A reader asks:
My friend recently sent me an article saying that young people shouldn’t save money. The argument is based on the life-cycle model. It argues that in order to maximize happiness out of your income every year, and to avoid changes in standard of living throughout life, high income earners should not save at a young age, and instead it should be made up in middle ages. Some context: (not to brag, I count my blessings for the position I’m in) I am 24, single making ~$252,000 per year. Thus far I’ve been socking away all my money in S&P 500 index funds with some money saved on the side for potential real estate investments. Should I start saving less and enjoy the money in my youth more? I would love to buy a Porsche, but it seems irresponsible given the power of compound interest!
This question is tailor-made for me.
There are like 5 different layers of Ben content here — retirement savings, behavioral finance, spending money, striking the right balance between happiness now and comfort in the future and luxury vehicles.
A number of people sent me the paper referenced in this question when it came out. I read it. I don’t agree with every conclusion the authors make but I do appreciate the spicy take they put forth.
Retirement research papers are generally boring, even to people like me who enjoy this stuff.
This is the main crux of it:
We argue that, under realistic assumptions, the life-cycle model implies that most young people should not save for retirement. First, high-income workers tend to experience wage growth over their careers. For these workers, maintaining as steady a standard of living as possible therefore requires spending all income while young and only starting to save for retirement during middle age. Second, low-income workers, whose wage profiles tend to be flatter, receive high Social Security replacement rates, making optimal saving rates very low. Finally, for all workers, low real interest rates make a front-loaded lifetime spending profile optimal.
In theory, this conclusion makes sense from a spreadsheet perspective.
Most people do see their income grow over time and young people generally don’t make a lot of money starting out. So the idea that you should enjoy your youth and put off saving for another day has some merit.
And there probably are a handful of people who are disciplined enough to plan ahead enough to pull this off.
Here’s the problem with this idea:
As your income increases you begin to spend more money and get used to your new lifestyle. You gain responsibilities as you age. Maybe you get used to some of the finer things in life.
It can be extremely difficult to flip the switch and start saving once you get used to a certain level of spending. It’s also much easier to live a more frugal lifestyle when you’re young.
Psychologically those savings are going to feel like a loss of income, not a gain at that point. All of the behavioral research shows losses sting twice as bad as gains make us feel good.
So this idea is probably a pipe dream. I’ve heard plenty of people over the years tell me they’ll start saving for retirement when they’re ready but something always seems to get in the way.
Having said that, I understand it’s not easy to save as a young person, especially when you want to enjoy yourself and you’re not making a ton of money.
I went through this.
My first job out of college didn’t pay very well. I still wanted to have some fun and didn’t have a lot of discretionary income.
So I started small — just $50 a month.
As I eventually made more money each year I would save half of my raise and spend the rest until I got to a savings rate I was happy with.
That $50 a month in savings didn’t build up a huge capital base for me but it did instill the right savings habits. One of the best parts about saving from a young age is good habits compound just as much (or more) than the interest you earn.
I like the idea of building up to a steady state savings rate rather than ripping off the bandaid because small changes over time are psychologically easier to handle than big sweeping changes made all at once.
I didn’t make much money in my 20s but the person asking this question certainty is.
It’s not hard to find some spare change to save when you make a quarter of a million dollars when young and single.
Is it OK to splurge if you’re already saving money in index funds and real estate when you’re making six figures?
You should enjoy yourself when you’re young. If you have a reasonable savings rate (10-20% works) you should still have plenty of discretionary income remaining at that income level.
However, before you buy that Porsche at age 24 do me a favor and read the book Happy Money by Elizabeth Dunn and Michael Norton.
Their research lays out the 5 biggest ways spending money can make you happier:
1. Buy experiences (not stuff)
2. Make it a treat (don’t overindulge)
3. Buy time (pay up for convenience)
4. Pay now and consumer later (avoid credit card debt)
5. Invest in others (charity, picking up a tab, helping others, etc.)
The big one for someone in their 20s is to spend money on experiences.
You might think material possessions like a sports car will make you feel better but the dopamine hit from driving a Porsche wears off in a hurry the first time you’re stuck in traffic and realize it’s just another car on the road.
Go on more trips, go out to eat with your friends (and pick up the tab on occasion), get outside and do stuff rather than buy stuff.
The new car smell fades pretty quickly.
The memories you make from a trip with your friends or family can last a lifetime. The ability to create those memories when you have fewer responsibilities in your 20s will compound for decades.
You can always hold off on the Porsche until you have a mid-life crisis in your 50s.
We discussed this question on this week’s Portfolio Rescue:
Our resident tax expert Bill Sweet joined me again to chop it up on questions about interest rates vs. inflation, the most tax-efficient forms of cash management, turning a 529 into a Roth IRA for your children and backdoor Roth conversions.
Now & Then
Podcast version of the show here: