Here is Part three!
The next money psychology problem affects all individuals, but can be particularly heightened for the professional. It is commonly called “lifestyle inflation”. Most people get gradual raises within their careers and have their highest income earning levels in the last 5 years of it. These individuals slowly creep up their spending to adjust to this new raise. It may be one more nice restaurant or an extra massage and manicure. Typically, as soon as the spending has adjusted to the higher income, that individual doesn’t actually know where that extra income is being spent. They also are unable to reduce their lifestyle to go back to their previous level of spending. The fact that the individual can’t pinpoint what has actually improved in their standard of living secondary to the raise speaks volumes. They feel like they are in the same position as they were before the raise and are no closer to wealth.
The challenge here is that the raise was the perfect time from a behavioral finance perspective to increase their savings rate and long term nest egg accumulation. This applies dramatically more to professionals then the average salaried individuals that slowly work their way up in their careers. Almost no other career than a professional will go from negligible earning power to top 1% earning power with the flick of a switch. Throughout their career, a doctor’s income will often shadow inflation with small increases over time, but they will never experience such a significant “raise” again. A salaried worker with pensions may not receive significant raises, but they do not need to worry as much about retirement savings, assuming that their pension is secure. Other careers without pensions but with “upward mobility” will often create opportunities for significant pay raises as a career progresses. Since these raises come later in the worker’s life, typically the individual will be more responsible with their money management then if received at the start of their career.
Most doctors and other professionals immediately adjust to their new large incomes and can never improve their savings pattern later on. They have to wait until their mortgage is paid off and then they can finally direct that money to savings in the latter part of their career. They have lost a significant opportunity to let the snowball of compound interest start early. To further illustrate this point, here is an interview that shows the difficulty with lifestyle inflation and debt.
Lifestyle inflation is a common physician issue and the individual in the interview doesn’t seem much different than most doctors. He mentions the difficulty with now living in an upper-middle class neighbourhood with fellow professionals and externally wealthy people. We have discussed keeping up with the Jones’ in our previous post, but debt adds an interesting variable to the concept. Low to middle income earners will compare themselves to a peer’s lifestyle, but they have much less disposable income or ability to borrow compared to high income earners. They are also more restrained by high basic living costs to worry enough about what their peers have. In the professional world, individuals who are not driving fancy cars, going on exotic trips, or sending their children to private school may feel pressure to show their equivalent status to their peers. Professionals will have both the disposable income and access to credit to chase after their peers’ lavish spending. This can lead to a much worse financial position than lower income earners when significant debt becomes involved in the chase to keep up.
Solution #1 – Live Like A Resident
Professionals have the unique opportunity to still take on a small degree of lifestyle inflation and save a HUGE amount of income as well. The most beneficial decision my wife and I made to lead us to financial freedom was choosing to live like a resident for a few years after starting work. This sounds pretty straightforward, but it has a powerful effect. We knew we had already enjoyed life very well as a resident outside the long work hours. Despite our incomes increasing by 4x our previous residency salaries, we kept our expenses exactly the same for almost 2 years. We still enjoyed life via a backpacking trip through Asia with friends and travelling to a few weddings, but all the core expenses remained exactly the same. We did not buy a new car or house. We travelled for work and had someone renting out our townhouse to cover those expenses. Work paid for accommodation and travel to remote areas of BC. I think we almost reached a point where our core expenses were LOWER during those two years than in residency, but overall the same after accounting for our fun travels. I seriously doubt we could attempt to cut back our lifestyle now to those first few years, but at the time it seemed effortless!
I also had the realization that I was already used to doing long shifts and coping with sleep deprivation better than I ever would later in life. In the first few years, I picked up extra night shifts and worked the occasional extra weekend to take advantage of the resilience I built up in residency. Looking back, there is no way now I could pull off the double shifts and frequent overnight call I worked in those early years. Yet, the extra work and savings was a significant contributing factor to why we are each working a 0.5 or .75 full time equivalent while financially free in our mid 30’s.
First Year Tax Trap!
