Lifestyle Creep can Ruin Your Retirement!

When you get a raise or a bonus, does your spending on lifestyle consume all the increase, or do you maintain (or better yet, increase) your savings rate?

If you’re spending all your raises and bonuses on current consumption, your savings rate (in other words, the percentage of your gross income that you save) is declining.

A declining savings rate can cost you more than you realize down the road.

Most personal finance professionals recommend saving 20-25% of your gross income in order to maintain your pre-retirement lifestyle in retirement.  And for those pursuing FI/RE (Financial Independence / Retire Early), the percentage is likely higher since you will be spending more years (and money) in retirement.

NOTE: this percentage can include any matching contributions your employer makes to your retirement accounts; however, be careful with including extraordinary matching or equity awards.  For instance, if your employer contributes 20% while you contribute only 5%, 25% may not be enough in this instance since your lifestyle is likely consuming the other 95% of income.

Lifestyle creep becomes a problem when you fail to save the first 20-25% of that raise or bonus, thus driving up your consumption percentage and driving down your savings rate over time.  You may have started out with a robust 25% savings rate, but over time, if you simply save the same dollar amount, the percentage of your gross income that you are saving declines.  This can happen very easily when maxing out retirement accounts.

Let’s say you earn $80k per year and max out your company 401k plan in 2022 at $20.5k per year.  That’s a savings rate of just over 25%, which is great.  But you’ve hit the max.  So, now let’s say you get a big raise, up to $100k per year.  If you don’t save $5k of that twenty thousand dollar raise somewhere, your savings rate will decline to just over 20%.  And if not addressed, eventually the rate can drop to a level that puts your retirement in jeopardy.

Consider another common scenario for my friends in the tech industry where equity compensation is common.  If you view your stock grants and RSUs as “bonus spending money” to spend on current lifestyle (or even on a future lifestyle purchase), you could easily find yourself with a lifestyle that your savings rate cannot support in retirement.

Make sure you maintain that 20-25% savings rate THROUGHOUT your working years, even as your compensation grows.  Starting out strong is important, but so is maintaining consistency.

Some numbers to think about:

Using the 4% rule, you would need $2.5M in retirement savings to replace $100k of income.

If you plan to retire earlier than 60, a safer withdrawal rate might be 3%.  It would take a $3.33M portfolio to replace $100k of income at a 3% withdrawal rate.

Maintaining your pre-retirement spending level in retirement requires sacrifice throughout your income-producing years.  But the alternatives of working longer or spending less in retirement may be worse.

The best way to avoid lifestyle creep is to save based on a percentage of your household income rather than a dollar amount.  Whether you make $80k or $500k per year, you should be saving 20% to 25% of your gross income toward retirement…and even more than that if you’ve fallen behind or want to retire early.