Am I Wealthy? Part 2: Income ≠ Wealth
Am I Wealthy?
Part 2: Income ≠ Wealth
In Part 1 of the series, I gave some unsolicited and probably unhealthy advice on how to benchmark your income to others. Comparing your income to others is not recommended, but we can’t seem to help ourselves. The gist of the article was that if you’re going to make a comparison, at least compare your income to people at different wealth levels.
In Part 2, we shift our focus from income to wealth.
Income ≠ Wealth
Earning an income requires time and effort, and earning more income typically requires even more time and effort. The sad thing about earned income is that regardless of how good you get at it, it is not sustainable. It will cease, voluntarily or involuntarily, at some point in your life.
Take income, subtract taxes and your spending, and what you have left are the seeds of wealth. Water your wealth seeds and give it plenty of sunlight, and over time, it will grow into a wealth tree that provides shade from the sun and fruit when you’re hungry. The more seeds you can plant, and the earlier you can plant them, the more shade and fruit you will enjoy later on in life.
Wealth, unlike income, has the ability to sustain itself. Grow a big enough wealth tree, and it can even outlive your own life! For example, give one of your wealth trees to your child and your wealth will live through your child’s lifetime (aka trust fund baby). Give a big enough wealth tree to a university and they will even name a building after you that can live forever.
A better way to benchmark
While spending is an easy way to benchmark yourself to others, how much you save is a better way to measure how you are doing financially. The difficulty in benchmarking your savings to others is that you don't know how much everyone else is saving. The good news is that you don’t have to worry about how much others are saving.
If spending is a benchmark to compare yourself to others, the amount you save is an internal benchmark for yourself. You can use how much you saved in previous years, to how much you are saving today, to benchmark how you are doing.
Once your basic needs are met, you should strive to save at least 20% of your gross income towards retirement, and another 10% for large expenses like cars, home appliances, and education. Not everyone can save 20% and 10% right away and increasing your income or reducing expenses will be a gradual process that can take years. Make sure to track your savings rate over time so that you have the data to benchmark your progress.
How much you should be saving
There is no single metric that can be used to define whether you are wealthy. As someone that manages wealth for a living, my definition of wealth is if you are happy with your current lifestyle and are confident that it can be sustained for the rest of your life.
Remember that earned income is not sustainable and it will stop at some point. The average retirement age in America is 621 while the average life expectancy is just under 802. In order to sustain your lifestyle even after the loss of earned income, your savings has to be large enough to sustain your lifestyle during your retirement years.
It can be complicated to estimate how much you need to save, but it largely depends on one main variable - your expense. An oversimplified estimate, but useful for illustrative purposes, is that a savings of 25x your expense should be enough to sustain you for life.
Saving 25x your spending can be daunting, but it is doable if you can save consistently each year. In a world where everything stays consistent, saving and investing roughly 20% of your gross income for 30 years will get you to a savings of 25x your expense if you can earn an average of 7% per year.
Lifestyle Creep
The math gets a little more complicated when raises are added to the mix. A small bump in your salary for inflation is not a raise. A legitimate raise from either good performance or a promotion should be celebrated.
Lifestyle creep is where an increase in income leads to an increase in spending. This happens naturally and is not necessarily a bad thing. In fact, it probably means you’re doing well and earning a higher income over time. However, it carries a negative connotation because people tilt too much of their raise towards upgrading their lifestyle and not enough to their savings. A $10,000 raise does not justify the purchase of a brand new Tesla.
Recall the 5 levels of wealth from part 1.
Level 1: I buy groceries on a budget: People that add up the cost of groceries as they add it to the basket. If you can buy whatever you want at the grocery store, move onto level 2.
Level 2: I eat at restaurants on a budget: People that don’t know the cost of a tomato, but probably know the cost of a pizza. If you eat whatever sounds good at a regular neighborhood restaurant, move onto level 3.
Level 3: I eat at fancy restaurants on a budget: People that eat at neighborhood restaurants without a budget, but treat dinner at a 3 Michelin star restaurant as a special outing (and therefore have a budget). If you need to be reminded that restaurant menus not only have meals but also prices, move onto level 4.
Level 4: I don’t have a food budget: People that don’t look at the price on a menu. If you prefer restaurants come to you, move onto level 5.
Level 5: People that hire private chefs. What is money?
A raise may move you up from level 1 to level 2, and allow you to enjoy eating out more often. When you move a level up, you want to ensure that you will be able to stay there, because while moving up a level can bring you joy, the pain of falling down a level can be unbearable.
There are entire movies made about the pain and suffering of falling down levels of wealth. The Company Men is a movie about three employees Ben Affleck, Chris Cooper and Tommy Lee Jones) that are laid off, and chronicles their denial of having the move a level down.
Successfully leveling up
What you need to understand about lifestyle creep, is that in order to maintain the upgraded lifestyle, the increased spending requires an even bigger increase in savings.
For example, let’s say that Ryan has been earning $100,000 for the past 15 years. Ryan’s expense averages $80,000 and he has been diligently saving and investing the rest for retirement. Since Ryan is saving 20% of his income, he should be making good progress towards retirement.
In year 16, Ryan gets a raise and his salary jumps to $200,000. The raise allows him to continue saving 20% but also upgrade his lifestyle, win-win right? Not exactly. Because Ryan has been saving 20% of $100,000 for the first 15 years (blue arrow) instead of 20% of $200,000 (gold arrow), he will not be able to sustain the upgraded lifestyle at retirement if he continues to save just 20% (red arrow).
Ryan needs to save a minimum of 35% of his new income to upgrade and sustain the upgraded lifestyle.
Using a raise to retire early - FIRE
An alternate option is to not increase your lifestyle at all, but rather use the raise to save more aggressively for retirement. If Ryan saves all of his raise, he is likely to cut the number of years he needs to work in half - from 15 years to 7.5 years!
FIRE, or Financial Independence Retire Early, is a lifestyle movement where people accelerate financial independence by taking extreme steps to minimize expenses. This is a lifestyle that requires minimalism and is probably not appropriate for most people.
Find the right balance
The key to successfully managing your finances and getting to your good place is striking the right balance between lifestyle and savings. Lean too heavy on lifestyle and even the wealthiest go broke. Lean too heavy on savings and you might not be living your life to the fullest.
One of the joys of my work is helping clients find the right balance for them, so that they can live their life to the fullest while being confident that they can sustain their lifestyle. If I can be helpful in getting you to your good place, schedule a 15-minute discovery call with me below.
