How Small Lifestyle Upgrades Can Derail Retirement Plans

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Karen Wallace: Hi, I'm Karen Wallace for Morningstar. The standard advice for saving for retirement is fairly straightforward; start early and save as much as you can. But another important piece of that puzzle that investors often overlook is keeping your spending in check as your earnings grow. Joining me to discuss that topic is financial planning expert, Michael Kitces.

Michael, thanks so much for being here.

Michael Kitces: Thanks, Karen. Thanks for having me here.

Wallace: You wrote an article recently where you talked about how your spending can creep up as your earnings grow. You began the article by talking about how, in the early stages of saving, it's more about compounding and in the later stages, your raw savings. Could you go through that a little bit?

Kitces: There's an interesting effect that happens when we start saving. When you get started, the reality is, as much as we like to talk about where you're going to invest with your first IRA and what are you going to buy into, the mere fact that you save is actually the biggest driving factor to the outcome. Because the unfortunate reality is, just kind of the mathematics of the compounding, for your first IRA contribution, if you had a couple of thousand dollars and you earn an extra 1% of returns, which in our investment world is a pretty big number, an extra 1% of return on a couple of thousand dollars will buy you Starbucks for a week. That's about it. It doesn't have a big dollar impact because the account balance just isn't as big yet. Whether you save and creating the savings habit is overwhelmingly, dominatingly the biggest factor that drives the outcome.

Now, when you get to the other end, as you're getting closer and closer to retirement, that equation really starts to flip around and suddenly the reality is, even if I am adding a couple of hundred dollars a month on an ongoing basis, if I'm trying to get to that portfolio of hundreds of thousands of dollars or $1 million of retirement money, which is the kind of the big nest egg that a lot of people shoot for, a couple of hundred dollars a month just doesn't really actually move the needle very much anymore. And if you've got hundreds of thousands of dollars of savings already, a 1% change in your returns could be a year or two worth of savings, all at once. And so, there's really this kind of balancing shift from, it's mostly about whether you save at the beginning but how you invest starts to really, really matter by the end.

Wallace: In your article you also mentioned something that I found interesting and that's that at the beginning of your career when you're saving and when you're earning less, you could actually have a shorter retirement savings shortfall than in the middle of your career when you're earning more.

Kitces: Yes. There is an interesting trade-off. If we think of someone, they're just a couple of years out of school, they've got a solid first job, they're making $40,000 a year. And if I kind of went through the math of retirement, like what would it take for this person to retire? So, Social Security is actually probably going to cover almost half of their income if they can earn that steadily throughout. I got to cover the other half with the portfolio. If I kind of go through the math of withdrawal rates, I might need like $400,000 to make that retirement work, to have a nest egg blended with Social Security. And so, you can kind of think of it like, good news, I'm making $40,000 a year; bad news, I've got zero dollars of savings because I just got going. But I got to only get to $400,000, which is a big number, but I can get there, I can chip away at that over time.

So, you imagine then that person, we fast forward 10 years. Now, you're in your mid-30s; you're doing really well at work. You've got a couple of really nice promotions. You're in a manager position. Now, you're making $80,000 a year. And you're like, awesome, I doubled my income. And then we start doing the math and say, well, now I live an $80,000 lifestyle and not a $40,000 lifestyle, because it's what all of us do when we start making twice as much money. So, we start going through the math. Well, what do I need to sustain us an $80,000 lifestyle in retirement? Well, Social Security now is probably only going to cover maybe a quarter of that or a little bit more. And if I start going through the math of what I need to retire, now I probably need over $1 million on top of Social Security to make that lifestyle work.

And so, I used to only need $400,000 to retire. Now, I need $1 million to retire, which means even if I did a great job of saving in the first 10 years, and I accumulated tens of thousands of dollars of savings, which is great progress for someone in their 20s, I'm still like $950,000 short in retirement. It actually got farther, not because I wasn't saving and doing a good job getting the savings habit going, but because we often underestimate the consequences of what happens when our lifestyle starts creeping higher. We get those raises, we spend a little more, we buy a nicer car, we move to a nicer house. Once you have a nicer car and a nicer house, we rarely back to a lower-level car and a lower-level house. And so, that's why I like to call it like a lifestyle creep.

We usually don't say, hey, I got a great idea. I'm going to change my lifestyle so I need twice as much money to retire. That doesn't really feel very good. But you say, hey, I'm making a little more, I'm going to upgrade a little. I'm going to get a little bit nicer car; I'm going to move to a little bit nicer neighborhood. Like, the expenses start creeping up. Once it becomes a part of our lifestyle, it's hard to go backward. But it's so increases the need for retirement that we routinely see situations where people were working with who are saving are further from retirement in their late 30s and early 40s than they were on day one, because their income went up, but their lifestyle went up so much that the actual dollar need to ever replace that, grew even faster than their income and their savings did.

Wallace: And it's interesting to call it a creep because you may not even realize that these things have crept in there, your cable bill, your landscaper …

Kitces: Yeah, they are, like I used to mow the lawn, but now I got a little more money. So, I'm going to pay someone to mow my lawn. Well, once I pay someone to mow my lawn, I rarely go back and mow lawn again because I kind of get used to doing some other things. And we do it with cars, we do it with houses, we do it with a lot of kind of lifestyle maintenance-oriented things. I used to mow the lawn, but now someone that does that for me. I used to change my oil, but now someone does that for me. I just take my car in. We used to vacuum the house, now we have a housekeeper.

All those little items that individually may not really be budget breakers, or if they were, we would probably balk at them at the time. But you start adding a couple of bucks a month here and tens of dollars a month there and $100 or $200 a month here and you do whatever a year over time and suddenly the cost your lifestyle is much higher than it was, and the money you need to retire now is much more than it was because you got to replace this much heavier lifestyle that you sort of unwillingly adopted or crept into.

Wallace: And you also make the point in your article that sort of intuitively if you aren't spending as much, you are saving more and in that way, you need less to get to retirement.

Kitces: And that's one of the kind of the cruel ironies that we end up seeing in how people save and progress toward retirement. I mean, we see this often with the folks that we work with. Those who are the best at savings, just they are--some people are just kind of hardwired to be frugal I find that just seems to be how they naturally operate, their lifestyles are very modest. They save very actively and aggressively and they get this kind of double benefit.

The more aggressively I save, the faster I get to retirement. And the more aggressively I save, the less I'm spending. Like, there's only so much money that comes in. So, the more I save, the less that went to my lifestyle. So, the less I'm spending, the less I need in order to retire. So, the people who are the best at the savings also are the ones that need the least to retire. And so, they kind of get there double fast. Part of it is because they save so much and part of it is because they didn't need to save as much in the first place.

And then you got the double whammy effect in the other direction. Those that allow that lifestyle to creep higher over time, not only does that mean they are saving a little bit less because their spending is moving up as their income moves up, but now they need more in order to retire because the lifestyle has gotten more expensive. And so, they get there half as faster or quarter as fast because not only are they saving a little bit less when they save more, but they need to replace more spending in retirement which means they've got further to go on this journey.

Wallace: Great. That's really interesting research. Thanks so much for being here to discuss it.

Kitces: Absolutely. My pleasure. Thank you.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.