Regardless of income level, the vast majority of people spend very nearly everything they earn, if not more. Most people know that living paycheck-to-paycheck is a problem. What they may not realize is that the higher their income, the bigger this problem actually is. Common sense tells us that more income is always better, but that’s not always true. If you have a high income and are spending it all, then you might be in serious trouble with limited options.
Consider the following scenario and think about who is financially more secure? Who is wealthier?
Introducing Bob and Bill
Bob earns a salary of $50k per year. He owns his 10-year-old Toyota Camry outright, makes the mortgage payment on his comfortable home, and is still able to save $5k each year in his 401(k) account.
Bill earns $250k per year and leases a new Land Rover every two years. He lives in a very nice house with a pool and a beautifully landscaped yard. Bill is also saving $5k per year toward retirement.
Bob and Bill both consider themselves responsible personal financiers. Neither one has any credit card debt and both are careful to keep some money saved for unexpected expenses. In fact, Bob has $10k in the bank, and Bill has $20k.
So, who is doing better financially? Obviously, Bill’s and Bob’s kids know who is richer. It’s not even close. They all prefer to play over at Bill’s house. Bob’s kids complain about having to mow the lawn, and whine about why they can’t have somebody take care of it like Bill does.
Everyone knows Bill is richer than Bob, but everyone is wrong, as they are about to find out.
What Lies Beneath
By all outward appearances, Bill is absolutely prospering, keeping his expenses in check, and even securing his future, but the car, the pool, the house and the fancy life are obscuring a ticking financial time bomb which explodes with surprising devastation as recession hits causing both Bob and Bill to lose their jobs.
Bob is disappointed to lose his income, but he figures that if he cuts the cable and his cell phone and all restaurant meals, he can cover his mortgage, utilities, and groceries for four months. While he’s looking for a new job, he takes on some odd jobs around town. In this way he is able to make his savings last for 6 months.
Bill is also bummed about losing his job, but within days he has started to panic. He realizes that his $20k savings will last little more than a month at his current burn rate. Even after cancelling his kids camps and sports and the bouncy house for Billy’s birthday party, he’ll be flat broke within two months.
Luckily the gardener lets bill out of his contract without a penalty, but now Bill has to figure out how to maintain his yard all by himself. Things don’t go as well with the Land Rover dealership. They let him return the car, because that’s easier than sending out the repo man next month, but they also charge Bill $10k for early lease termination. Bill decides to just let that go to collections for now, because he has a bigger problem. He kind of needs a car to look for a job, but he also needs to hold onto as much of his cash as he can. Maybe Bob will let him borrow the Camry.
So, who was really wealthier? Who was financially more secure?
Problem Solved
The story does have a happy ending. Within six months, the economy has recovered and both Bob and Bill find new jobs. Both are happy to return to their pre-recession salaries.
Bob’s finances had been getting pretty tight. He had even thought that he might not be able to pay his credit card in full that last month, so he is relieved to have some breathing room. In fact, the last six months weren’t really all that bad – other than the increased stress and anxiety. Bob’s family didn’t really miss some of the expenses they cut, so Bob has decided to resist inflating his lifestyle back to pre-recession levels so he can increase his 401k contributions.
Bill, on the other hand, has some serious rebuilding to do. He was able to hang on to the house, but only by taking a home equity line of credit. The pool and yard didn’t fare so well. He couldn’t afford to open the pool that summer, and an algae bloom led to clogged filter pipes and a burned-out pump. It’ll cost $10k just to get the pool going again. Its pretty much the same story with the landscaping. As it turns out, he didn’t really save any money on landscape maintenance after the cost of landscape repair. Bill still doesn’t have the money for camps and activities, and with all the expenses that have piled up, it doesn’t look like those luxuries will be within reach any time soon. In fact, Bill has decided not to contribute to his retirement accounts until he has fixed the yard and the pool and paid off the HELOC.
But I’m Indispensable. I’ll Never Lose My Job.
Perhaps you are thinking that this story is overly pessimistic, that your chances of being laid off are miniscule. I am temped to argue that point, because I believe that job security is much less robust than most people think. But I don’t have to make that argument, because losing a job is a foregone conclusion for everyone. That is, everyone will eventually be laid off into retirement if not sooner.
