When you get a raise in income, it is usually seen as a good thing for your retirement as you can now save more for your retirement. However, new research claims otherwise, suggesting a raise may hurt your retirement plans.
How can a raise hurt retirement plans?
This new research comes from Morningstar, which says that “Raises — and how we spend them — can actually make it more difficult to retire comfortably.” Morningstar team uses the term “lifestyle creep” to explain their research.
As per the research, titled More Money More Problems, when you get a raise, the things that were financially out of reach previously become more affordable, such as buying an expensive car, a bigger house and more. This results in larger monthly bills than before. It also means saving the same percentage as prior to the raise, may no more be adequate to support your new standard of living and retirement.
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It wouldn’t be wrong to say that lifestyle creep may put your retirement plans at risk as existing savings and other assets are relatively fixed. Thus, unless you save more, you may not be able to fund the increased expenses in retirement easily.
“It’s a continuing bill – you have to continue paying for this new lifestyle,” said one of the co-authors of the report, Steve Wendel, who is also Morningstar’s head of behavioral science.
Further, the report notes that Americans usually don’t increase their savings after getting a raise. For instance, the habit of saving 10% – both before and after the raise – won’t serve the purpose, the report says.
“People by and large aren’t increasing their contributions when they get a raise,” Wendel said. “It’s not something many Americans do.”
Moreover, a person’s retirement savings and Social Security benefits stay constant or grow less quickly than a raise would produce. This means, these benefits actually shrink when compared to the retirement needs.
How much to save?
To ensure that a raise does not hurt retirement plans, the researchers tested three ways. The first follows a simple rule – spend twice of the years to retirement and save the rest. For instance, assuming a retirement age of 65, a 50-year-old should spend 30% of the raise and save 70%.
In the second option, you save your age. This means, if you are 45 years old, you should save 45% of the raise.
The last method is to save 33% of the raise, irrespective of your age.
All three strategies work well for young workers, giving them a new lifestyle along with an expected retirement. However, from the age of 35 on, the strategy of saving 33% of the raise doesn’t seem to work. And, from the age of 45, the effectiveness of the “Save Your Age” strategy starts to fade away.
As per the research, the strategy of “spend twice your age to retirement” worked for all ages. “You’re locking in a standard of living from now until retirement instead of setting yourself up for a drop in retirement,” Wendel said.
Retirement planning tips
Apart from the above strategy of spending twice your age to retirement, investors can follow a few more tips that could help them with their retirement plans.
Start early – this is the advice that all financial consultants will give you. However, people usually get serious about retirement when they are in their 50s. The problem is if you start to save late in your career, then you may not have enough time to save up for the retirement that you want. If you start late, you will have to make big contributions and also compromise on your standard of living.
Don’t make mistakes – those who start to save late usually go for assets that could give them more returns, to make up for the time gap. Such users typically go for stocks. However, one thing that you should know is that investing in stocks also requires a long time horizon. Even if you are an expert with stocks, this strategy may backfire sometimes.
Capital preservation – it is all about understanding the risk, and thus, could help in building wealth. As per the experts, investors may have to delay their retirement by six years to make up for the 25% loss in the portfolio. This means that users should avoid large losses by neglecting overvalued assets and diversifying investments.
Consider Annuities – annuities provide a guaranteed income. Thus, if you have such a financial product in your portfolio, it gives you a stable income and allows you to be more aggressive with other parts of your portfolio.