23 Sep 2016 It’s all relative

Source: “What Do Data on Millions of U.S. Workers Reveal about Life-Cycle Earnings Risk?” by Guvenen, Karahan, Ozkan & Song

If you’ve been reading our Brief for any length of time you may have seen the term “lifestyle creep” come up once or twice. It’s a fascinating concept with an equally emotive name, and it has all sorts of implications in the practice of long-term financial planning. Lifestyle creep is, more or less, the natural but potentially dangerous rising standard of living that occurs over the course of a lifetime as salaries increase with age (to a point). It’s potentially dangerous, because if it creeps too much, then retirement becomes prohibitively expensive to fund at the level of your creeped up lifestyle, since your rate of consuming dollars will by definition have outstripped your rate of saving dollars.

And in previous posts we have talked about some ways to help avoid too much lifestyle creep, or to catch up if you feel you have already creeped too much. A rather simplistic–yet effective!–approach would be to simply commit 50% of every raise to saving and investing for retirement while doing whatever you want with the other half. Ideally your approach would be crafted specifically for all the unique nuances of your particular personal and financial situation, but the “50% commitment” is certainly better than nothing.

Today, however, I want to talk briefly about why avoiding lifestyle creep is so important in the first place.

In 1993 two psychologists by the names of George Loewenstein and Drazen Prelec (what amazing names!) published a study in Psychological Review called “Preferences for Sequences of Outcomes,” and while the name of their study was decidedly less amazing than their own names, their findings were striking. Here’s an excerpt from Stumbling on Happiness that summarizes the study:

When people are asked whether they would prefer to have a job at which they earned $30,000 the first year, $40,000 the second year, and $50,000 the third year, or a job at which they earned $60,000 then $50,000 then $40,000, they generally prefer the job with the increasing wages, despite the fact that they would earn less money over the course of the three years. This is quite curious. Why would people be willing to reduce their total income in order to avoid experiencing a cut in pay?  

Why? Because we as humans are much more sensitive to changes in our income over time than we are to the absolute magnitude of it. And for that reason, we would prefer to take a job that made us less money in total but with incremental raises than a job that made us more money but that included a scaling back of pay.

And that’s why avoiding too much lifestyle creep is so important, because if we don’t, we will likely find ourselves having to cut back our lifestyle when of course we would much rather maintain or even increase it.

Finding the sweet spot where you can enjoy life today while not spurning your future self is a difficult and ongoing process, but it’s a process that pays dividends both now and in the future. It’s also a process that we’re here to be a part of, so please let us know if we can help you navigate that tension.