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 …