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Behavioral Finance

Lifestyle Creep: The Biggest Threat to Financial Planning

Lifestyle creep can severely impact financial planning by spending more income over time than we plan on saving.

Articles by Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: February 28, 2019

For most of us, income growth happens in our 20s, 30s, and 40s, but stops or reverses in our 50’s and 60’s. Good planning includes some representation of these likely earning paths.

If you’re under 40, it can make sense to plan to save more in the future, given higher expected income.

Be wary though: lifestyle creep can ruin this plan. Lifestyle creep is when we increase our spending too much in response to income increases.

A conservative guideline is to save about 95% of any income increases from age 25 onwards.

For the median person making $57,000 a year, it sounds ludicrous that others making $500,000 feel like they’re ‘scraping by.’ However, they’re humans just like us: we might find ourselves in a similar position in the future.

How can we avoid excessive spending ruining our future? In this article, I will discuss the idea of “lifestyle creep”: what it is and how to realistically plan for it,  how you can level expectations for earnings throughout your lifetime, and practical ways to avoid overspending gradual income raises.

What is Lifestyle Creep?

Income usually increases in irregular little jumps: 3% this year, 8% that year. After taxes and inflation are accounted for, the take-home difference is even smaller. So it seems harmless to use the extra cash to upgrade our apartment, car, sofa, TV, buy more takeout… There is always more you could spend money on.

The problem isn’t the amount of money: it’s a combination of human behavior and the defaults in our financial system. When our income increases, by default, our saving rates decrease. Usually, the paycheck rolls into a deposit account and it’s spent. Spending more today is easy and pleasurable; saving more requires effortful planning.

Two caveats to what I’m about to say:

  1. If you’re at a low income level, spending most of your income makes sense: a warm coat, a safe home, and reliable transportation are worth it.
  2. I’m discussing enjoyable spending only. A new home, car, food, clothes, phones, are all fair game. When daycare for my daughter, life insurance, and my mortgage end, I won’t feel worse.

Lifestyle creep is one of the biggest invisible dangers to retirement plans. Why?

Your requirement for ‘enough’ goes up.

Downsizing our lifestyle is very unpleasant. People will take extreme actions to avoid it, including choosing risks and acquiring debt. It takes a strong person to voluntarily reduce their spending when they lose their job or take a pay cut. And increasing your lifestyle means you’re constantly raising the table stakes for contentment higher.

It can blindside you long before retirement: a larger lifestyle means a larger emergency fund, further to fall if you lost your income, and more pressure to keep a high paying job you hate.

One of the best ways to protect yourself against the pain of future income drops is to keep your lifestyle modest, which can give you breathing room if you want or need to have a lower income for a while. It also increases career options: I took a serious salary cut for a job once, which was okay because I had kept my lifestyle humble.

A happy retirement gets more expensive.

At retirement, you’ll probably want to maintain your previous lifestyle, or even bump it up temporarily by doing more traveling.

By my estimate, for every additional $100 in monthly lifestyle spending you start having before retirement, you’ll need about an additional $30,000 at retirement to keep steady.

It really is simple: An additional $100 per month x 12 months per year x 25 years in retirement = $30,000

Now, let’s analyze what that looks like depending on different levels of lifestyle creep. If you’re 25 years old making $40,000 a year, with a 60th percentile lifetime earnings—and who can earn a 1% in returns—then how much will you need in retirement savings if your lifestyle creeps upward? That’s what I show in the figure below (the horizontal axis shows lifestyle creep).

Just look at it for a moment: Someone in that situation who spends 80% of their raises needs a retirement balance that is 41% larger than somebody who only spends 20% of their raises. While yes, there are some easy criticisms of this analysis—not including social security, spending on children that ends, possible investment returns, or taxes—the fact is, lifestyle creep’s impact on retirement is complicated enough as it is. And perfect is the enemy of what’s clear and understandable.

A bar graph demonstrating the concept of lifestyle creep versus the required retirement balance.

[Caption]: The figure above shows a hypothetical simple view of the required retirement balance needed based on increases in “lifestyle creep” or current pre-retirement spending. This analysis is based on the simple scenario described above of a person making $40,000 per year and who earns 1% in returns as if earned in a savings account that isn’t subject to market changes. Neither the base scenario or percentage increases shown in the figure account for the impact of taxes or market changes.

A few assumptions we made: The 25 years old we described will retire at 65 years old and plans to live until 90. We also accounted for taxes. We simulated gross income reduced by appropriate Federal, Social Security and Medicare, and a fixed 5% state tax rate.

Lifestyle creep ruins your future savings plans.

When we see how much we need to save for retirement, it can seem like it’s too much, we can’t afford it. And that since we plan on earning more in the future, we can save then, right?

