One of the first books that I ever read on the subject of personal finance was The Richest Man In Babylon … if you haven’t read it, get it and read it.
It is a wonderful primer on the basics of personal finance.
The part that stood out for me – since repopularized by David Bach in his hugely popular Automatic Millionaire series – is the notion of paying yourself first.
The story goes: if you would only pay yourself first [insert popular pay yourself first amount here: 10% of your gross; 15% of your net; up to the employer match; one hour of salary a day; etc.] you will be well on your way to financial success.
Except that it’s a crock …
If you pay yourself first, you’ll be slightly better off than the Jones’, but that’s about it.
Does that mean that you shouldn’t bother to pay yourself first i.e. save a portion of your income?
Of course you should, but not:
(a) where the popular financial press tells you to,
(b) in the amount that the popular financial press tells you to, and
(b) for the purposes that the popular financial press tells you to!
Before we examine how they got it so wrong, let’s take a look at why it doesn’t work; we’ll start with the typical ‘pay yourself first’ amount of 10% of your gross salary:
Let’s say that you start with a $50,000 annual household income, and you want to maintain your current standard of living in retirement … which is in approx. 20 years.
[AJC: why anybody would want to work for 20 years just to maintain their current standard of living is beyond me?! But, let’s go with it, just for the sake of proving a point ;)]
Firstly, you can assume CPI salary increases between now and your retirement date, so in 20 years your salary will approximately double to $100,000. Of course, since they’re only CPI increases, you haven’t really earned a pay rise as all as your gas, bread, milk and so on have also doubled in that time.
At a 4% so-called ‘safe’ withdrawal rate (to allow for average investment returns less the effects of taxes and ongoing inflation, etc.), you will need an approx. $2.5 million after tax lump sum in 20 years to generate $100k for life [AJC: assumption, assumption assumption … but, we’ll go with this, too].
Note: you can get by with less, if you trust that Social Security will be around in 20 years, but I wouldn’t bet on it … and, neither should you.
In order to generate $2.5 million in 20 years you will need to pay yourself first … drum roll please …. 75% of your gross income, starting now and continuing for the next 20 years.
This assumes a 9% after tax return on your investments; 8% undershoots by a couple of hundred grand and 10% overshoots by about the same.
So, what does David Bach’s 1 hour of salary a day (or 12.5% of your gross) actually do for you?
It gives you about $15,000 a year to live off (a little less than $8k a year in today’s dollars) making you a real Automatic Thousandaire 🙂
Next time, I’ll answer the where in for questions …
The Richest Man in Babylon is also the first PF gook I read and it’s still my favorite.
I’m thinking your figures are way more pessimistic than realistic. When you run them based on an average career of 40 years, the compounding makes huge strides. But I’m not interested in arguing about numbers.
The real issue is what’s the alternative to Paying Yourself First? Spend all of your money and keep nothing for yourself? Never accumulate any wealth or security? Give all of your income to others?
The whole idea of paying yourself first is to ensure you become wealthy, not to get rich quick.
I have found that since having started the discipline of saving, my motivation for finding ways and means to boost those savings, has increased hugely.
Numbers can be manipulated to and fro by selecting different datasets of historical performance, but I think there is a psychological shift that takes place the moment you start saving and investing.
And that difference makes you begin to respond to financial situations differently – and that ultimately – in my case, has caused a turnaround from going backwards financially, to moving forward at a reasonable rate. I’m not at my number yet, but the forward rate seems to be accelerating, and ideas seem more plentiful when you’re driving forward positively, than fighting the current and being driven backwards.
“Because I was quietly doing what I advise my readers to do: take your income and use it to buy income-producing assets instead of spending it. What my family and friends don’t realize is that’s how I made I made $7 million in 7 years, starting with $30k in debt.”
This is the same thing as ‘live below your means’ or ‘pay yourself first’.
It’s what you do with that money after you live below your means and pay yourself first that makes the difference, but however, you still have to live below your means in order to have that cash to invest, lol. You can’t hide it under the mattress of course(but nobody really does that anyway), you must invest it into things that have the potential to grow; stocks, income-producing real estate, additional business, etc..
But it’s simple semantics, it’s the same thing.
Obviously, the whole process goes a lot quicker if you make 250k, 350k or even 500k per year while you pay yourself a 50k per year salary and invest the rest, than say, earning 75k per year and living on 50k.
The former is going to get richER quickER and the latter is going to take longer.
About that mattress thing … In China it’s still quite common, and just the other day some of my wife’s cousins decided to buy their mother a new mattress…
By the time they got to the dump where they had dumped the old one, the 100 000 that she had stashed away in it, was gone.
lol wow, looks like they need more books and education over there on finance. We need to get more of them reading 7million7years. 😉
@ Brett – You don’t find that needing to work for 40 years v 20 just to try and replace your current salary isn’t just a little pessimistic, either?
