors call “lifestyle creep”--a few years
ago, and this is what he had to say:
"We usually don't say, 'Hey, I got a great idea. I'm
going to change my lifestyle so I need twice as much money to retire.' That
doesn't really feel very good. But you say, 'Hey, I'm making a little more, I'm
going to upgrade a little. I'm going to get a little bit nicer car; I'm going
to move to a little bit nicer neighborhood.' Like, the expenses start creeping
up. Once it becomes a part of our lifestyle, it's hard to go backward."
Here’s a more optimal situation: By staying conservative
about spending and not taking on too much debt, you’re not only able to save
more while you’re working, you’ve created a less expensive lifestyle that
doesn’t require as much money to fund during retirement.
In fact, Kitces says, the reality is that “managing the retirement
savings need” (by managing lifestyle expenses) is just as important as managing
retirement savings itself. It’s especially important to look out for lifestyle
creep in the early years of our careers, he adds, because not managing it then
can result in a savings/investing shortfall that’s much more difficult to
rectify in later years when your investments don’t have as much compounding
potential.
If none of this sounds particularly revolutionary to you,
that’s because it’s not. Proponents of the FIRE movement (Financial
Independence, Retire Early) have set up blogs (such as Mr. Money Mustache and
Our Next Life) to coach others on how to spend mindfully, save as much (as
early) as they can, and retire (or achieve financial independence) as soon as
possible.
3 Ways to Prevent Lifestyle Creep
Even though they started in the same place, whether Fred or
Sarah will fare better when it comes to retirement savings is, in many ways, up
to them. That's because retirement savings shortfalls can happen regardless of
how much money one makes. Here are some ways Fred and Sarah--and you--can make
sure the plan is staying on track.
1. Make a budget and stick to it: Make sure you keep
tabs on how expensive your lifestyle is and what your spending habits are like.
Even though retirement might seem like a foreign concept when you’re a young
worker, someday all of us will want (or need) to stop working. How much you are
able to save, and how much you need to save in total, are dependent on you, to
some degree.
2. Consider raising your retirement savings contribution
rate: Some 401(k) plans offer "autoescalation," which is an
automatic increase in the deferral rate--say, 1 percentage point per year.
Consider signing up for that, and revisit your contribution rate occasionally
to make sure it still makes sense given your current circumstances. If you get
a big pay raise, you may be able to save a bigger percentage of your salary
than in years past.
3. Pay off your debts: People tend to think about
credit card bills and student loans separately from their investments and
savings. But everything is connected and funded from the same source. It’s
important to consider prioritizing debt paydown because of the guaranteed
return on investment it offers: If you have thousands of dollars’ worth of
credit card debt compounding at an interest rate in the midteens, your debt may
be the fastest-growing thing in your portfolio. To put it another way, you
would be hard-pressed to find an investment that would give you a guaranteed
rate of return of 16%, which is the average interest rate on a consumer credit
card, according to data from the Federal Reserve.
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