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Don’t Change Your Lifestyle – Save Your increment Instead

You would think that the closest people associated with me would have my best habits rubbed off them.

Often the people that are closest to you are the ones that you have the biggest problem convincing.

Enter my best friend.

He loves to live a good life.

Has a great job earning an above average salary, a house that was bought when the prices were far more reasonable, a weekend off peak vehicle during the times when Hyundai Avante was costing $44k.

His big problem: A reluctance to save more.

In his case, the problem is that he wants to keep his current standard of living yet he wants to build his wealth.

Often a persons problem with saving are psychological.

I can tell him to set aside 25% of his disposable income for saving like I always do. But to him that is loss aversion. Its like taking 25% of spending money from him.

You can imagine the reluctance for him not to do that.

People also couldn’t see far enough to want to save for a future that they do not know whether they will have.

With these problems in mind do we have a better solution to this?

Researcher Shlomo Benartzi has a good solution.

A person  like my best friend feels more comfortable saving in the future. He also doesn’t want to set aside X amount of money which mean reducing his standard of living.

Saving your Increment

What do  we do?

Save more of his Salary increment

We make him commit 3% of his future increment to saving. With the left over he can supplement to his lifestyle.

So if my best friend is earning $50,000 per year,

  • He starts off saving 3% of 50k, which is $1500
  • In year 1, he gets 5% increment, he increases his savings rate by 3%, meaning a total of 6%. On a salary of $52500, he will now save $3150
  • In year 2, he gets 5% increment, his savings rate increase by 3%, a total of 9%. On a salary of $55125, he will now save $4961.

The first thing you will notice is that after 5 years, his savings rate increase from a puny 3% to 18%, which is close to the 20% we are expected to save.

Second thing is, his standard of living is maintained and he did not cut down on this original lifestyle.

In fact he have more spending money when he started out.

In this way there is no loss aversion and he was able to achieve saving more.

Benartzi’s research shows that 78% of those who were unwilling to save initially, was OK to participate in something like this.

And the drop out rate is lower than expected.

However, not all plans are without flaws:

  1. In this time and age, it will really depend on whether we get a consistent 5% increment. You have to be at a good company or always jumping to achieve that.
  2. It is difficult to automate such a plan on a large scale because not all companies will have increments, and its difficult to fix a percentage to save.

For a better explanation of the plan watch this video. Look at your past salary increments, and tell me whether this is doable.

 

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