@ Scott – absolutely! My point here isn’t that living below your means is useless, it’s about what you DO with it that counts [see Part 2, tba] 😉
Absolutely Adrian, my comment is really just designed to point out that the first requisite is to live on less than you make, regardless of what you make(ask Mike Tyson if earning 300 million is enough to keep spending all you make and still be fine).
I think you have to be careful in some of these posts because they can be confusing to the average reader and look extremely contradictory to someone who is just starting out, ROFL!
I can remember when I first started out a couple of years ago on my journey of building wealth, I would read one post that would say that in order to become rich, you absolutely HAVE to live on less than you make, after taxes, because you have to start investing in things that go up in value, period, preferably things that go up in value quickly. But the first essential(basic elementary mathematics) step was to live on less than you make so that you HAVE money to invest, which is the same as living below you means, or any other dozen ways you can say it semantically.
But then the very next post I would read would be posts like this that says “You can’t live below your means and get wealthy”, “Living on Less than you Make won’t do it!!”, etc..etc…
It confuses the average reader, lol. The Richest Man in Babylon got it right, not wrong, but what must be added is: “Step 2.: What to do with that money that you paid yourself first, saved after living below your means, budgeted to be able to save, etc..etc..” Not titles that read that paying yourself first is a myth. 😉
@Adrian – No, I figure I would have been working that 40 years either way. So, I may as well become wealthy and enjoy my life. The saddest thing I see are people who work their entire lives and wind up with nothing. It breaks my heart.
Don’t get me wrong, I would love to get rich quickly. But, it didn’t happen. I had a family of four to take care of on my single income. And I didn’t make that much when we were young and starting out. But, I still saved dilligently and that allowed us to have a nice house, retirement funds and college funds for the kids.
I guess that’s the point I wanted to make. It’s great if you can save 7 Million in 7 years. But, for most people, that’s not going to happen. Most people become wealthy over the course of 30-40 years.
@ Scott – “The Myth Of Believing That You Can Become Rich Just By Paying Yourself First” just doesn’t seem to have the same zing 🙂
“The saddest thing I see are people who work their entire lives and wind up with nothing.”
@ Bret – Unfortunately, too true 🙁
But, there’s a whole (admittedly, minority) other class for whom working for 40 years to get what I say you can get in less than 7 would be almost as sad.
BTW: you can’t SAVE $7 million in 7 years unless you’re the CEO of GE or IBM 😉
lol, yep Adrian, they wind up with nothing because they spent all they earned, just ask my folks how well that’s worked for them, spending all of their wages each and every month, all their lives instead of living on less than they make. But also in the case of “saving”, would anyone really try and “save” 7 million dollars directly into their checking or money market account? 😉 Even the average Non-GM CEO Joe(who does in fact live on less than he earns) is putting his 10 or 15% into his retirement account(stock market), not piling it up into his money market or local branch savings account(aka < 1% mattress). So of course, 10-15% of Joe Sixpacks 50k per year salary isn't going to grow to 7 million in 7 years, but it IS going to grow to somewhat of a retirement for him in 30. Remember, it's a better plan for the general masses who will never even think to strive to do more than that and who were planning on living on government support as their "retirement plan". Oh how I wish my parents would have at least done that over the course of their lifetime so I wouldn't have to watch them try and get SS checks into the future or try and dupe the government into giving them disability checks, etc… and now I have to deal with the possibility of supporting them financial, like kids.
How much nicer would it have been for everyone if they had at least saved up a cool 1.5mil to retire off of?
The David Bach, Dave Ramsey's and Suze Ormans of the world are marketing to and catering to the masses, who aren't in the least bit interested in opening a chain of sporting goods stores and will most likely never be. To me, that's fewer of society leaning on social programs and that's better for everyone.
So there's a financial plan for them and their's a different financial plan for us, who want to be richER, quickER. It's a good thing we have both for different audiences with different goals. 😉
Parallax, I fully agree with you.
If we could at least get most people in most countries to retire financially independent, by e.g. 60, or 65, the general financial conditions in which we all live will be much better.
And that will mean more opportunities for the get richer quicker tribe 🙂
Exactly Ashton, that’s really the point I was trying to make. The masses aren’t really interested in doing what it takes(sacrifice) to become really rich, especially doing it quickly, so my idea is that they need the Dave Ramsey’s and Suze Ormand’s of the world, so they can at least have somewhat of a retirement next egg and no debt, no car loans and no mortgage when they retire, so they don’t have to depend on society to take care of them.
I think the key is to have several different plans that can be applied to several different goals and skill sets for several different levels of wealth creation.
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We are making him wealthy by purchasing his books, so I guess it works for him.