With New Year’s celebrations now over it’s time for the hard work of resolution honoring to begin in earnest. Many of us will start the year resolving to spend less money and save more. If you’re like me and Shannon, the objective may be to accumulate enough to travel the world; or maybe you’re trying to build a college fund or pad a retirement nest egg. All worthy goals.
Unfortunately our good intentions are typically doomed to failure right from the start. By mid-year most of us will have fallen back into the same bad habits we resolve each year to end. We do that not because we lack the necessary willpower, but because we lack the correct perspective. To change our financial behavior we need to fundamentally change the way we think about money. We need to find a way to turn human nature, which constantly tempts us away from our long term goals, to our advantage. Fortunately that is easier to do than you may think.
Before we get to that, though, it’s worthwhile to reflect on the way people typically approach personal finance and why that approach so often leads to bad outcomes. Most of us think about our finances as a series of flows: income minus expenses. If income exceeds expenses we’re doing well. If they match we’re doing okay. If expenses are higher than income we’re in trouble, or soon will be. Intuitively this makes perfect sense and is true to an extent.
Everyone’s income eventually stops. Are you ready?
The problem with this approach is that it leads us toward a monthly payment mindset. We start believing that we’re doing fine as long as our monthly income is at least as large as our monthly expenses. If income rises, as it tends to over a working career, we tell ourselves that we can afford more and nicer things. We size large purchases, like houses and cars, so that our monthly payments roughly match our current cash flow.
What we rarely consider is that at some point income eventually stops. Expenses, meanwhile, continue until the day we die. If we’ve planned well, income stops because we’re able to retire voluntarily. If we’ve planned poorly, income stops because we become too old or sick to keep working. At that point the unaffordability of our “balanced” income minus expenses approach becomes painfully obvious.
Folks who thought they were doing well because they never spent beyond their means and because their checking account always balanced one day discover, often too late, that their lifestyle depended too heavily on a paycheck that was destined to end.
So what is the alternative?
If you were to consult a financial planner1 and ask “how much money do I need to retire?” they’d collect a ton of personal information, run a fancy Monte Carlo financial projection, print out pretty looking papers with lots of charts and numbers, charge you a generous fee, and then tell you something fairly similar to this: “You need to accumulate 25 times your uncovered annual expenses in savings.”2 By “uncovered expenses” they’d mean the amount by which your expenses exceed the income you expect to receive from pensions, social security and other continuing income streams.
25 times!
Let that sink in for a minute. For every dollar in spending we need to accumulate twenty five dollars in retirement savings.
That is a basic rule-of-thumb. It comes with all kinds of conditions, caveats, and assumptions. Depending on circumstances, that number could be somewhat lower or it could be far higher. Knowing the rule of thumb does not replace the need for a detailed retirement plan and it won’t exactly fit every individual situation. What it will do though, if taken seriously, is change your relationship with money.
How? By altering the equation. No longer is a dollar of expenses equal to a dollar of income. Expenses carry far more weight; twenty-five times more to be exact. Instead of comparing monthly payments with monthly income, you start thinking about the giant lump sum of cash that is needed to sustain those payments in retirement. Everything looks more expensive, and less affordable, in this context.
At this point in the conversation, it is easy to despair. All of a sudden the financial situation for the average American, where savings is currently just 3.4% of income, looks mighty precarious. Accumulating a savings balance of 25 times annual expenses is a daunting task.
Expense control is an extremely powerful financial tool
The good news is that we each have tremendous control over our expenses. The better news is that our financial future is significantly leveraged to how much we spend.
If what we just said is true, that a dollar in annual spending requires $25 in retirement savings, it is equally true that our savings needs decline by $25 for every dollar in annual spending we eliminate. That relationship sets up powerful incentives to slash spending.
Cutting out the daily three dollar latte seems trivial from a monthly expense perspective. Why bother? Things look quite different once we realize that eliminating the latte reduces our savings requirement by $27,000. 3 That’s right, deep-sixing the frothy coffee reduces the amount we need to save for retirement by $27,000. How does Folgers taste now?
Infrequent purchases that need occasional replacement have a similar dynamic. A new iPad may seem like a one-time cost of $400. What we don’t often consider at the point of purchase is that new things eventually become ingrained in our standard of living. Luxuries transform themselves into necessities. Buying that first iPad often means committing to a replacement device every couple of years. By doing so we also increase the amount of savings needed for retirement by about $5,000; a hefty price tag almost never considered when evaluating the affordability of such “one-time” purchases.
Be happy, save money
Thinking about money this way yields important psychic rewards. For most people buying something activates pleasure centers in the brain. We like acquiring new things. It makes us happy, at least for a little while. Saving money, meanwhile, is painful. It requires sacrificing current pleasure for some murky future benefit. This kind of delayed gratification isn’t something the human mind is very good at accepting. For obvious reasons of survival, we’re designed to value eating an actual meal more highly than the promise of one tomorrow. This suits us well when things are in short supply but can lead to self destructive over-consumption in times of plenty. The “25 Times Principle” helps turn these primitive instincts to your advantage by dramatically increasing the cost of current consumption.
Instead of feeling good about our shiny new bauble, we’re forced to consider the damage its purchase causes to our financial future. Not spending, meanwhile, moves us 25 times closer to our financial goals and, more importantly, to the life we want. Suddenly we realize tangible, quantifiable, and immediate benefits by foregoing spending where previously there was only pain. This psychic 180 has the potential to completely reprioritize our financial lives, making it easy and even enjoyable to save money.
It also has the potential to change the way we see the entire material world. I already suspect that many of us will never look at a three dollar latte the same way again. The same holds true for big houses, fancy cars, designer wardrobes and anything else we’re told we should want. Instead of viewing these things as objects of desire, it’s now possible to see them for what they really are: albatrosses that make it impossible for us to ever stop working.
