By Charles Rotblut
Jan. 29, 2019
It’s that time of year when budgets and savings plans--and resolutions to stick to them--abound.
Cognitively, I know the importance of saving and can make a strong argument for doing so. But this doesn’t change the fact that I’m not a naturally thrifty person. I don’t like being held to a budget. My natural inclination is to acquire things. Yet, my savings rate—the percentage saved relative to my gross income—is at a good level and continues to rise.
How do I do it?
In simplistic terms, I make sure I pay myself first. I also track what I save with the goal of raising my savings rate each year. The combination has worked—really well—and can be replicated by anybody who possesses a basic level of financial literacy.
There are three steps to my process. All of them can be done using the calculator on your phone, a pen and paper, an email program and your bank’s, mutual fund’s and brokerage’s website or app. I personally like to use a spreadsheet, but it’s not necessary to do so.
The first step is simply tracking my income and saving. Every year, I plot out what I’m going to receive every pay period. From there, I start allocating to my various accounts: X dollars to my 403(b) retirement savings account, X dollars to my wife’s IRA, X dollars to my Roth IRA, X dollars to short-term savings, etc. It’s far easier to save an extra $1,000 by figuring out how to set aside an additional $40 per pay period than it is to find an extra $1,000 lying around. Getting granular helps to avoid being intimidated by large numbers.
The second step is extremely important: I’ve set up automatic deposits to coincide with when I get paid. Whenever possible, the money goes directly from my paycheck and into my various savings accounts. I don’t let it touch my checking account. For savings dollars that have to go into my checking account, I’ve set up automatic deposits to those other accounts to coincide with the days I get paid. Every pay day, my compensation is split among six different accounts.
This process is referred to as a Ulysses contract. I’ve voluntarily given up the chance to decide in each pay period how much I’m going to save. The decision is made only once per year; to change the amount saved, I have to make a special effort.
My process also takes advantage of another psychological phenomenon: mental accounting. Mental accounting is our tendency to view money held in separate accounts as being different even though it all contributes to our overall wealth. Seemingly insignificant psychological tricks can have a big advantage when used properly.
The third step is to ratchet up my savings rate every year. The savings rate is simply dollars saved divided by gross dollars earned. Near the end of every year, I create a new spreadsheet for the following year, plotting out every pay day and the pay period contributions to each account. I then seek to increase the savings rate by boosting what’s set aside.
When I do this, I send an email to the person in charge of our human resources with the new paycheck deductions to revise my Ulysses contract. If there is a raise, I re-adjust the savings rate so that it stays at the new higher percentage rate.
How much you increase your savings rate will depend on your salary and expenses. Some of you may find that increasing your savings rate by more than 2% of your salary each year isn’t painful. Others may struggle to boost their savings rate by 0.5%. That’s fine. It’s more important to make gradual, but sustained progress than it is to be disappointed about failing to reach a lofty goal.
Once you get in the habit of using this process, you’ll be amazed at how much more you’ve saved even over a period of just a few years.
Charles Rotblut (@CharlesRAAII) is a vice president with the American Association of Individual Investors.
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