Everyone loves getting a big jump in salary, either from a career promotion, a big raise or a change of company in which you work for. More money for your time is a positive thing and is likely something you have been working towards for a while now. You have been financially intelligent up to now, putting aside a good portion of your income and investing it towards financial independence. What could be dangerous about a big salary increase that came with the recent promotion?
Well if not handled correctly, it can derail your retirement or savings plan very quickly if you don’t take the proper factors into consideration. To illustrate this, we will use the example of John Doe, who makes $36,000 a year at 20 years old. John decides he wants to retire at 55 years old and determines he will need to save 17% of his income every year in order to do this. The following assumptions are made:
Starting Income: $36,000 a year
Income Growth: 1% above inflation
Savings Rate: 17% of Income
ROI before Retirement: 6% (after inflation adjustment)
ROI after Retirement: 4% (after inflation adjustment)
With these factors in mind, John can predict that his retirement savings will grow, and be consumed in accordance with the graph below.
Everything is planned out with the assumptions above. If the ROI (Return on Investment) is as expected or better, all will work out. But what if John’s salary increases faster than expected? Initial logic would make you think that John’s financial position would be even stronger? Unfortunately, this is not the case. Let’s look at this same example, but John now received a big career promotion at 40 years old and his salary was bumped up by 25%.
Reviewing this graphic, John would now run out of money with his savings plan. In fact, he would be out of cash a little after his 83rd birthday. But how is this possible, if John maintained his savings plan of 17% of his income being put aside? Sure, he started to make more salary at age 40, but he was now putting aside 17% of a larger income. This leads to a higher investment value by age 55 (873k vs. 812k).
Let’s take another example, but this time John received his big salary bump of 25% at age 50, instead of age 40.
This time the impact is even larger, with John running out of savings by age 80. Again, why is this happening if John continues to stick with his savings plan of 17% of income being put aside?
To understand why, you must look at the other side of the 17% savings. That is, John is spending 83% of his income. If the income is increased by 25%, spending also increases by this much. While the portion of income being put aside also jumps by 25%, the investments already in the bank that have been growing for 20 years (or 30 years in the second example) did not get a 25% sudden increase. So, its kind of like John had inadequate savings the first half of his career. As the second example shows, the closer to the end of your career that this happens, the more striking the impact.
The main message here is always be cautious when you are increasing your spending in dollar value, even if your income is increasing. Looking at your spending exclusively as a percentage of your income can sometimes be misleading when initial assumptions change.
In our first example, with the salary bump at 40 years old, what could John do differently in order to secure his retirement? He would need to adjust his strategy at this point in time from 17% savings rate to 23% savings rate. This would still result in a sudden 16% increase in spending from the prior year. It would also result in a 70% increase in savings rate, when compared to the previous year. The graph would now look like this:
A similar adjustment can be made if the increase is at age 50, but with a more drastic change of the savings rate from 17% to 29%. Again, this still results in a spending increase, but maintains the security towards the initial retirement plans.
Finally, one last thing that can be looked at. What can you do differently, to potentially account for these salary jumps, when you are 20 years old? We had originally set the assumption of 1% salary increases (above inflation). If we set this to 1.5%, we now need to save 22% to reach financial independence by 55. If you end up getting smaller salary increases, well then you can just bump your spending once you hit retirement. It’s easier to increase your spending then to suddenly cut it, isn’t it?
The main point to take out of all this is that any kinds of sudden spending increases can be dangerous to your investment plan. Sometimes, even when you maintain the same savings to spending ratio. Always re-evaluate your plan periodically or whenever there is a sudden change in your situation. The assumptions you initially made, may no longer apply.