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By Christine Benz | 06-11-2014 10:00 AM

Don't Let Your Standard of Living Outrun Your Savings

Instead of focusing on how much of your income you save, focus instead on how much of your raises you spend, says financial-planning expert Michael Kitces.

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+

Click here to see Kitces' recent Nerd's Eye View blog post related to the following discussion.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Investors are often urged to save a percentage of their salaries, but a better target might be to bank a percentage of their raises. Joining me to discuss this topic is financial planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Great to be here today.

Benz: You wrote a blog post recently where you looked at some of these rules of thumb that investors might have in their mind that they should be saving 10% or 15% or 20% of their salaries. You think actually a better way to look at it is to focus on what you're consuming. Let's talk about that thesis and how that requires a change in mindset for a lot of people who are saving.

Kitces: The big challenge I have with these traditional rules of thumb--we're going to save 10% of our income, we're going to save 20% of our income--is when you look at that over a lifetime, there are really two faces to this. As I get raises and I increase my income over time, there's a percentage that I save and I keep saving that percentage as my income rises, and there's a percentage that I consume, because I'm also going to lift my consumption as my income rises.

The problem that occurs when you have a strategy like, I'm going to keep saving 10% of my income or 20% of my income, is that it basically says, I'm going to spend 80% or 90% of every raise. And what ends up happening when you go down that road is, your standard of living starts to rise so quickly that your savings actually lose pace, and you end up further and further behind on your retirement. Think of the logical extreme, by the time I'm in my 60s, I'm suddenly spending $150,000 a year and saving 10% of my income from when I was making $50,000 when I was 25; that isn't going to cut it.

The problem is, when I lift my standard of living, not only do I lift how much I'm spending, I'm generally lifting how much I'm going to be spending for the rest of my life, so that every increase in my spending is an increase I'm going to have to fund for 30 years of retirement. And so we see this outdistancing effect where, as my standard of living rises, it ends out rising so quickly and my early savings are so far behind that I basically never catch up, or I have to save something like 20% to 30% of my income throughout life just to get there.

It's really problematic, and I think one of the reasons why we find so many baby boomers and even maybe some late Gen Xers say they are feeling behind on their retirement is that they've gotten stuck a little bit in this trap. Their standard of living ramped up so much through their 30s and 40s, and now they are looking at their retirement savings, which often is actually not a bad number for where they are in their age and for how much they've been trying to save, but given where their standard of living is now, it's nowhere close to funding what retirement needs to look like. And we tend to look at it as a savings problem, but I actually look at it as a spending problem or as a standard of living problem.

Benz: You think those preretirement years in your 40s and 50s, maybe after college is funded and some of those big expenses during one's working years are out of the way, you think that's a prime time for people to really get busy in terms of saving and enlarging their nest eggs. Does that happen in practice?

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