Lifestyle Inflation and the FI-o-Meter

99_booth_of_truth

Step into The Booth of Truth

The conventional wisdom is often wrong.  Sometimes the problem is not the stuff we don’t know. Its that the stuff we think we know is often wrong.

I recently learnt something about financial independence that I want to share with you as an example of this.  I had always assumed that earning a higher salary must be a good thing in terms of time taken to achieve FI.   Surely the faster your salary goes up, the quicker you must get to Financial Independence, right?

This seemed intuitively obvious…even though it was contradicted by what I’ve seen working in the City. There I noticed that Lifestyle Inflation seems to thwart the plans of even the highest earners to escape the Prison Camp.  Actually, Lifestyle Inflation is a slightly misleading term. Spending Inflation would be more accurate, given that the more stressed you are at work, the less Life and the less Style you will end up with.

I had a striking example of this last year. Whilst I was in my notice period leaving my job last summer, I was contacted by a headhunter and asked to go for a job interview at one of the biggest global accountancy / consulting firms.  Given that I was easing my way out of the Prison Camp at the time, I was about as likely to take the job as I was to gouge out my own eyes, but I thought I’d drink their coffee and hear them out anyway. There is usually no downside in talking to smart people and hearing what they have to say.

I was interviewed by 2 partners of the firm. Last year, the average partner in that firm earned £750,000 a year.  One of the two partners was the head of a significant division of the firm, so I think its safe to assume that he made significantly more than the average. I’d guess he was on maybe £1.5m pre-tax per year, maybe more.

As described in Get Rich…Honestly, I have a strange compulsion to tell the truth these days. As well as being good for the soul, this a rich source of social comedy.  So I thought I’d give it a go during the interview.

I told them that I was financially independent and wasn’t really that interested in money or looking for another full time role. This was a clear breach of interview etiquette – a bit like going to church and letting slip to the vicar that you are a devil-worshipper and are only there to check out the competition.

Just in case you are going to a job interview, I should make clear that if you actually want the job, the best approach is to look “hungry”. Employers are usually looking for people who think about money in the same way that a Vampire thinks about blood or candidates on The Apprentice think about status.  In other words, not much thought activity in the pre-frontal cortex, just a deep-seated reptilian yearning.

The senior partner (lets call him Mr Spendy) looked me up and down. He told me that it was impossible that I could be financially independent because he was ~10 years older than me, earned way more than I did and he could not afford to stop working. In a very polite English way, I guess Mr Spendy was either saying I was lying or that I couldn’t add up. I’m not sure which would be worse in his world view but neither seems complementary.

Mr Spendy had obviously been suffering from Lifestyle Inflation. According to him, it is hard to save when you are scraping by on a £1m a year these days. I suspect he and his wife had been spending with the same amount of restraint as an 18 year old Afghan Taliban fighter with a new AK-47 who’s just found ten crates of Russian ammunition in the cave next door.

Now a lot of people assume that spending brings happiness.  If that were true, then Mr Spendy would have been as happy as a pig in shit. He would be spending his days high on endorphins, dancing down the office corridors in a state of bliss, stopping only to high-five his colleagues as he went.  But I have to report to you readers, that Mr Spendy didn’t seem very happy at all. Instead, he looked suspiciously like a stressed and grumpy man in a grey suit.

Mr Spendy may have been an accountant, but he clearly needed some help with the basic arithmetic of financial independence.  So, Ladies and Gentlemen, I can now unveil The Escape Artist’s FI-o-MeterTM spreadsheet. This simple model allows you to plug in your own age, income, spending and salary growth assumptions and spits out how long it will be until you achieve FI.

Unsurprisingly, I found that the earlier you start, the less you spend and the higher your investment returns, the quicker FI is achieved. But when I played with the assumption on salary growth, something strange happened. I found that the higher the salary growth rate, the longer it takes to get to financial independence. My initial reaction was that this must surely be wrong. After all, everyone knows that higher income is better if you want to get rich?

Well, yes and no. I had wired up the spreadsheet to run off an assumed savings rate of 50% (or whatever). So if salary growth increases, income rises (Duh!) but so also does your spending (at any savings rate less than 100% ).

At a given savings rate of (say) 50%, an increase in salary growth rate has 2 effects:

  1. Good news – you save more and your portfolio gets bigger
  2. Bad news – spending goes up and you now need more to achieve FI

It turns out that the second effect outweighs the first, so getting to FI takes longer.

This paradoxical finding is a function of the way in which the maths of financial independence works. Based on an assumed 4% Safe Withdrawal Rate, you need a portfolio of 25x your annual spending to get to FI. This means that every change in your spending is multiplied by 25 when considering whether you have enough.

There is a clear takeaway from this: as you get on at work, get promotions and pay rises you need to minimise lifestyle inflation and increase your savings rate. Keeping the same savings rate means that your FI hurdle is getting higher and higher. Its like running to keep up on a treadmill that is getting faster and faster.

