There is a lot of power in deciding what you’re going to do before something happens. It is far more likely that you’ll do what you said you would do. At least, that is the case researchers are making about raises and retirement savings — and their advice is working!
Behavioral economists Richard Thaler and Shlomo Benartzi developed Save More Tomorrow, or SMarT, which aims to help people save their future raises in order to reach their retirement goals. They say that this strategy works, because by deciding in advance what you are going to do with income such as raises, bonuses or tax refunds, this decreases the likelihood you’d spend it on something else. Plus, by using partial future bonus money for retirement savings, people avoid feeling ‘deprived’ — which is often what happens when cutting expenses as a savings strategy.
The researchers said in a report, ‘The basic idea is to give workers the option of committing themselves now to increasing their savings rate later, each time they get a raise.’ The analysis found that those who adopted SMarT increased their retirement savings from 3.5% to 13.6% four years later, and nearly 80% of those who adopted the strategy stuck with it.
Americans are saving, but need to save more
Though Americans increased their savings rate by 5.5% according to the Commerce Department, we are still not saving enough. A Fidelity investments study found that 55% of Americans are at risk of not being able to afford essential living expenses in retirement.
Additionally, a telephone survey of 1,003 workers and 1,001 retirees from the non-profit Employee Benefit Research Institute (EBRI) and Greenwald and Associates found that 64% of workers feel they are behind on saving for retirement. Reasons people are unprepared for retirement include cost of living, day-to-day expenses and debt.
â€‹But, this does not negate the need for people to save as early as possible. Behavioral economics appears to hold promise. That’s why a financial plan like the SMarT program could help a 25-year-old earning $45,000 save nearly $1 million by investing partial raises and bonuses over the course of his or her career, according to Nerdwallet.
How to save $1 million using future bonuses
Nerdwallet did the calculations and found that a 25-year-old who makes $45,000 a year and expects to receive 3% annual pay raises until retirement at 65 will reach $223,924 in retirement savings if he or she earns an average annual return of 7.5%. Additionally, if the 25-year-old also receives an annual 5% bonus on the previous year’s salary and invests all of it, the amount saved turns into a nice, healthy $1 million for retirement.
Two factors for success
Two keys to success in this savings plan is deciding what you’re going to do, and sticking to it. In addition, the bonus plan assumes that the participant avoids ‘lifestyle creep’ or spending more as you make more — using pay increases and bonuses for retirement instead of falling prey to spending more.
“No one ever has enough,” says Daniel Sheehan , a financial planner in Fresno, California. “When people get a raise or bonus, they look at that as an opportunity to do whatever they weren’t able to do before.”
It’s tough, but fighting the urge to ‘keep up with the Jones” is huge when keeping yourself on track for retirement.
Check out Clark’s investment guide here to get started now!