Around this time of year, people start talking about raises at work. I wonder what our increases will be this year and Do you think it’ll be the same as last year? are phrases that you hear people pondering out loud. On the inside, they are secretly planning on how to spend that extra dough:
- That extra $100 a month could get go towards a new car!
- I can totally join that new gym by my house since I’ll have a little extra money
- This means we can eat at a really nice restaurant each month now.
I would consider myself an expert-level saver, and I still get those intrusive thoughts! Other people have to get them too. It’s so easy to start fantasizing about all the cool things you can get with your money. I’ve noticed it feels the same way as when you start fantasizing about winning the lottery. You get feelings of elation. The future is looking bright!
But is it, really?
How long will those feelings last? Pretty soon, that extra money you’re getting each pay period becomes just that–your regular ol’ paycheck. Which brings me to my first point: lifestyle inflation. Lifestyle inflation is what happens to many people each time they get a raise. The money immediately goes to a new car, clothes, vacation, or other items that involve the spending of money. At first, it feels like a huge difference. You now have room to breathe! However, after a few weeks, it just becomes how you live. It is no longer new, no longer fancy, and the behavior is now integrated into your daily routine. Lifestyle inflation happens when you’re not loving your money.
Before you know it, it’s been eight months since your raise and you get a familiar thought: I can’t wait until we get our raises; it’s coming up soon. We’re human, we adapt really well, and our ability to convert something new and shiny to something normal is something we do really well. Our awesome skills at adaptation quite often screw us.
So how do we avoid a lifestyle inflation disaster? By immediately introducing automation. Before we start talking about the mechanics of how to handle a raise, I’d like to talk about my new favorite word: incremental.
“Incremental” is an awesome word
I’ve noticed that executives at many companies love the word incremental. When I first heard the word used, I had no idea what it meant. After busting out the ol’ dictionary, I learned that it essentially means “increasing on a regular basis”. No wonder the executives love this word; it signifies a constantly improving bottom line!
Yearly pay increases provide an opportunity for us to incrementally increase our own bottom line via what I like to call The 1% Method. The 1% Method is an easy answer to the question of what to do with a raise.
The 1% Method
The 1% Method revolves around one idea: the power of increasing your 401k contribution rate by just one percent. There is a very positive effect of a small, but consistent increase in contribution. It goes something like this.
Let’s say you make $45,000/year. If you receive a two percent raise, that would be an increase of $900/year before taxes which comes out to about $35 per paycheck. If your old (pre-tax, pre-contributions, etc) was $1,730, your new paycheck would be $1,765. Now, let’s say instead of you getting that full $35/paycheck increase, you increase your 401k contributions by 1% of your salary the same pay period that your raise goes into effect. You still get a little bit bigger of a paycheck ($17.50 vs $35), but you are now putting more into your 401k which does wonders for your net worth.
An extra $17.50/paycheck going to your 401k comes out to around $450/year. Bust out your handy compound interest calculator, and let’s see what that would look like after 6% per year annualized interest and 25 years. The result? $26,170. Not bad! But wait, what if we were to use our new favorite word and make this an incremental routine. Each year we increase our 401k by an additional one percent. Year two, you get the same two percent raise and increase your 401k contribution by one percent of your salary. After your last raise, your salary became $45,900. The year two salary increase puts you at $46,818–an increase of $918. Your 401k increase means an additional $459/year goes into your 401k, which equates to $24,723 in 24 years (I’m using 24 years now because another year passed and I’m holding your retirement age constant). After two years of using the 1% Method, your 401k balance at retirement age is an extra $50k! That’s just after two years of using this method. You can imagine the effect if you were to do this each year you get a raise.
The key to success with the 1% Method is to take action as soon as your pay raise takes effect. Hop onto your 401k provider’s website and increase your 401k contribution rate by 1%. Some companies, like Fidelity, have an awesome feature that lets you set this up automatically by specifying an automatic annual increase percentage. As discussed in Dominate Savings with Automation, you have to make this stuff automatic–you don’t want to rely on your brain which is already overloaded with daily to-do’s!
One quick note about the 1% method. This works best for those who aren’t financially drowning. A small incremental change is always a good thing, but sometimes you need to take bigger steps. Maxed out your 401k already? Check out What Should I Do With My Money for ideas of where to implement the 1% Method next.