More on the the myth of paying yourself first …

You can play with numbers until you go blue in the face, but unless you understand the principles you won’t be able to make the right life choices.

So it is with the myth of paying yourself first.

It’s usually pitched as putting aside the first 10% to 15% of your paycheck into your 401k with any excess (when your 401K’s maxed out) I guess being put to work elsewhere. Some offer slight variations on the theme, like David Bach’s one hour of salary a day (or 12.5% of your gross).

Any way the ‘gurus’ put it, the alluring promise is of following this discipline your whole working life to ‘finish rich’. David Bach – author of the book to the left – goes even further calling this a powerful one-step plan to live and finish rich.

We have to examine this promise very carefully, because following this line of reasoning for 40 years to see what happens leaves very little room to maneuver if you come up short.

If the ‘normal’ working life is 40 years – to me this concept is almost incomprehensible – then, picking a mid-point in your career and a mid-salary of $50,000, adjusted for inflation, that you think (another terrible assumption) that you will be happy with for the rest of your life, then in my last post I showed that you would need to save almost half of your pay packet (again, indexed for inflation) until you retire …

… simply to replace your $50k salary (by then, inflated to roughly $100k but so have all of your living expenses).

But, what if you start young – as Bret @ Hope To Prosper suggests – and are happy to work 40 years?

Firstly, I would have to ask why you’re reading a blog titled “How To Make $7 Million In 7 Years” 😉

Putting that aside, you would need to save a tad under a quarter of your paycheck if you want to maintain your $50k per annum lifestyle beyond retirement (inflation would have roughly halved your buying power twice in that period, meaning that you would actually be withdrawing around $200k per annum just to maintain the same lifestyle that $50k buys you today).

Unfortunately, you are unlikely to reach your desired salary so early in your 40 year working career …

So, if you’re a graduate with a starting salary of, say, $30,000 and you somehow ramp that up to $50,000 after 5 years (at which point you start saving for retirement), you would need to save around one third of your paycheck for the remaining 35 years until you retire.

To be clear, following the common wisdom and “paying yourself first” 10% of your $50,000 gross paycheck (then indexed for the next 40 years for inflation) as recommended by many (if not most) personal finance ‘gurus’ is a sure-fire way to make sure that you retire on over $60,000 a year.

However, far from being a pay increase, because of inflation it actually represents less than 50% of your current $50k salary. Work and save diligently for 40 years and cut your paycheck in half …. nice 🙁

Any way you look at it, paying yourself first is no Powerful One-Step Plan to Live and Finish Rich as claimed by David Bach and his ilk.

Next time, I’ll share a plan that will work much better …

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13 thoughts on “More on the the myth of paying yourself first …

  1. Agree – unless you have a very high income and are prepared to live on a lot less than you earn, pay yourself first is an excellent way to get not very far slowly – assuming things like job loss, marriage, children, bad investments, divorce, illness and other common life events don’t happen.

    On the other hand, saving from job related income is usually the easiest way to get some money together to invest or start a business.

  2. @ traineeinvestor – you pessimist 😉

    We’ll dig a little deeper into the second part of your comment, next time …

  3. On the optimistic side, it is sometimes possible to retire on a lot less than what you needed to live on, up to that point. For one thing, if you’d been putting away 1/3rd of your salary every month, you might stop doing that when you retire.

    If you’re reasonably adventurous, you can move to a cheaper country. My folks never read 7M7Y in their younger days (seeing that computers weren’t around yet), and on top of that their final retirement investments went bang because of corruption in a large financial institution in South Africa, called Dynamic Wealth Management (whom we’ve now dubbed Dynamic Wealth Mismanagement). So when we moved to China, they moved with us (being at the time semi-dependent on us).

    In China, they are living on less than half the money they had needed in South Africa, and living a much more comfortable life. (Bigger house, money spare for going out and so on), and they’re still saving about half of that income on top of that. And they’re having a blast of a time.

