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Save More Tomorrow?

All my life I’ve been told I need to start saving as soon as possible.  The power of compounding helps make retirement much more attainable if you start early.  Numerous studies have shown how much easier it is to reach your retirement goals if you start saving in your 20’s.  So I enrolled in my 401(k) plan as soon as I was eligible at my first job out of college and I opened a Roth IRA for additional savings.  It was the right thing to do and I’m very glad I did it. 

So when I saw financial planning expert Michael Kitces had written an article titled “Why planning to save more tomorrow and NOT today may be a better approach” I was shocked! Save more tomorrow, NOT today?  That’s the exact opposite of everything I’ve been taught my whole life!  How could he say such a thing?

Kitces bases his article off research done by behavioral finance experts Shlomo Benartzi and Richard Thaler.  They found that retirement plan participants were much more willing to increase next year’s savings rate than to increase their current savings rate.  The reason for this is obvious but I’d never really thought about it before: it is REALLY hard to cut down on our current living expenses!  Why is it so hard?

We tend to get used to a certain level of spending based on the income we make and as our income increases, so does our spending.  This was illustrated best to me by another CPA financial planner, Jim Shambo, who wrote a paper titled “The Hedonic Pleasure Index”.  I’ll review this paper in more detail in a future blog post but the general idea is that the consumer price index (CPI) doesn’t accurately reflect inflation because Americans constantly want to improve, not maintain our standard of living.  So while costs might increase according to CPI, our own spending increases faster than this.

So if we increase our spending each year as our income increases, are we also increasing our savings?  Probably not!  Most people set their 401(k) to a certain percentage of income and leave it there.  When we get a raise, we might feel like we are saving more in dollar terms, but in reality we are saving the same amount as a percentage of our income but our spending increases by the amount of the raise!

This is where Mr. Benartzi and Mr. Thaler think we can really improve our savings rate.  If we set our savings to increase each year, we don’t have to cut our expenses at all.  Instead we just don’t increase our spending by quite as much each year.  This helps to not only save more but it also helps us keep our expenses at a level that will be more manageable in the long run.

The key is to make sure you commit to this process and actually follow through with the annual increase in savings.  Some 401(k) plans will let you automatically increase your savings by a certain amount each year.  If you don’t do it automatically, it will become all too easy to change your mind next year and put that raise towards something other than your savings.  If you can stick with it, this might be one scenario where it’s ok to procrastinate!