When I graduated from college in 1995, saving about ten percent of after-tax income for retirement was widely thought to be sufficient. By investing this amount in a diversified portfolio, I could expect to enjoy decades of compounding and feel relatively confident that I would avoid impoverishment in old age.
If we invert this advice, the implication is that we should feel free to consume ninety percent of after-tax income. What we are not saving is obviously used for some sort of consumption, whether it is housing, food, clothing, travel, or entertainment.
If an individual has $100,000 of after-tax income and takes the conventional advice to save ten percent, he will save $10,000 and consume $90,000. He will hopefully arrange his life in manner which gets the most “bang for the buck” for that $90,000. After all, no one wants to waste money on things that produce little or no satisfaction. But however the money is spent, it establishes a baseline consumption level.
We can categorize spending into discretionary and non-discretionary buckets, but there are no bright lines in many cases. In the short run, the choices one makes regarding where to live and what type of car to drive represent non-discretionary spending. Other categories, such as food, clothing, and entertainment are subject to greater variability, but it is painful to cut back once a certain lifestyle is established.
Financial independence is reached at the point where one’s accumulated financial assets are capable of safely supporting a certain level of consumption. It obviously takes a smaller investment portfolio to reach financial independence if you are used to consuming $50,000 per year than if you are consuming $90,000 per year.
Perhaps these points are obvious to many readers, but I do not think much of this is understood by the majority of young people. The “you only live once”, or “YOLO”, culture advocates spending now, often for “experiences”, because the future remains unknown and we should enjoy life while we can. It is obvious that no one can be sure of even reaching old age, so there is a kernel of truth in the “YOLO” mentality, but all too often it is extrapolated in dysfunctional ways.
A young person who loves his or her job, intends to work for four or five decades, and is confident that their line of work will continue to exist might end up doing well enough with a ten percent savings rate and a ninety percent consumption rate. This is due to two factors. First, a half century of compounding will prove magical even with relatively small sums. The “snowball” effect will gather steam in the final decades of employment and produce an impressive nest egg in the end. Second, someone who works until seventy or seventy-five will, on average, have a shorter retirement than someone who retires at fifty. A shorter retirement requires a smaller pool of savings.
Sadly, relatively few people love their work to the point where they are content to contemplate four or five decades at the office. The FIRE movement, which stands for “Financially Independent, Retire Early”, has gained a great deal of popularity over the past decade. A growing number of young people wish to escape the rat race early. Not merely at fifty-five or sixty, but often at thirty-five or forty.
If very early retirement is the goal, being aware that savings and consumption are two sides of the same coin becomes absolutely critical, as I wrote about several years ago in Fifteen Years to Financial Independence. As that article showed through contrasting examples, the couple with a low consumption rate (and a high savings rate) was able to achieve financial independence in a short period of time. This was due to two factors: First, the couple’s financial assets obviously grew more quickly given that they were saving over half of their income. Second, and equally important, they had a lower level of consumption spending to replace.
In contrast, a similarly situated couple that saved just ten percent of income would not come anywhere close to reaching financial independence even after three decades, at least not without making drastic cuts in consumption at the point of retirement.
But wait, there’s more … by the time the frugal couple reaches their tenth year of retirement, their portfolio will have grown to the point where they would enjoy a higher level of potential consumption relative to their more profligate peers. While the free spenders are still toiling in employment to support their spending, the frugal couple could now sit on a beach and enjoy that same level of consumption based on their investment portfolio alone.
It is unrealistic, and probably very uncommon, for people to voluntarily reduce their standard of living in any material way. In many cases, they cannot do so even if they want to because they have a lifestyle that, at least in the short run, imposes high fixed costs. The key to financial independence at an early age is to steer clear of high fixed costs and to keep variable costs reasonably low.
When I get to this point in real-world discussions, the objection often turns to a desire to avoid impoverishing oneself in the here-and-now in order to enjoy life later. In my view, the framing of this objection is wrong. It equates a high level of spending with happiness when such spending often merely represents background noise once it is established as a baseline. After the thrill of driving a $80,000 car off the lot subsides, how much more utility does the driver really get compared to someone who bought a $30,000 car? The examples of hedonic adaptation are truly endless.
Obviously, I am writing about individuals who are firmly in the middle class or above and I am not castigating poor people for their low (or non-existent) savings. There is a certain level of spending that is necessary to function well in our society, and certain luxuries do add value. I am sympathetic to the idea of spending on experiences while still young, although I would note that my best experiences, particularly travel, have also been the cheapest. Impoverishment today in order to produce a bounty tomorrow is ultimately a straw-man argument for those at or above the median income.
Perhaps I am preaching to the choir given my audience. However, the two-sided nature of spending and consumption seems to escape the consciousness of many people. Ultimately, we live in a free society and everyone can choose how to balance current consumption, savings, and future financial freedom for themselves. But it is important is to do so with eyes wide open. There is a price to be paid for adopting the unrestrained “YOLO” culture that seems to grow more popular every year.
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