How Giving Your Retirement Account a Raise for Just a Couple of Years May Mean You Retire Successfully and Enjoy Life More
As of this writing in the late spring and early summer, we are all probably quite familiar with the concept of a treadmill. It is that wonderful (awful) contraption that we (would never) use to feel confident (ashamed) during our summer vacation. Treadmills are as important to the summer vacation ritual as it is to later blow our fitness routine by lying at the beach and devouring delicious food and beverage.
While we’re all familiar with the exercise device, you may not be familiar with the “hedonic treadmill.” The “hedonic treadmill” is a term coined by British psychologist Michael Eysenck, although the concept dates back to St. Augustine. This brings us to the “hedonic” piece of our treadmill analogy.
Hedonism is a theory or belief that “pleasure is the highest good and proper aim of human life.” There are infinite examples to further illustrate this concept, but our purpose here is to apply the concept to personal finance. Our goal within personal finance is to develop, execute, monitor and convey a plan to help people achieve their goals. The primary reason we develop and seek to achieve goals is to promote both financial and general well-being.
To walk on the hedonic treadmill is to say that your desires and expectations (spending) increase with your income.
You get a raise, but your happiness remains idle just as a walker on a treadmill does not actually advance. Sure, it is important to enjoy your lifestyle and benefit from an improved standard of living; however, we also know how important it is for our happiness to maintain a balance between expectations and reality.
Since humans are naturally myopic planners, tending to plan poorly for long-term needs, we should all strive to condition ourselves for saving—this is particularly true for young adults. Even better, there is a very simple way to do this that typically only takes a couple of simple actions.
Let’s run through a scenario with the following details:
- John is a 30 year old with no savings
- He earns $45,000 per year,
- He is saving 5% of pay toward retirement
- He receives a 2.5% annual pay raise or cost of living adjustment.
At a retirement age of 67, John would have accumulated about $215,000 in savings (today’s dollars, accounting for inflation)—not bad!
However, if instead of permanently saving 5% each year, John saved 5% the first year, then directed the 2.5% pay raise into savings for a savings rate of 7.5% the second year. On the third year, he did that once again for a savings rate of 10%, a savings rate which he then maintained for the rest of his career. By taking these small steps, John would see a significant increase in future savings and retirement security. In this second scenario, the savings at retirement would amount to $415,000, which is a 93% increase!
Doing this for just a couple of years can have a significant impact on your retirement future. Once the 1-5 years are complete, you will likely be sitting at a comfortable savings rate for the rest of your life if you don’t reduce it, you will have arrived there in a relatively painless manner, and you will have the peace of mind to really enjoy your income for the rest of your life.