Your raise can benefit your future more, if you let it
I was reading an interesting article by one of my favorite financial researchers, Michael Kitces, who made a great point. Before I get to that point, let me give you some background. There’s an adage that the way to a successful retirement is to save 10% a year. That’s a nice number, easy to remember, and often it will work. But there are some problems with it.
First, it assumes you start that 10% pretty early in your career, as soon as you get through your apprenticeship, college degree program, or boot camp. If you’re delayed because you are blowing off steam, have problems paying off school debt, or a need a down payment on a house, and you don’t get started until your 30s or 40s, then that 10% won’t cut it.
Likewise it assumes that you invest in something, well, reasonable. Maybe a nice balanced mutual fund or a well diversified portfolio of stock and bonds. Put all your money into CDs and it just won’t grow fast enough. Likewise if you get sidelined by the “sure bets” you hear about at the lunch room table or from that uncle of yours from Omaha, your missteps can also derail your plans.
But Kitces brings up another potential problem with the 10% rule: You might have a successful career. How can that be a problem? After all, if you get big raises and jump from the line to supervision to management, that 10% would climb as well. The problem is that your standard of living increases at the same time, so your early saving pales when compared to your end-of-career spending pattern.
To combat this problem, Kitces suggests that folks ditch the 10% savings thumb rule and substitute a 50% rule. No, he doesn’t propose you try and save half of every dollar you earn, but rather half of every pay raise you get. Let’s see how this works.
Let’s say that you earn $40,000 a year. Fortunately for you the company is expanding and needs someone to head a new division. Your promotion comes with a $10,000 pay raise. If you were doing 10% savings, then your $4, 000/year saving rate (10% of $40,000) will increase to $5,000 for the year. But if you were doing the strategy of saving 50% of every pay raise then your current savings would get an additional $5,000 per year, or a total of $9,000.
Before you poo-poo this idea, realize that you still get to spend the other half of the pay raise. This is, after all, money you didn’t have before so it shouldn’t be too painful suffering through a $5,000 raise in your spending money. An added benefit is that not only will you save more, but you won’t become accustomed to as high a standard of living, making your lifestyle easier to afford come retirement.
And for you who are currently saving nothing, it is a way to get your savings going without having to sacrifice a tremendous amount.
This article was published under the title "Put half of future raises in savings"
in the Wichita Falls Times Record News on July 20, 2014.