Most writings for advisers are directed to helping clients in or near retirement, for the same reason why Willie Sutton robbed banks: That’s where the money is. But more attention is due to those just entering middle age, who still have the time to avoid their parents’ mistakes. This second part of columns on Young Investors is directed at clients in their 20s through 40s.
Get Off the Hedonic Treadmill
If you observe friends and coworkers after they get a raise, you will usually see them react in the following five stages:
- Satisfaction—at being validated
- Indulgent—enjoying spending extra
- Irritated—at their higher tax bill
- Confused—at how their glee evaporated so quickly
Economists call this the “hedonic treadmill”: More income leads to more spending, but more spending generates little added happiness. We quickly become accustomed to our new spending level. Better to save your raises now to buy you peace of mind later. An added bonus is that if you do not enhance your lifestyle with each raise, you will need to replace less income when you retire.
Try a Budget
Only a small fraction of Americans budget their expenses. So it isn’t surprising that the majority of households spend every dollar they earn—and often more.
When you retire, you will lose the ability to make up for unexpected expenses by working harder. So it is a good idea to gain the habit of spending within a constraint. Build a simple budget. It need not be elaborate; in fact, it is easier for you to conform if it has only a few, broad expense categories. Begin cultivating the habit of discipline early, so that it will be thoroughly ingrained when you really need it. This may also help you estimate your real income needs in retirement, and give you useful insight into how to implement the envelopes strategy.
Put It on Autopilot
Psychologist Daniel Kahneman won the 2002 Nobel prize in Economics for his work (with Amos Tversky) explaining how real people make real financial decisions, as opposed to how economists theorize decisions are made. In his Thinking, Fast and Slow, he argued that we all have two cognitive systems: System II is careful and deliberative, relying on evidence and logic (slow), while System I is intuitive and mercurial—and fast. But engaging System II involves mental effort that no one has in unlimited supply. So we often fall back on System I, that uses shortcuts and rules of thumb (that Kahneman calls heuristics)—and often is wrong. As a result, we often default to whatever the status quo is.
If you need to deliberate over each dollar whether to save or spend it, you will save less. Employers who establish a default retirement contribution for their employees find that large fractions never change it because it takes too much effort. So retirement plans are increasingly setting as their defaults a low but meaningful contribution rate, and a target date fund as the default plan. Under this default overall employee contribution rates rise, and employees’ assets are more sensibly allocated. This is because saving and investing were put on automatic.
Financial advisors commonly say “pay yourself first” instead of saving only what is “left over” after spending, which is often nothing or very little. They argue you should designate the first use of your paycheck to investing, leaving only what is left over to spending. Payroll deductions, such as those taken to pay taxes, make this process automatic. No mental energy is needed to save and invest each pay period.
Your employer may set a default contribution rate, probably a low number like 3% of your gross pay. Do not assume that amount is right for you; chances are it is too low. At least, set it to the maximum amount that your employer matches, if you are fortunate and have an employer match available (many went extinct in 2008). For your investment election, take the target date fund option that comes closest to your likely retirement year, or a bit later. That assures your asset allocation will be automatically adjusted over time.
The idea is to put savings and retirement investing on autopilot, until the day when you are ready to focus on it. In the meantime, use the reports you receive from your account custodian as a way to begin educating yourself about investing, so you can decide if you wish to take more control. But until you do, or if you never do, you’ll know that your retirement savings are moving in the right general direction.
Forewarned Is Forearmed
The above is hardly the playbook your parents followed, but the environment you face is far more challenging. You should congratulate yourself for facing it squarely and employing a specialist to help you.
But bear in mind that it is your money and your retirement, not your adviser’s, at stake. You are taking an important step towards being a smart investor by beginning your education now. You should continue this lifelong process. Even if you engage a financial advisor, you should never rely solely on that person. Your knowledge will help protect you against charlatans and allow you to confirm that the professional’s advice is in your best interest.
Philip J. Romero, a finance professor at the University of Oregon, and Riaan Nel are authors of “It’s the Income, Stupid! 7 Secrets for a Stress-free Retirement” (Post Hill Press, 2017).