    The sacrifice of course is being away from life-long friends and family.

    So I’m not saying that’s the ideal situation for everyone, but if all your 7m7y (or 5m8y or whatever they are) plans fail, life is not necessarily doom and gloom. Come to China 🙂

  4. @Ashton

    While China is certainly interesting (I live in HK), it is a long way down my “quality of life” country list.

    Separately, one issue which is adversely affecting a number of people who retired to low cost countries like Thailand is the combination of the local currency in which their expenses are incurred appreciating against the currency in which they invest most of their money (usually the USD) and local inflation. Quite lethal if you didn’t set the “m” high enough.


  5. Adrian,

    The Pay Yourself First strategy can’t be dismissed as inadequate. The simple fact is that it works and this is supported by the statistics of millionaires. Most wealthy people care more about financial security and independence than a high income or a lavish lifetyle.

    If everyone could make $7 million in $7 years that would be awesome. But, most people can’t. Everyone has an opportunity to save a million dollars during their working lifetime. But, most people won’t.

    If anyone wants to think I’m a fool for saving 20% of my net income so I can retire a millionaire, then let them think I’m a fool. Now that my kids are raised and my house is almost paid off, I will be living in style on a fairly modest income.


  6. I forgot to mention that I am interested in reading about your “better plan” in the next post. There is no single financial plan that is right for everyone and I’m always learning and adjusting my strategy.

  7. @ Bret – Nobody thinks you a fool. The problem isn’t the saving … it’s the target: to “retire a millionaire” in 40 years is simply aiming way to low.

  8. Pingback: Pay Yourself Twice!- 7million7years

  9. I’m a bit late to the party here, but I’m interested in seeing your calculations. My financial plan is largely based on “pay yourself first” and a 5% real return, and it shows some nice numbers.

    Then again I may not be like everyone else. I tried to start with 10% but I did what seemed right at the time and it ended up being 20%, maybe jumping to 30% soon. I’m expecting my business to increase my income by a nice multiple over time (which will then boost the investments). And I enjoy business and making money, so “retirement” would just be trying another way to make money.

    All that just helps accelerate things though. The main problem with paying yourself first isn’t that it won’t make you an instant multimillionaire, it’s that most people can’t even handle the baby steps that would undeniably improve their situation.

  10. @ Value Indexer – Tell me how much you put aside and what you end up with (net of inflation i.e. in today’s dollars) and I may do a follow-up post. My hypothesis is that you (the typical person) simply can’t become rich in this fashion … I’m happy to be proven wrong 🙂

  11. No one can really be wrong here, we’re just throwing around numbers and for any given numbers the math is simple. My model/plan is all built on inflation-adjusted values which is very convenient if I’m right about inflation 🙂

    Adjusting my model a bit to have someone with a constant real income of $60k and a spouse who earns between 25 and 35 for the next 5 years, with a constant 20% of total income invested every year and a 5% rate of return (real like everything else), in 40 years that would result in around $1.7m.

    My own plan puts that number around $2.6m, with a rise and then fall in earned income from my business over the next 20 years as I eventually step back and try other things. Just for fun I turned it up to an 8% real return on the investments and it said $6.5m 🙂 Looking at it now I think I put the amount invested too low in a few of the years.

  12. @ Value Indexer – Let’s assume that’s $1.7 million in today’s dollars. Since financial ‘experts’ (there are fewer of those around than one might imagine) recommend no more than 4% as a ‘safe’ withdrawal rate, that provides a $68k (‘real’) gross income for life.

    That’s a very slight pay-rise for the one who worked 40 hard years to get there … with little buffer for indulgences and disasters. Doesn’t sound greatly attractive to me … then again, it’s better than the other alternative 😉

  13. All true – for someone whose best life experience in those 40 years is compatible with a modest income and a decent saving rate, it’s not a bad choice. It’s also built on fairly conservative assumptions except for the saving rate so there’s less risk of bad surprises than in many other plans.

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