Lifestyle inflation refers to when discretionary spending increases at roughly the same rate as your income.
An extreme example is what typically results after someone wins the lottery. However, more subtle increases are far more common and may even be hard to detect, or perhaps, just much easier to ignore. If you’re maxing out your 401(k), should you be concerned if there’s not much else left at the end of the year?
For high earners, the slow creep of lifestyle inflation can be a real threat to retirement.
[See: 7 Dividend Stock Alternatives to Fuel Retirement Income .]
Enjoy responsibly. As a financial advisor, clients are sometimes surprised when I encourage them to take a big vacation or splurge on a Peloton. Spending money on activities, experiences and items that bring you enjoyment isn’t a bad thing. After all, why work if you cannot enjoy your success?
But just like many other things in life, moderation is critical.
A central reason lifestyle inflation can be so toxic to an investor’s financial situation is because an investor’s savings rate can’t keep up with the increases in spending. This is especially true for individuals who aren’t saving for retirement or other goals outside of their 401(k) or 403(b) contributions.
Here’s a simplified example:
In 2017, a single executive earned $300,000 in gross income from salary and a bonus. The executive contributed the maximum to their 401(k) ($18,000 in 2017) and was in a 30 percent average marginal tax bracket. Aside from the retirement plan, the executive made no other contributions to savings or investments in 2017.
In 2018, the same single executive earned $350,000 in gross income and bonus, a 17 percent increase from 2017. The executive contributed the maximum to their 401(k) ($18,500 in 2018) and for simplicity, is still in a 30 percent average marginal tax bracket for the year.
The executive’s after-tax lifestyle inflation resulted in $2,888 in extra spending per month, an amount which is rather quickly consumed in many high-earning households.
As this example illustrates, the challenge for the executive becomes how to save enough during the high-earning working years to be able to maintain a similar quality of life in retirement. Even assuming a long-term time horizon for investment growth and compounding, it may be difficult to afford a similar lifestyle in retirement if you’re only saving a small fraction (in this case 8 percent) of what you spend annually.
Here are three ways to combat lifestyle inflation:
Beware of fixed costs. Lifestyle inflation is essentially the modern version of “keeping up with the Joneses.” One of the fastest ways lifestyle inflation happens is through real estate: either by upgrading a primary residence or purchasing a vacation home. An extra few thousand dollars a month in a monthly mortgage payment, insurance, property taxes, and so on, can quickly evaporate a bottom line. Cars and boats are other common fixed-cost culprits too.
[See: 7 Things You Need to Understand About Your 401(k).]
For investors with a variable income, such as sales executives and business owners, adding new fixed costs may jeopardize retirement savings even further if an economic downturn makes it difficult to keep up with fixed obligations. When faced with missing a mortgage payment or skipping a 401(k) contribution, the choice is pretty clear.
Assess your needs versus wants. If it’s been a while since you took a deep dive into your spending history and itemized fixed expenses, that’s a great place to start. Identify trends, what expenses add the most value to you, and work on unpacking the dreaded “miscellaneous” category.
Try to be objective about whether big-ticket items are truly affordable. If you saved and invested the funds instead, would the amount be meaningful to you in 10 or 15 years? Assuming a 6 percent annualized return, investing an extra $2,000 per month would result in a balance of $581,637 after 15 years when compounded monthly. Many people regret not having saved more along the way. Few people look back and lament things like annual vacations in business class.
Throughout this process, challenge your justification of any expense you label a “need.” Housing, food, exercise, transportation: these items are all necessary expenses. However, total spending on these categories will vary widely from person to person, as there’s a lot of choice involved. Depending on the expense, it may not be realistic or necessary to make a change in the short term. Take a candid look at where you choose to splurge and assess whether that may impact your ability to live the life you envision in the future.
There’s a lot you can do to reduce overspending without feeling like you’re doing without. If you love to travel, consider skipping the flight upgrades and choosing an Airbnb instead of a five-star hotel. Reducing the frequency of your reoccurring expenses can also help curb spending. Some examples include new cars, vacations, electronics, personal training sessions, spa services, and home furnishings, services or improvements.
Automating your savings. Rather than spending too much time budgeting and tracking every purchase, consider earmarking a portion of your income to go to saving for retirement or other goals, and then automating the process through online transfers. Unless a significant portion of your income comes in a lump sum, like an annual bonus, automatic transfers each month or quarter can help even out your cash flows.
Assuming you’re already maxing out contributions to your retirement plan at work, consider opening a brokerage account to save and invest toward any of your financial goals. Because a brokerage account does not have any special tax benefits, investors are generally free from the restraints imposed by retirement plans.
[See: 11 Steps to Make a Million With Your 401(k).]
For high earners, it may be possible to double or quadruple your annual savings by scaling back a bit and automating additional savings. Especially if you’re still a ways away from retirement, this dramatic increase to your asset base could significantly change your retirement projections.
Working with a financial advisor can help you pull everything together to develop a cohesive investment strategy and a plan to make the most of your high-earning years.
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How Lifestyle Inflation Can Harm Investors originally appeared on usnews.com
