Could An Increase In Your Income Postpone Your Retirement?

It might, if you’re not smart about lifestyle creep.

Lifestyle creep is a financial term used to describe an increase in spending after your household income goes up. For most people, a higher income often means a bigger house, a fancier car, and other new luxuries.

Don’t get me wrong, I completely understand why people do this. You’ve got more money, you worked hard for it, and there’s no guarantee of the future.

The trouble is that the cost of the lifestyle you become accustomed to after the increase, can actually put off your retirement far longer than you were expecting.

I’m in the camp that believes there’s a way to manage lifestyle creep responsibly so it doesn’t put off retirement while also increasing your lifestyle now.

A client recently reached out to me to discuss the purchase of an extravagant new car. He was feeling uneasy about it, either buyers remorse or second guessing whether this was burning too much cash. “Should I be doing this?,” he asked.

Feeling guilty when making large purchases is very common. Many of my clients feel this at one point or another.

However, when you’re investing and saving properly, you don’t need to feel guilty about spending money.

Let me explain with an example of how lifestyle creep can be managed so you can indulge without putting off retirement.

To start, imagine an investor: JoAnne.

JoAnne is a young lawyer earning a starting salary of $100K/year. JoAnne responsibly saves 25% of her income each year and spends $75K a year on her lifestyle.

For simplicity, let’s ignore taxes and make some assumptions:

• She wants to spend the same amount in retirement as she spends while working.
• We use a rule of thumb that she needs to save 25 times her annual spending to retire. Therefore JoAnne will need to save $1,875,000 to retire ($75K x 25).
• For JoAnne, it will take 32 years to retire (assumptions are 5% after-inflation or real rate of return).

Fast forward 10 years and JoAnne gets a salary raise of $100K and is now earning $200k.

If JoAnne continues to save 25% of her income, she will now be saving $50K per year. This is a default that many people use, to keep the % of savings constant.

This means that JoAnne’s spending has gone up from $75K per year to $150K per year.

Do you see the problem with this?

All the savings she invested for 10 years was to secure a retirement of $75K per year.

However, now she has to fund her new lifestyle, which costs $150K per year.

If she keeps saving at 25%, she will have to save for a longer period, now 26 years, delaying her retirement by 4 years. Each raise would delay retirement if the savings rate remained a fixed %.

Saving a percentage of income as a constant should not be relied upon as the rule of thumb for retirement.

 

What most people don’t realize is that in order to keep your initial retirement goals, you need to save a greater percentage of increases in your salary.

This will help you in two ways:

1. It allows for a rise in your lifestyle spending.
2. It doesn’t delay retirement.

In order for JoAnne to keep her retirement time frame on track, she should save approximately 50% of her raise and any other future raises.

50% of raises might seem like a shockingly high number, but it’s not. It strikes a compromise between enjoying rewards now and looking after your future self.

Let’s look at how that works.

JoAnne who is used to living off $75K per year and saving $25K now has a raise of $100K.

If she spends half of her new raise, her lifestyle has now increased from $75K to $125K per year. She gets to reap the reward of hard work and success now and increase spending by $50K per year.

She also increases her savings from $25K to $75K keeping her on track to retire in 22 years, on target from her original 32 year plan 10 years ago.

Can my client buy the car? They are saving approximately half of their income above their base income. If the car brings them joy and happiness, I say go for it!

This 50% concept is straightforward but almost no one realizes it – I hope it serves as an AHA moment for you or someone you love.

Keep in mind that this is a good starting point and a great opportunity to think about your savings and investment strategy.

Of course rules of thumb don’t apply uniformly to everyone.

For example, if you’re closer to retirement (10 years away), you might have to save close to 80% of your raise. If your children are just starting their career and saving to buy a house, they might not be able to save as much early on. That might be ok, as long as they acknowledge they’ll have to save a higher proportion of their income as it increases and their careers take off.

If this isn’t something you’ve accounted for, let’s set up a call.

Sources:

For more reading and examples around this topic (if you want to see more of the math) check here:

1. Percentage to save of static/starting income based on desired years to retirement: https://www.mrmoneymustache.com/2012/01/13/the-shockingly-simple-math-behind-early-retirement/
2. More on 50% rule of thumb: https://ofdollarsanddata.com/lifestyle-creep/
3. Morningstar rules of thumb: https://www.morningstar.com/insights/2020/01/23/control-lifestyle-creep