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Don't Let Your Standard of Living Outrun Your Savings

Christine Benz

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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Kitces: Varyingly. We can come at this from two ends. For people who have gone down this road a little bit already, and maybe their standard of living did ramp up a little bit faster, we do have these natural life transitions that are catch-up points. The kids are done and they're out of college and hopefully they didn't boomerang back, so we're at the empty nest now, and spending can decline. We don't have the actual cost of supporting children. We don't have college expenses. A lot of people actually downsize their homes and free up some capital in the process. And so we see a pretty significant transition opportunity that happens there.

The problem that we see in a lot of situations is, once I'm used to that spending, however much it is--$5,000 a month or $8,000 a month or $10,000--whatever that amount is that we live on, however much that goes out of our checking account every month, tends to be the number that we're so used to spending, that when college expenses and kids expenses and mortgage expenses start to disappear, we just start substituting. So oh, I'm done with the mortgage, so I'll buy a second house. Oh, we're done with the college expenses, now we can take more vacations. And we start doing these trade-offs, which means we don't start playing catch-up.

One of the actual big warning points that we have for a lot of clients who are going into their 50s, where we tend to start hitting these transitions, is to take a hard look at whether and how your spending behavior changes as you start getting to those transitions. These are the years you can do some really big saving and catching up, and that's normal. Part of what that means is, a lot of baby boomers are not actually as far behind on retirement as we make it out. It's normal that you don't have a lot to save in your 30s and 40s. You're building a career and you're making a home and you're raising a family, and all of those pieces, but it does mean you have to be prepared to do a little bit of catch-up in later years as we hit some of those transition phases.

Benz: What are some concrete steps that individuals can take, or advisors who are working with them, to ensure that their spending isn't getting out of control and that in fact they are saving an appropriate amount given whatever standard of living they are targeting?

Kitces: Well one of the rules of thumb that I've been experimenting with as an alternative to this idea of saving 10% of your income or 20% or whatever number you want to use, is don't focus on how much of your income you save, focus on how much of your raises you spend. Give yourself permission to spend 50% of every raise that you get going forward. It's a pretty good number. You are going to feel like you are getting wealthier and you are spending more every year. So, you get all those enjoyment aspects of, I made more money, let's go spend more money.

But what actually happens over time is, if you merely spend 50% of every raise, you are implicitly saving 50% of every raise. And over the span of just a couple of years … if you are getting raises of maybe 4% or 5%, particularly when you are younger, so you are often outpacing inflation--you get promotions, you have job changes, things that move up our income a little bit more quickly. We see scenarios where suddenly after 10 years of doing this, you've gone from saving absolutely nothing to saving 20% of your income, and it's painless.

You didn't have to give up anything. Technically, all you've given up was future increases you weren't spending yet anyway, so you never feel like you are going backward. And we see it as a path to get to absolutely extraordinary savings rates by basically committing to save a lot of our future spending increases and therefore making sure we don't spend our future income increases.

When we go down this road and we run the numbers out for a period of time, you get scenarios like, if you are 25 and you save 10% of your income very year, by the time you are actually ready to retire, you've only got about half of what you need to retire. You've actually got a big account balance, it's almost $1.6 million at that point if you just make $50,000 a year and save 10% and get a healthy growth rate. But it doesn't do enough to fund your retirement because your standard of living has gone up so much that even $1.6 million isn't going to cut it.

On the flip side, when you start saving 50% of every raise and your standard of living just rises more slowly, 30 or 40 years later, you're spending 30% to 40% less than the other scenario. Your account balances are much bigger as well, and it's the difference between being 65 and only halfway to retirement or 55 and you can actually retire early. So, these are extraordinary differences for how they compound by just finding a strategy that moderates our standard of living. Because, again, it's the way we're hardwired. We don't like to go backward. Once we get used to a certain standard of living, anything that goes backward is pretty traumatic. Maybe I can tighten my belt for a year or two, but I don't really like to go backward.

And unfortunately, I think we're very cavalier about how quickly we raise our standard of living as we get a little bit more income, and then don't realize how hard that makes it to go backward. If we're just a little bit more controlled about how much we move up our standard of living as we go, the whole path is much easier. You get an incredible ability to save, you get a much easier transition to retirement, because there's just not as much that you need to save, and it's just a much steadier path for people.

Benz: What are some concrete ways that people can check their consumption to see if, in fact, it's outpacing the averages or if it's out of line with what it should be?

Kitces: This is my big frustration point. There really aren't actually a lot of good checks out there right now. I joke sometimes that we need the something like the food pyramid for--now it's the food pie. We have the food pie of what typical proper consumption looks like in terms of food in the categories that you eat. We desperately need the same thing in terms of consumption.

Now, there's a little bit out there right now. The Bureau of Labor Statistics runs some numbers about what typical household consumption looks like. That technically doesn't tell you the best practices; it just tells you average practices. But at least it gives you some sense about where your spending is anchored to everything else. It's really a challenge because basically we have no natural anchor points for this to know what is a reasonable amount of your income to spend on your housing? What is a reasonable amount of your income to spend on your automobile, your transportation? What are the standard rules of thumb we use? Well, the lender says they'll give me this much, so I guess that's how much house I can buy. When in reality from the lender's side is, this is the absolute maximum we think we can lend you before you're going to go bankrupt.

Benz: Not really something you want to reach for.

Kitces: Right. This is not a target! If you're a lender, they do the math. If we lend to a thousand people, only 5% or 10% of them will probably default on this. So I guess that's OK, we can average it out as a large lending institution.

But when you're an individual of one and this is your life, targeting your spending level to a bank's bankruptcy threshold for you is not a prudent standard. But we don't really have a lot of other prudent standards to clarify that, and so we tend to do this. I buy as much house as the bank will lend me. I buy as much car as the automobile lender will give me.

And those become the problems that I think we need to start figuring out. How can we build the spending pie of what does healthy, recommended, prudent spending look like? Because once we get those anchor points it gets more comfortable. I'm looking at buying a car. It would mean my spending on automobiles is 20% of my income, the prudent standard is 12%. OK, I can see this is going to put me out of whack, and it corrects us. But when we don't have a base point to compare to, that's how we tend to get ourselves into trouble.

In the long run, I'd love to see us get a recommended spending pie, prudent spending standards for people. In the meantime, I think the interim point are anchors: focus on the raises that you're getting and focus on only spending a portion of those raises, and budget around the money that's going to be in your accounts when you do that, and it gives you a path to slow down how quickly you ramp up your spending and keeps you from getting into some of these problems.

Benz: So it's kind of a paradigm shift--the idea is to help keep people from encountering nasty surprises when they do get close to retirement?

Kitces: The paradigm shift is to back away from let's just figure out how to save a percentage of our income, which automatically means our standard of living rises quickly, and let's come up with a rule that actually focuses more directly on our standard of living itself, and try to control the pace of how quickly it rises. That's the key fundamental difference between saving 10% of your income, or 20%, or whatever your number is, and spending 50% of your future raises.

I like to talk about the spending side because, we like to spend. The rule is, save 50% of every future raise, but it's more fun to talk about spending 50%. Look forward to every raise, because you're going to spend more. Just don't spend all of the raise and don't even spend 90% or 80% of the raise. Just spend 50% of the raise. You're still going to feel richer, but you're going to be on a much better path.

Benz: Michael, thank you so much for being here to share your insights.

Kitces: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.