Yes, this can work out if you stick to it. But saving more tomorrow means saving a significant proportion of your increases, which requires a lot of self control.

Challenges To Keep in Mind

So, our challenge is to be intelligent about:

  1. How much we’re likely to earn over our lifetime, now and in the future.
  2. How much we will spend and save, now and in the future.
  3. How to set ourselves ourselves up to have a path over our lifetime through retirement which is robust to income and expenditure shocks.

Have realistic lifetime earnings expectations.

At 50 years old, the median individual earned slightly twice what they earned at 25 before tax, according to the Federal Reserve Bank of New York. However, that’s the point of greatest difference: after about 55, the earnings ratio begins to drop.

The graph below shows a summary of earnings curves from the same paper with data on millions of American workers divided up by their lifetime earnings percentile. While we can’t predict what lifetime earnings percentile we’ll fall into, we can use these data as a guide.

Over time it seems people either work fewer hours or a less financially rewarding job. This may or may not be voluntary: it could reflect changes in life priorities or job options available as the demand for specific skill sets decline in an area. Whatever the cause,  it means less potential savings.

A graph demonstrating "real" income on the y-axis versus age on the x-axis.

Saving more vs. spending more: the balance act.

You can run numbers to see how earning and saving more in the future is reasonable.

Let’s consider the same typical 25 year old with no retirement balance, earning $40,000 a year, spending their full, likely after-tax income of $32,612. Again, we’ll assume they’ll be in the 60th percentile of lifetime earnings.

Let’s look at 30% lifestyle creep. Each time they get a raise they save 70% of it and spend 30%. When their income starts declining later in life, they don’t spend less because their lifestyle spending has magnified. As a result, their highest savings rate happens at 50 years old, and they’re actually saving nearly nothing the year before retirement – they’re spending it to keep up with their lifestyle.

Pre-retirement they’ll be spending $40,399 per year (adjusted for inflation). To maintain that standard of living for 25 years in retirement would require a $842,025 balance.

A graph demonstrating your spending versus savings versus projected income chart.

Let’s assume a 1% real rate of return over the entire investment period. At retirement our example will have saved a total of $427,810, which has grown to $516,730. That’s not going to hit their $840,000 target balance.

How much lifestyle creep could our youngster bake into their financial plan, and still be ok? It depends on the return they will experience.

Reasonable returns you could plan on.

Acceptable lifestyle creep is very sensitive to the expected real return. Remember, real returns mean inflation has already eaten away about 2% of your growth. With a Betterment portfolio, you would need a portfolio with 45% stocks, 55% bonds to have an average expected return of 3.5%, and that comes with an expected 9.4% annual volatility (those are our actual projections). The graph below shows that the individual can hit their target retirement balance with a 4% or higher return, but with anything less, they’re in trouble.

A graph showing the retirement goal balance overall

Putting this all together, below I show the minimum return required to support any given level of earnings growth and lifestyle creep. For a person with median earnings growth, a conservative 2% real return yields an acceptable lifestyle creep ratio of 5%. You should save 95% of each raise you get, starting from 25.

A graph showing earnings growth percentile along the y-axis and lifestyle creep ratio on the x-axis.

Practical Ways To Avoid Lifestyle Creep

So what can we do to avoid the lifestyle creep trap? As long as you’re willing to live intentionally and thoughtfully, there is a ton you can do. It’s a very manageable problem.

Escalate your savings rate.

Evidence has shown that escalating your savings rate over time is one of the best ways to avoid spending what you should be saving. I like to do this both when I get income increases (I usually dedicate 75% of any raise to saving), and by small amounts over time so I don’t notice the loss of spending.

If you have a way to do this automatically, either through your 401(k), payroll, or your financial advisor, that’s even better.

Choose your peers and environment wisely.

The best way to make someone go bankrupt is to have their next-door neighbor win the lottery. It’s very hard for us to resist trying to keep up with our peers, so be thoughtful about who you spend time with.

Could you live in a less expensive house or apartment? Could you move to a neighborhood where your economic standing is in line with that of your neighbors’? When you vacation, could you choose inexpensive settings like outdoor trips and small cities?

Spend time with people who value conversations over carats, books over Bugattis, and closeness over square footage. Mr. Money Mustache and Morgan Housel are wonderful at showing the joy in needing less.

Cultivate a taste for inconspicuous consumption.

It’s trivial to see that someone has an expensive car, watch, handbag, clothes, etc. Don’t be fooled by the surface: you can’t see if they’re in debt, or have no retirement savings, or how much they learned and shared last year.

The longest lasting and most joyful experiences are rarely defined by their cost: a walk in nature; getting lost in a book in a cozy pub; helping someone overcome a challenge; a late running dinner with just a bit too much wine and good friends. Feel free to consume as much of these as possible: they’ll just set you up for an even more enjoyable retirement.

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