Why we should save up for things in the reverse order in which we plan to buy them

I would like to propose a novel saving plan:

1. save for an emergency fund[1]
2. save for your ability to make money[2] and reduce expenses 
3. save for long-term purchases 
4. save for mid-term purchases 
5. save for short-term purchases 

The first half of this is established wisdom in the financial management circles – create a buffer for unforeseen circumstances such as losing your job; make large purchases that will pay-off in the end - not necessarily tertiary study, mind you; and max out your superannuation/401k.


The idea that we should save up for things in the reverse order that we plan to buy, however, requires elucidation.

Firstly, saving for our retirement before any other discretionary saving goals is important because (1) once we’ve retired we can’t earn near as much money as before, (2) the return on investment is the greatest, and (3) the tax benefits are difficult to beat.

One limitation of my idea is that since it defers when we are able to reap the benefit of our hard work and investing, we are likely to be less motivated to save up, compared to if every dollar we saved was for something we would buy that year. However, it also allows those with sufficient investment discipline to get vastly more bang for buck compared to saving up for things just on time – which, after all, is just a step away from living hand-to-mouth.

1) It is too late for voluntary contributions when you’ve already retired
Retiring compromises our ability to earn more money. Once we've retired, financial management is pretty much just damage control. Though there are exceptions, we cannot perform most types of work at the same pace for our entire lives, particularly once we have hit 60 or so. Age factors seriously into our earning capacity, both positively and negatively at various times in our lives; however, at retirement, by definition we are going to be making less money. We might retire with the flashiest car and the most luxurious holiday house. However, if we have retired without an income stream that will see us through thirty or forty years, our problems will not be which route we will take to the beach house this summer – they will be in the realm of wondering how we will pay the rent. Therefore, we need to ensure that we have invested in our retirement - before thinking, for instance, of luxuries such as a second home or car.

2) Greater return on investment
Thanks to compound interest and dividends, we get a disproportionately higher return on investment on longer-term investments than shorter-term investments. A retirement fund, for instance, is the cheapest investment you will ever make, for the greatest return.[3]

Example: In Australia at least, we start saving for our retirement early, through compulsory superannuation contributions. This could mean starting in our early 20s – and only cashing in when we hit our mid 60s.[4] The $1 that we put in to our super during our working life will equal, say, equal $1.50 in today’s dollars when I hit 65. For instance, if I leave my super to my employers (9%), I will save about $200k for retirement - but that will build $100k worth of interest on top of that.[5] Contrast that, to say, a short-term savings - I put $1 in a 6% term deposit for 12 months, and I get back $1.06 - substantially less than the $1.50 from my super fund.

In short, longer-term investments provide a greater rate of return on investment. If I save for a car, in the short term, even if I pay in cash in the end, the ‘saving up time’ will not result in a ‘cheaper’ car than if I bought it right away.

3) Kick-ass tax benefits
One final reason why saving for one’s retirement first is a good idea is that the government taxes it less when it goes in (15%), and does not tax it as it grows or once it has matured.

Scenario
Once we have our emergency fund together, invested in our earning capability (including safeguarding our health), and then invested in our retirement until we have an amount that, upon retiring, will have matured into an acceptable amount, we can simply stop contributing to our super,[6] and turn to our medium-term goals.

Example: we may need $500k upon our retirement to live off, but we only need to save $300k when we are 40 because, by that point, our retirement fund will keep on growing of its own accord, and cover the final $100k or approximately on its own.

Such medium-term goals can include a down payment on a house, a mini-retirement so that we can take read Ulysses or a working-holiday around the world, or seed money for our business venture. Such savings may take anywhere between five and ten years. The money will not ‘grow’ as much as our super – after all, we will be saving up for such goals for a shorter period, which means less compound interest and lower rates. However, it will grow at a faster rate than any short-term investments.

Saving for a long-term goal such as retirement, before more medium-term goals, such as providing your children with the opportunity to study for several more years (or the pleasure of being able to play in the back yard rather than the park down the street) will pay other dividends down the road. When your children are middle-aged and you are retired, they will appreciate not having to build an extension on their house so you can move in.



Image by urbandata

End notes
[1] The emergency fund is very important because it reduces the likelihood we will go into debt. Even short term debt will be screw up our overall return on investments, since credit-card debt (and even loans, and mortgages) are naturally going to be higher than anything we could safely earn with our investments. Think of it this way - your credit card debt, if you have one, is actually negating all of the interest that you earn on your super fund.

There are always jobs out there, even if they mean making coffees or pulling beers, and that is always enough to cover our basic living expenses. Subsequently, I do not see how anyone with even a few years of professional experience could reasonably go into debt. If we have liabilities that we must maintain - the mortgage on a house, for instance - that ‘emergency fund’ should be in the form of mortgage payments that we have made, but can call upon at a moment’s notice. This is because we should be pouring as much money, as quickly, to reduce the principle on such debts as early as possible, as well as all our liquid assets (for example, cash). The emergency fund, then, operates for the following reasons:

• As one comedian has remarked, the mark of financial independence is when we do not have to move back in with your parents; that is exactly what can well happen if, for some strange reason, you cannot secure a hospitality job between losing your professional job, and having to pay rent. 
• The luxury of being able to pick and choose whether to stay in your current role, and which professional job to take, if you leave, or are fired, from your earlier job. 

[2] I used to think of ‘investing in your earning potential’ as meaning that we should have the discipline and motivation to spend as long as we can at university before actually entering the job market in earnest. For instance, if circumstances allow, going from our Bachelor degree straight on to a PhD by the time we are in our mid 20s. However, now I am more of the opinion that the increase in salary diminishes around the Masters by coursework mark, and certainly before the PhD mark. Further education beyond that can be useful for a few reasons - getting very specific licenses or qualifications relating to our occupation, as well as laying the foundations, through study in a radically different area, for a career change. We might want to move sideways, inside or outside our current profession, just for some variety - or, it might be useful to diversify to reduce our risk, should our profession suddenly become in low demand for whatever reason. In any case, using university to increase our salary, rather than our professional flexibility, does not seem to make as much sense as it once did. However, I do still believe that taking the time to get at least one marketable undergraduate degree is a good idea.

[3] Since we can afford to ride out the fluctuations of the market, we can tolerate higher risk-profiles, and subsequently greater compound interest rates. Even for low risk-profile investments, such as term deposits, the longer you lock your money in for, the greater interest rate you will typically earn.

[4] This retirement age might even be further postponed in the future, considering that many developed countries, such as the UK, are increasing the retirement age for public-sector jobs, because people are living longer, are able to work longer - and, of course, the economy is going to shit and the government can’t afford to actually pay them their retirement benefits.

[5] Obviously that 50% growth applies to the retirement fund overall, across its lifetime. The first dollar that I put in, for instance, would have grown considerably greater, while the last dollar that I put in would return very little.

See Vanguard Retirement Calculator for reference.

[6] I have already determined that I can invest plenty into my retirement, and then when I have reached the critical mass that I will need, I can simply stop investing. For instance, I can invest the minimum untaxed amount until I’m 55, and even if I were to start taking money out then (which I can’t), I could spend a retirement income that’s 100% of my pre-retirement income until I’m 88. Otherwise, I save up until I am 65, but I would not likely live long enough to spend that in (certainly beyond 100). Therefore, it makes more sense to, say, work until I am 55, semi/unofficially retire on some other savings if I wanted to, and then officially retire at 65. Of course, I would want to keep on working in some capacity after 65, and I would like to be able to work less before I am 55.