Why Spending Less Is Better Than Earning More

In the last post on The $50k a Year Budget I mentioned that spending a dollar less is better than earning a dollar more. Doing both is better still, but in the short term, it's often easier to curb our spending while we look for opportunities to increase our income.

The question remains though, why is it better to save a dollar than earn an extra dollar, or depending on how you look at it, earn an extra $162.
Crazy number alert. See below for some kind of sense.

For Those About To Save, We Have (Already) Taxed You

The first reason is an easy one to grasp. The dollar you are about to save, has come into your possession after Income Tax has been deducted. You probably paid the tax before it landed in your bank account thanks to New Zealand's (and most counties) Pay As You Earn (PAYE) scheme.

If you earn another dollar however, then you'll be paying tax on that before it hits your account. So you'll need to earn, depending on your tax bracket, up to $1.50 to be able to save a dollar. So for that $4.50 coffee you were about to buy, you'll need to earn $6.75 extra to make up that amount.

If everything suddenly became 50% more expensive tomorrow, would that put you off buying things? Because that's how it impacts our ability to save.

Lifestyle Creep

This one gets into the weeds of the finance around saving and withdrawal rates. I hope it all makes sense.

There's a common rule-of-thumb that says in order to retire and never have to worry about running out of money, you should save 25 times your annual expenditure. This is based off a 4% Safe Withdrawl Rate.
And it turns out, in the US this would have worked out for you over 90% of the time regardless of when you had retired in the "modern era" (which seems to be about 1920ish).

There's some gotchas here that are not often talked about, and they centre around Inflation. In New Zealand, average inflation over the last 100 years has been 4.6%. This means if we want to live on $50k a year in today's money and plan to retire in 15 years, you'll be spending $94k a year at that point. So you wouldn't need 25 x $50k = $1.25m, you'd need 25 x $94k = $2.35m. That's quite steep.

It gets worse. The 4% Safe Withdrawel Rate is based on American inflation and American annualised returns on savings. In New Zealand, with higher inflation and other factors, we can more likely assume a 3% Safe Withdrawel Rate - therefore 33 x $94k = $3.1m.

Basically nearly triple what you (cough… I) might have initially thought you should budget for.

There is some saving grace in here. Right now, the inflation rates are at a historic low, and even if they rise it's unlikely $50k will be $94k in 15 years time. We also have better access to foreign (read US and Australian) markets that at any time in the past, so can take advantage if they have higher performing stocks.

Keeping the Annual Expenditure Down

What this all means is, if that $50k annual spend you need to live happily becomes $40k, then that feeds through all the figures. That total savings required is $1.98m, nearly half a million less than if you wanted that $10k extra.

So what does that mean for your coffee?

  • $4.50 today will be $8.45 in 15 years thanks to that pesky inflation.
  • You'll need to have an additional $279 in your savings, assuming a 3% safe withdrawl rate, to allow you to withdraw that $8.45.
  • If you invest $108 today, given 7% annualised returns and compound interest, you can save $279 in 15 years.

So for each coffee you want to drink per year in 15 years time, better squirrel away $108 now.

Still thirsty?

What this really means is, learning to discover happiness in a more deliberate, frugal lifestyle will enable the Financial Independence goal to be achieved much more easily.