It’s easy to get wealthy – just spend less than you earn, and do it for a long time.
I first heard that quote (I wish I could recall the author) when I was 22 years old, and it’s stuck with me ever since. I can’t tell you how many times I’ve used it in conversations with others. I like it. It’s simple, it’s true, and I’ve seen it happen first hand in the 30 years since first hearing it.
As mentioned last week, I’m going to weave in a few posts on some foundational principles of Personal Finance. I strongly encourage you to take some time to study the concepts, as they are essential to helping you achieve a great retirement (which is, after all, the objective of this blog!).
Realistically, it is only through successfully managing these factors that we increase our chance to build the wealth required to fund our expenses when the paychecks from work stop flowing. Of course, you can always assume you’ll just continue to work for your entire life and continue to earn that paycheck, but in my world that isn’t the definition of A Great Retirement.
For Building Block One, the focus will be on these three basic levers for building personal financial wealth:
1) How Much Money You Make
2) How Much Money You Spend
3) What You Do With The Difference
The goal: Increase income, reduce spend, and maximize the investment return you earn on the difference.
Simple, right? Let’s discuss each one in broad terms:
1) How Much Money You Make: in my view, this is the most important of the three for building financial wealth. While plenty has been written about minimizing spending, the reality of the matter is that you can only reduce spending so far. While spending is clearly very important, the primary focus during wage earning years should be on maximizing how much money you make. Excel in your work, earn promotions, seek opportunities, find a “side hustle”. Spend 30 minutes brainstorming on things you could do to increase your income. Think. Apply. Maximizing the earnings you can earn for the value you can create is, in my mind, the most secure path toward long term wealth building.
2) How Much You Spend: There are volumes written on ways to reduce your spending, and I won’t get into detail here (perhaps a future blog post). The point to consider at this point is to be very conscious of what you’re spending your money on, and recognize that money spent today will have a signficant impact on how much you’re able to save for tomorrow. If you’re not saving at least 10% of your income today, AGGRESSIVELY target your spending NOW.
Last year, my wife and I (for the first time ever) tracked every dime we spent for 10 months. It was part of our 5 Year Retirement Plan to develop a realistic baseline of what our monthly living expenses were. We’ve always been relatively frugal, but it was still eye opening. By simply looking at a few categories we never really considered, we were able to trim several thousand dollars a year out of our spending with minimal effort, and never felt the impact (e.g., we shopped, and changed, our insurance company). I strongly encourage all of you to try doing the same thing, even if you only do it for 1 month.
3) What You Do With The Difference: The obvious way to maximize “The Spread” between inflow and outflow is by focusing on BOTH levers at the same time. Maximize your income, minimize your spending, and The Spread will magically increase.
I tend to think in terms of targeting a “Savings Rate” as the metric to measure “The Spread”. You should target a minimum of a 20% Savings Rate (or, having 20% of your paycheck left over after all expenses). If you can’t achieve that now, focus on allocating 2/3 of each raise over the next 5 years into savings. For example, if you earn a 3% raise next year, only increase your spending by 1% and increase your savings by 2%. Automate it (for example, set up ACH auto withdrawals from your checking account into a Vanguard mutual fund. On the date your pay raise becomes effective, increase your ACH withdrawal by an amount equal to 2% of your pay). You’ll never feel it, and your savings rate will increase over time. Aggressively fight the plague of “Lifestyle Inflation” that so many fall into – do NOT let your spending increase simply because your pay goes up. Maintain your same lifestyle as your income grows, and your savings will increase. Simple as that. Don’t buy that new car, don’t buy that bigger house, etc. etc.
Historically, conventional wisdom has been that a 15% savings rate, maintained over a 40 year career, is sufficient to fund a retirement. However, more current writings on the subject (from folks much wiser than I) have been starting to push this target up to 20%. Why? Several factors, including risks to social security, the demise of defined benefit pensions, increased cost of medical insurance, higher end of life medical costs, increased lifespans, risk of inflation, etc.
As you first start to generate your Savings Spread, follow the advice from Dave Ramsey; First, build an “emergency savings fund” to cover 1 month of living expenses. Second, pay off debt. Next, start building your investment portfolio. Finally, increase your emergency fund to 3-6 months and continue to fund your investments. I’ll have future “building block” articles on many of these topics. The focus, initially, should be to maximize the difference between the dollars you earn and the dollars you spend.
I’ve been blessed with parents who instilled in me, at a very young age, the importance of living below one’s means. I’ve also been blessed with a wife who shares similar values. To us, it almost seems instinctive, and we have no desire to “keep up with the Jone’s”, or maintain a certain image based on what others think. However, I’m also aware that there are many who live paycheck to paycheck, some in spite of some having very large paychecks. For those of you who aren’t as naturally predisposed to living below your means, I encourage you to think seriously of your responsibility to prepare for your retirement years.
It’s prudent to be realistic about the looming costs of funding your retirement. In addition to replacing your paycheck, there are uncertainties around the stability of Social Security, long term health care risks, uncertain health insurance options, and longevity risks. Let’s face it, if we all knew the exact date we were going to die, it’d be a lot easier to plan! Given the unknowns, your best plan is to to build a sufficient retirement reserve to cover a long life, with potentially expensive health care in the final 5 years.
You may argue that you’ve tried, but you’re simply unable to save. I would challenge that mindset with the argument that if you don’t save now, you’re intentionally deciding that you never want to retire, or you’re satisfied living a meager life in retirement on a minimal social security check (if it’s still available). The reality is that each of us must take personal responsibility to fund our own retirements.
Sacrifice a bit today, so you can have a great tomorrow. Or, have a great today, so you can sacrifice tomorrow.
Your choice, you decide. To me, the choice seems obvious.