Realizing these benefits requires one simple change: we need to value financial independence. We need to value a future were we have a chance of saying goodbye to paid work. The good news is that even if we value that future 1/25th as much as we value today’s purchase, putting that item back on the shelf is still an even money trade. And that’s a trade we can feel good about all day long.
Related: 20 ways to save for travel
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Footnotes:
1 The information contained on this website and from any communication related to this website is for information purposes only. Neither Brian nor Shannon are registered financial advisors and do not hold themselves out as providing any legal, financial or other advice. We do not represent that any financial suggestion made here or elsewhere is suitable for you. Please consult your own financial advisor.
2 The “25 times” rule of thumb, alternatively known as the 4% safe withdrawal rate, was first quantified in research called the Trinity Study. The basic concept is that a portfolio of stocks and bonds has historically supported an inflation adjusted annual portfolio withdrawal of 4% for periods as long as 30 years with relatively high levels of success. Subsequent research has added to and refined this initial study. As always, past performance does not guarantee future results.
3 $3 * 365 * 25 = $27,375
4 Image of shopping girl courtesy of Photostock
Everywhere Once 
This is so true! When I was still working for someone else, I used to figure out how many hours I would have to work to afford That new **** when you realize that something costs 10 hours of your income, suddenly it doesn’t seem like such a bargain. Now that I work for myself, it becomes even less of a bargain!
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So true. Thinking about how many hours of your life you need to slave away to own something is another mental trick that helps you put the real cost of things into their proper perspective.
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look what i found, and even thou it’s not X25, but it’s still savings and very doable
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For the benefit of other comment readers, the link is of a chart showing the savings that accumulates over a one-year time frame if you were to add one new dollar to your savings each week of the year (i.e. save $1 week 1, $2 week 2, $3 . . .) It’s a good method of developing a saving habit.
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Hi, I have nominated you for: !Very Inspiring Blog award!
Please check the link for more details.
http://photographyartplus.wordpress.com/2013/01/04/blog-of-the-year-2012/
Congratulations!!! Regards, Marcela !
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Why thank you.
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Many experts have even said that 25x isn’t enough given our record low interest rates and fully valued stock market suggesting the new normal might be as high as 50x! That latte habit is now at $54,000!
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This is a topic that deserves an entire post of its own, but I think there is a quick and dirty way to think about it. Your point is that today’s high stock valuations and low interest rates imply lower future returns than the historic returns used to generate the 25x rule. I don’t necessarily disagree. An easy adjustment is to mark today’s portfolios down to what they’d be if stocks and bonds were valued at their historic median levels.
For example, historically a $100 investment portfolio made up of 60% stocks and 40% bonds would support $4 of real spending over a 30 year period. But the median stock valuation during that time period was 28% lower than today and bond valuations were 17% lower. If stock prices fell 28% and bond prices fell 17% our portfolio would decline to $76.40. But at that level, our portfolio would be valued right in the middle of historic norms. At that point we should be able to draw 4% of $76.40 (or $3.06) and be “safe” according to the historic data.
Therefore we should also be able to draw $3.06 from our current more highly valued portfolio, because even if stocks and bonds fall to historic valuations, we’d still only be drawing 4%. That means a safe withdrawal rate today might be 3% instead of the 4% indicated by the original study. Said another way, a 33x rule (1 / .03) might be more appropriate at today’s valuation than the standard 25x rule mentioned in the article.
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Yikes! This is some expensive food for thought, but valuable! Thank you so much, I am more determined than ever to save! My favorite incentive for saving is to make things myself like people used to do in the “old days.” I can spend $12 on a single bracelet, or make 10 bracelets for myself – and gifts for friends and family – at a third of the cost! 🙂
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My husband and I are starting our first joint budget this weekend, and this post is a great way to approach our budgeting. Thanks so much!
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What you say is spot on and the main reason I believe 20X expenses (once whittled down) is more than adequate for the more frugally minded…
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Great post, Brian. We are both retired and planned very well so we have been able to maintain our “normal” standard of living. Two things that surprised me with retirement: 1 – it was difficult for us to move from a saving mentality to a spending mentality. We can no longer tell ourselves when we make a major purchase, like a $10,000 trip, that we will be able to put that money back with our income. Now it is gone! 2 – I loved working and received a lot of mental and emotional satisfaction along with the income. I had to retire because of health which meant that I also couldn’t volunteer (if I had enough energy to volunteer, I’d do the work I loved instead) so I had to find other things to do and they cost more money. When we buy a IPad we also have to buy an internet plan – I just increased my internet plan to support increased uploading of photos and blogging. I have lots more to say but this is a comment not my blog. 🙂
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Hi Pat,
Write as much as you want here. This is a place where people hopefully come to learn, share and discover. Your comments are always welcome. And you’re right, retirement is a big topic with lots that could be said. Plenty of people have difficulty transitioning in the ways you mentioned. Lifetime habits, after all, are hard to change. Savers find it difficult to draw down that savings even though they know they “can’t take it with them.” People who have grown accustomed to having days scheduled for them find it hard to fill up their own time. Still others struggle to find meaning in their lives once a fulfilling career is over. Entire books could be, and have been, written on these topics.
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Reblogged this on mygoatpen and commented:
Great article to think about cost of retirement but more important some ninja mind tricks to help you value saving
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Ninja mind tricks. Love it . . . “these are not the droids you’re looking for.” LOL
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Great article to put things into perspective. Thanks!!
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Excellent article. Reinforces my tight ass philosophy. Every dollar I spend I measure up against how much time it would take me to earn that at work. That’s the amount of time I’ll have less in my life to do things I want. If I’m happy to be closer to my death by that period of time then the purchase is given the go ahead..
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