Since we are on the topic of the first year out of student life transitioning into working, I will quickly add another trap for the professional’s first year of earning an income. Most salaried jobs will take EI (employment insurance), CPP (Canadian Pension Plan) and tax contributions directly off their paycheck. The independent contractor or incorporated professional has no such requirement. Many professionals in this setting will fall victim to the first year income that seems huge since no tax has been taken off. They end up with a rude awakening when they suddenly owe 35-50% tax on everything they have spent. If the majority of the first year’s income is spent, the only place to go to make your tax payment is by borrowing even more off your line of credit (LOC).
The wisest approach here is to plan ahead. Most prudent people will put some money aside in a savings account to pay the big lump sum tax payment at the end of the year. This method will save having to borrow at tax time, but is suboptimal if you have student debt. In our first year out, I calculated our future projected tax payment based on our initial working income. Instead of placing this in a savings account where you earn nothing, I directed all future tax payments toward our student LOC debt. I was able to save the entire projected tax amount in the first 2 months. Our student debt total decreased about $80,000.
But wait, don’t you just have to borrow that $80,000 back when your taxes are due? This is correct, but 10 months of reduced debt translated into real savings of around $2400 of interest expense on the LOC during that first year. Try getting that kind of return in a savings account! This approach assumes you have remained with the flexible student credit line terms which most banks do for the first year. Avoid the first year trap of not planning for your tax bill and you won’t be stuck with more debt after year one then when you finished school!
Solution #2 – Live Off One Income
Another technique that works well for a two income earning family is to try their best to live off one income. This may seem harder in an expensive metropolitan center, but other families do get by on one income. Obviously the savings aspect of this technique would be formidable. It will often guarantee a savings rate of 20% or higher in perpetuity if it can be sustained. There is another advantage with this technique beyond the savings rate. A core aspect of financial planning includes planning around lost income from unemployment or disability via emergency funds and insurance products. These concepts can’t be totally eliminated, but often the amount of protection required will be less, which correlates with cheaper insurance.
Now you are likely saying thanks for all tips once they are way too late to use! You are past the first few years of working and have already taken on some lifestyle inflation. This live like a resident crap is totally useless to you. Well if you have missed this initial chance to save big, things are never too late. Most financial books will discuss that money psychology is such that it feels very easy to spend when you see large sums of money passing through your hands. If you don’t see it, it’s far easier to curb your spending. As with most things, gradual behavior modification is the best approach. You cannot make drastic changes one day and then expect to sustain them for the long term. Just like New Year’s dieting promises, you will likely lose some weight and then gain it all back a few months later.
Solution #3 – Pay Yourself First
Paying yourself first is the key behaviour modification technique to all of personal finance and savings. On a bi-weekly basis shortly after your pay cheque arrives into your account, immediately have a portion of that money disappear into an investment account. We will discuss later how you decide to allocate this money, but for now the initial savings aspect is key. The amount saved should be a minimum of 10% gross earnings per year if you have not started saving anything from your pay currently. This would mean saving $10,000 for every $100,000 earned. If you already have achieved this savings rate, try adding 5% more of gross income to the contributions. Depending upon how serious you are about financial freedom and wealth building, you will slowly continue this process until you have found the point you cannot reasonably reduce your spending without changing aspects of your life that truly contribute to your Inner Score Card happiness. My family is still achieving a 50% savings rate after always living by the concept of live off one income.
The process of how to reduce your spending from its current level requires more thorough discussion in its own post which will come shortly. The concept of paying yourself first seems simple and I can feel your skepticism already. I don’t expect you to just take my word for it as this is truly backed up by academic research in behavioral finance. Please refer to the section on Overcoming Investor Paralysis in this white paper document by UCLA PhD Shlomo Benartzi. It is a good read to discuss many of the simple behavioral finance concerns that hold people back from saving.
For those that want the quick summary, the research shows that employees that were given an automatic investment plan that took money directly off their pay checks, led to almost 4x the amount of contributions over a 3 year period! These individuals did not become saving gurus overnight. The simple act of not having that money flow into their hands was enough to change their spending rates substantially. These findings have been corroborated in Harvard research and many other areas of behavioral finance research.
The bottom line is if you can use any one or combination of Living Like A Resident, Living Off One Income or Paying Yourself First, you will be way ahead of most people on the road to financial independence.
What do you think? Are you still skeptical? Are you already doing this and it isn’t enough? Please comment below and we can continue the conversation and learn from each other.
Our next post will finish off our Financial Traps series with our final two and possible solutions.