If you think of spending as a ratchet that can only goes one way as your salary increases, then FI will just keep slipping further out of reach. The good news here is that spending is never a ratchet and you can always reverse lifestyle inflation. Salary income may depend on a degree of luck and the vagaries of other people’s opinions. But we always have control over our own spending.

Salary increases and the temptations of lifestyle inflation are the norm for hard-working and ambitious middle class people in their 20s and 30s. They work hard, keep their nose clean at work and start to get promotions. As the money starts to roll in, the pressures to spend it are all around. Remember these are also the years when our compulsion to establish our social and mating status are most powerful.  For the avoidance of doubt, I am not suggesting you turn down pay rises….take the extra money and stash away as much as possible.

Have a play with the FI-o-MeterTM spreadsheet which is embedded below. Embrace your inner geek (they need love as much as the rest of us). Its instructive to see how the age at which FI is achieved varies in response to the input assumptions. Remember that, like all models, it represents a simplification of real life…just like all maps are simplified versions of the real world.

There is no need to email me or comment below saying that you disagree with the input assumptions. You can easily just change them yourself and see what happens.

The maths is simple and the results may surprise you. But the numbers do not lie.

Image credit: Tim Hunkin

26 comments

  1. Dear EA,

    Very interesting post, but the glaring omission here is the presumption that financial independence is achieved without owning a property, and that it’s possible to live on £15K/year when you take into account rental. Thoughts?

    Best,
    Paul.

  2. Good point. A simple example demonstrates it nicely. Imagine you make 100k the first year while spending 20k. Good job, you saved 80k. In order to be FI, you’ll need around 600k. The next year you get a big salary bump to 1 million and you spend 200k. You’re now at the same savings rate, but you need 6 million to be FI. And that 80k you saved last year is dwarfed by the new total you need to save. For the average person, this effect is less pronounced, but is still something to consider when developing a savings plan.

  3. BeatTheSeasons · · Reply

    I think this is a really useful tool that will help a lot of readers work out how far they are from FI or what changes they need to make in order to achieve it.

    However, you are getting misleading results due to the design of the spreadsheet, which assumes your savings rate will remain at the same percentage as your income increases.

    If a 20 year old starts with a 50% savings rate and gets a 6% annual salary increase but manages to limit spending to a 3% rise each year then he or she can retire at age 40, even without any initial savings or investment growth.

    The same 20 year old with the same initial 50% savings rate who gets a better 8% annual salary rise can actually increase spending by 4% (i.e 1% more than in the first case) yet retire two years earlier at age 38, again with no initial savings and no investment growth.

    Hence while lifestyle inflation is important, and in fact as you say, more important than earning more money, pay rises do actually help in getting to FI faster, and some lifestyle inflation is even allowed 🙂

    By the way, I modelled this by using cell E2 for the rate of spending increases and then changing the formula in cell C21 to “=C20*(1+$E$2)” and dragging it down.

    Another important point to bear in mind is that your spending in retirement is likely to be lower than it was while working due to no commuting costs, no more special work clothes, being able to take advantage of cheaper holiday dates, etc.

  4. “Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like.” —Will Rogers

  5. I can certainly relate to your view of Mr Spendy in the accounting industry, with many of my peers at work being just like this. The most successful partner in our firm has more wealth than just about any client we have but still can’t seem to work out how to retire before 55 – his cost of living must be huge.

    I also found telling the truth to be a bad idea at work with respect to your need for money. People like to know that they have you locked in and needing to follow their path to pay for your ever-increasing lifestyle, but when telling someone about more money not motivating me I could see that it really confused them. They obviously aren’t aware of the maths that you have set out in your calculations!

  6. Earlyretiredguy · · Reply

    You don’t necessarily need to tell them you’re FI, but isn’t it just so empowering to know that you don’t need Mr Spendy’s job because you’re sorted enough financially.

  7. The after tax calculation is even more dramatic. To take Eric L.’s example of £100k increasing to £1m – most of the latter will be taxed at the additional rate if taken as current income. Pensions and ISAs of course have £1m lifetime allowance/£15k annual allowance respectively, thus not all savings will not get tax sheltered. Tax becomes much more of a burden at higher levels of spendiness (as it should be).

    Then again, this is being naive to the level of tax avoidance/evasion by high earners…

  8. Interesting post – Mr Spendy’s outgoings must be huge!

    I’m getting a 3% pay rise from next month so as I was thinking of saving half of it, what I save will increase by 1.5% and my lifestyle will increase by 1.5%. However, I may end up not spending that extra 1.5%, that too could go towards my savings!

    Thanks for posting the little calculator – according to this, I could be FI at 56, which is at the extreme end of my own predictions.

  9. B Shnady · · Reply

    My own experience of FI while ‘young’ is that other people often cannot get their heads around the concept. They seem to equate FI solely with Euromillions lottery winners – everyone else, and they really do seem to mean everyone else, from pauper to lord – must have to work, one way or another – surely?

