By Stephen Horan, PhD, CFA, CIPM
Some people like me can hardly save enough, always looking for ways to stash away more of each paycheck in case of a rainy day.
It may seem odd for an investment professional to focus on something as basic as plain-vanilla savings, but before we can be investors we must be savers.
Long before I studied finance formally, my mother told me a story when I was young that became imprinted on my mind, and I still enjoy retelling it today.
It’s the story of two identical twin brothers: one who saved early and one who attempted to save later in life. The youngest brother began saving 4,000 dollars a year into his IRA when he entered the workforce at 18 and stopped at age 27. His prodigal brother didn’t save a dime between age 18 and 27, but he began socking it away after that.
When the brothers reached 65, the diligent saver had 1.17 million dollars and the brother who neglected to save in his younger years had 952,000 dollars at an average return of 8 percent a year. Now here’s the kicker: The frugal brother saved 40,000 to achieve his nest egg while the lackadaisical saver had to put in 108,000 dollars and save over a much longer time period – ending up with less.
The mathematics are always explained as the power of compounding. For me, the story illustrates the power of learning to say no and delaying gratification. In the end, I think the inability to delay gratification is what holds most people back from reaching their savings goals. It’s only human nature, after all, to want to reap the rewards of the money we’ve earned rather than to delay receiving those rewards. Here are some tips to help counteract that basic instinct.
Saving Strategy 1: Save on Auto-Pilot by Default
Given this human tendency, some experts have designed ways to help people reach their goals – despite their natural inclinations. Such strategies are becoming increasingly important as companies move away from defined-benefit retirement plans and favor defined-contribution plans.
For instance, Richard Thaler, the University of Chicago economist, has written frequently on what he calls “choice architecture” or default settings that enable people to make hard decisions and forget about them. When a company or employer starts an employee off with an automatic investment into a 401K or a savings vehicle - except if the employee deliberately opts out - the employer has designed a default choice that serves the best interest of the employee.
The advantage of this approach is that employees have to make the hard decision only once and then the decision is repeated for them automatically month after month. These are simple but powerful tools; the evidence suggests people are heavily influenced by inertia.
In other words, once people are enrolled in an auto-pilot savings program, they often stay in it over the long-term due to the inconvenience of getting out of it. In the end, people serve their own interests but still act on their own free will. Thaler and others have called the concept “soft paternalism” or “libertarian paternalism.”
Saving Strategy 2: Set Aside High Percentages of Pay Raises and Bonuses
Thaler has even created a program called “Save More Tomorrow” that plays on the tendency of people to put off making tough choices. The idea behind this program is to increase a person’s savings rate incrementally over successive years by committing to set aside a certain percent of any pay raises.
Savers may also employ another technique that I support: setting aside high percentages of windfalls, such as bonuses. I know of people who save most of their bonuses, sometimes because they want to increase their cushion but oftentimes because they work in a risky sector that’s prone to layoffs, and their compensation may be based primarily on a bonus. These people know that next year’s bonus (or perhaps even their salary) isn’t a given and want to prepare for that eventuality.
Not everyone can discipline themselves in this way, however. In some cases, people who receive bonuses or other windfalls can become overconfident about their ability to repeat their success, even though their success may have been dependent on external factors. It’s simple human nature that affects almost everyone. [See my post about overconfident day traders here.]
Saving Strategy 3: Have More Withheld to Cover Taxes
Another strategy is to have the government withhold more of your pay each month to cover taxes than is actually necessary. By doing this, you are, of course, giving the government an interest-free loan, but just check the interest rates your bank is paying right now. The low interest you forfeit may be a small price to pay in order to help yourself save more.
One of my clients did this consistently and says his tax refund seemed like a bonus payment each year. He was a sophisticated investor but not too sophisticated for a simple “trick” like this, since he used the savings method with an understanding of his own emotional and behavioral tendency to spend rather than save.
I applauded his efforts because he seemed to have a better-than-average understanding of his strengths and weaknesses and he designed his savings plan around that.
Saving Strategy 4: Bucketing
In closing, I’d like to propose another simple method for organizing your finances that may help boost your savings rate. For a strict finance person, it may sound like heresy, but I have seen many of my clients successfully use the method I call “bucketing.” With bucketing, a person creates imaginary or real “buckets” (i.e. nicknamed sub-accounts) of money for achieving goals important to him in life. One bucket may be for a child’s education while another is for retirement and another may be for that dream sailboat for skippering along the coast.
Sometimes the government creates buckets for us – we have 401Ks, IRAs, 529 college savings plans and healthcare savings plans. It’s not a bad thing that the government bucketizes for us: indeed, it’s a type of choice architecture. My only word of caution is to plan in advance about the tax implications of each type of bucket and set up your buckets for maximum flexibility when it’s time to dip into them.
On an aggregate basis, the buckets aren’t so important but rather the overall amount in the buckets is. Still, the buckets can help identify a potential shortfall: If your child is nearing college age and the school bucket is empty, it makes a powerful statement….
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-With Rhea Wessel, a personal finance writer based in Frankfurt.
The information contained in this article and from any related communication is for informational and educational purposes only. The information in this article should not be interpreted or used as investment advice. CFA Institute does not recommend or endorse any investment security, product, or strategy or any service, product or material submitted by or linked to this article by third parties.
For more information, see: The Theory of Optimal Life-Cycle Saving and Investing by Zvi Bodie