Your employment may conclude on your timing, but your ability to survive without a job is determined largely by your expenses. If you are spending most of a large income, then you are going to need a lot more invested assets than the guy who is spending most of his small income.
If you have a large income but have saved no more than the guy with a small income, then you are going to be in a world of pain. The guy with a $50k income who saved $1 million will enjoy the same lifestyle in retirement as he has for decades. If your income is higher, but you have only saved the same $1 million, then you not only have to learn to live like the $50k income guy, but also deal with the expenses (like Bill’s pool, yard, and lease) that have become a natural part of your life.
Imagination Imitates Life – The Real Bill
While Bob and Bill are fictional characters, they are based on real-life people I actually know. In fact, Bill is a high-school friend of mine. He has always been a high earner. After finishing college in the late 90’s, he got his first job with a starting salary of $100k. In addition, as a traveling IT consultant, he had all of his food and housing expenses covered by his per diem.
Bill and I have had only intermittent contact over the years. We get together every few years and catch up, and we always get around to our personal finances. Bill stayed at my house while attending a conference about 12 years ago. At that time, I disclosed that I actually OWNED my house. He was completely stunned and admitted that even though he was now making $250k, he had essentially zero net worth. He had not given his future self a single dollar in his 10 years of work.
On a more recent visit I told Bill about my frustrations with work – making no discernable progress for many years toward a promotion – and told him that I was seriously considering retirement. Again, he was stunned that I didn’t even need an income anymore. And he expressed similar frustrations, but about his lack of progress toward retirement. Even now that his income was more than $400k, he was unable to save anything of consequence beyond the mortgage principle he had paid on the fabulous home his wife had built only a few years earlier in their expensive ski resort town. The equity in this $1 million plus home was significant in absolute terms, but he still had more than 20 years of payments before he could hope to live there without the income from his job.
Bill is Cursed with a High Income
Bill is different from most people in that his income is so high. But he’s quite similar to most people in that he spends most of his income. Bill’s habit of saving as poorly as most people makes his high income a curse. By the time he retires, he will have the well-established habits that come from spending many millions of dollars, but he will have (optimistically) maybe a couple million dollars to see him through his last few decades. There is no way he’ll be able to afford the house he lives in now, or the lifestyle he is accustomed to.
I admit that I might find some sense of evil poetic justice in watching a rich guy struggle with his money if Bill weren’t such a nice guy and a great friend. I honestly believe that he struggles to gain control over his finances the same way people of more moderate incomes do.
We talked about what Bill spends all his money on. Obviously, he has a huge interest payment on his mortgage. But he also talked about how he has to buy his five sons new ski equipment every winter and new mountain bikes every summer.
Like you, my initial reaction is to laugh at such ideas, but I also understand that a lot of this attitude should probably be expected as part of his family living in the community that they do. His sons’ friends all have the newest gear and fitting in is the same wherever you live. That is to say, the cost of fitting in is limited only by your neighbors’ ability to spend. Living in a super wealthy area naturally comes with richer Joneses to keep up with.
Reverse the Curse
The solution to Bill’s problems is the same as for anyone at any income level. Forget about the number of dollars Bill is saving; he needs to save a meaningful percentage of his income. I recommend everyone save at least 10%. By saving on a percentage of income basis, anyone can save enough to replace 100% of their income regardless of how big or small that income is.
Of course, Bill is approaching 50, so he has already lost much of the power of time. That means that 10% is not going to be enough for him. However, this is where Bill’s high income could become a real advantage. Like anyone else, Bill will eventually have to learn that limited resources are a key feature life on Earth. When he does, Bill has huge resources to work with. He could live a very comfortable lifestyle in many areas and still save half his income or more. That’s enough to still make retirement a real possibility even before he hits normal retirement age in 20 years or so.
Furthermore, Bill is right to consider selling his house and moving to a less-expensive area. Reducing his expenses will require some big changes, but that will be a lot easier if he builds a new lifestyle from the ground up. He’ll still be able to do a lot of the things that he really enjoys, but he will need to think a little differently about how he does them.
How Will It End?
Bill is at an inflection point. He is in a fabulous position to build a comfortable and prosperous rest of his life. Or he will see it all come crashing down after another couple decades of his current lifestyle. Which would you choose? Which are you choosing?
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