When you get a raise at work, what do you spend it on? Do you upgrade to a better car? Start taking more vacations?
For most people, when they get a raise, their first thought isn’t to put the money toward their retirement. However, it is important to increase your retirement savings incrementally over time.
One of the problems people often encounter when they receive raises is that they increase their spending to match, which can mean that they fall short of their retirement goals. A new research study from Morningstar found that raises can actually make it more difficult to achieve a comfortable retirement, due to lifestyle creep. People end up buying nicer cars or larger houses instead of putting the additional money into their retirement accounts, and these expenses make it more difficult to meet retirement goals.
The Problem with Failing to Increase Savings Over Time
People often think about their retirement savings in terms of a percentage of their income. For example, say that you set aside 10 percent of your income for retirement. When you receive a raise from your $100,000 yearly salary to $120,000, that would mean you’d save an additional $2,000 if you continued to save 10 percent. This might seem well and good, but if you’re like most people, you will likely use your take-home pay to fund a higher standard of living: more vacations, eating out, and so on. This phenomenon even has a name: lifestyle creep.
To maintain this more expensive lifestyle in retirement, you would need to save even more, since your costs will increase in retirement from your previous estimates. You might think that you can maintain a more expensive lifestyle during your working years and then economize once you reach retirement, but most people do not want their retirement to cause a dramatic change in their quality of life.
Morningstar looked at data from a large retirement plan manager to analyze the average change in savings rates between people who receive raises and those who do not. The study found little difference between these two groups. In other words, people tend to save the same percentage of their income, even after a raise. This behavior can become especially problematic when you consider that other sources of income in retirement, such as Social Security, are often fixed. Living a relaxed, comfortable lifestyle during retirement really depends on saving more of your personal income over the decades.
A New Framework for Progressively Increasing Retirement Savings
Using the data from the study, Morningstar issued a unique suggestion for people to follow when they get raises at work. The company says that you can spend a percentage of your raise equal to twice the number of years until your retirement, and then save the rest. For example, if you plan to retire in 10 years, feel free to spend 20 percent of a raise on whatever you wish, but put away the rest. As you get closer to retirement, you need to save more since you have less time to catch up and make sure you hit your goals. With more years until retirement, younger people can spend more of their raises, since any money they save has more time to grow in retirement accounts. People who have 30 years until retirement can spend 60 percent of a raise, according to the Morningstar rule of thumb.
To help people save more, some employers offer their employees automatic annual increases in retirement contributions from their paychecks. These increases are known as automatic escalations, and their effectiveness is backed by research in behavioral economics. However, this increase does not always correlate with a raise and not many employers make it easy for employees to dictate how much of a raise they’ll save. The Plan Sponsor Council of America does not yet track whether employers offer such a feature to employees. However, if more people become aware of this possibility and start putting pressure on their employers, more companies may offer automatic escalations tied to raises.
Potential Issues with the Proposed Savings Rule of Thumb
Some people may not have employer-sponsored retirement plans, which can make it difficult to save a specific percentage. People with individual retirement accounts (IRAs) and similar options can still use the Morningstar rule of thumb described above, but they will need to be more proactive about saving. For example, you will need to schedule regular transfers from your checking account into your IRA or arrange for a split deposit of a paycheck. These transfers should be timed to coincide with paycheck deposits, so that you do not spend the money accidentally or become tempted to funnel the income into different goals, such as purchasing a car. Then, when you get a raise, you’ll need to increase the size of the transfers accordingly.
The other question that people often have on this topic is what to do when money is tight and they aren’t receiving raises. In this situation, it is reasonable to start small and save as much as reasonably possible. Too often, people become discouraged when they read guidelines that seem impossible, such as saving 10 to 15 percent of a paycheck when they aren’t making much, and they don’t even try. However, saving even 1 percent of a paycheck is worthwhile, especially if you’re younger and have several decades for your money to grow in a retirement account. People in this situation should focus on boosting their savings whenever they get additional cash, such as a tax refund, a gift from a relative, or a year-end bonus.