    When people ask me, “so what do you do?”, and I answer, “this and that, whatever I like really (within reason…)”, they seem to think it’s bullshine and that I’m somehow “working from home on the Internet” but am secretive and reluctant to go into details.

    I was recently telling a friend a little more detail of how I operate my investment portfolio [hands-off, requiring little to no input] and they seemed unable to grasp this hands-off aspect, determined instead to convince themselves that I was slaving hard at it every day, just as if it was a job. The only way they could rationalise what I was telling them was through the prism of their own life experience, which meant that what I did during weekdays must by definition amount to work.

    I think I would very much have enjoyed that interview with Mr Spendy, oh yes 🙂

    1. NotKeith · · Reply

      B Shnady, you’ve hit on the biggest issue I’ve found with early FI. I finished work 2 years ago, at 46. Colleagues assumed I was having some kind of breakdown. Neighbours quietly believe that describing yourself as FI/retired in your forty’s, is simply placing a positive spin on being unemployed. Even close friends just don’t get it. It’s made worse, for me, in that my wife still works (because she wants to, not that she has to), so you can add ‘kept man’ to the list.

      We can’t wear a t-shirt with our net worth printed on it, and it isn’t really British to openly discuss money, in any case. When strangers ask what I do, I generally talk vaguely about consultancy work from home, as it’s just easier to believe and understand.

      I don’t expect any sympathy from those still working – FI, and the options it provides, is great – but I would interested to hear how TEA, and others, manage the ‘what do you do for a living’ question?

      The answer, of course, is probably just not to give a sh*t what other people think, and to watch them leave for work whilst still wearing my pyjamas…

      I must admit, I totally overestimated the time I would spend on portfolio management – it doesn’t add up to more than an hour or two each week. I spend more time than that reading blogs like this (excellent) one.

      1. NotKeith & B Shadny

        Great points guys. The question “What do you do?” has also been intriguing me recently as well. I’ve tried different answers…all true, but with different emphases. One that works reasonably well is “Writer” as people can visualise you tapping away at a PC at home. If I say “investor” or refer to FI, I usually get a blank look…Saying “I do some consultancy” or talking about my coaching can sound a bit vague. If I talk about volunteer work, they “decode” that as unemployment.

        The best answer is probably “I do lots of different things” and then list them with examples but most people love a super-quick answer so they can put you in a pigeonhole without too much effort.

        Like you say NK, its not worth worrying too much about what other people think 😉

        TEA

  10. red kite · · Reply

    Being female of a certain age and with children, I doubt whether strangers would even be interested in asking what I do for a living. Even now, people don’t assume I am working, and if I told them I wasn’t, they’d just put me in the ‘middle aged housewife’ box. I’m not sure that’s a better place than the ‘must be unemployed but ashamed to admit it’ box!
    Still, it is in my experience very hard to pull the plug on a regular income. It just feels, to me, reassuring to be bringing in enough to pay the bills from earned income (I guess that’s why I never went for the housewife/kept woman option before we got rich/lucky). And I imagine the larger the income, the harder it is to walk away – presumably not many people end up with enormous salaries without that earning power being quite important to them. I imagine Mr Spendy just can’t compute.

    1. Ha-ha…”Housewife” definitely beats “unemployed but ashamed to admit it” for social acceptance!

  11. I would have loved to been in that room with you and Mr. Spendy 🙂

    Just added your spreadsheet here to my ER list – gotta get the word out as far and wide as possible!

    http://www.budgetsaresexy.com/2015/02/early-retirement-fi-spreadsheet/

    SFL, baby! (spreadsheets for life)

    1. Thanks J$….entry into the spreadsheet Hall of Fame at last!

  12. As somebody with hardly any income and looking to increase my hours of work, I filled in the spreadsheet to see how it would cope…well, I shall achieve FI at 86…probably after I am dead! Oh dear!

  13. Really great motivation. Just found your website recently.

    I’m just about to graduate and I’m already planning for early retirement.
    Pah! It’s a little to early to early to be disillusioned by work. I must just be lazy 🙂 Somehow the dream makes the idea of working for 30 (minimum) years more palatable.

    I’ve only ever been a student so I haven’t yet experienced “spending inflation”. I wonder how well it’ll go when a family and wife appear.

  14. Sundeep · · Reply

    Interesting insight from NotKeith and B Shadny above regarding having to resort to telling white lies to prevent having people’s minds melt as they try to fathom how FI is possible before their 60’s, I get a kind of similar deer in headlights look just trying to tell friends an coworkers about early FI in general and stopped that just a few months into my own discovery of it. A pity they can’t get it.

    Also, I was secretly hoping for an Office Space type moment when you were talking to Mr Spendy where he offered you some insane salary due to your devil may care attitude and you kept saying no. A great story nonetheless.

  15. Reblogged this on Sparkle Bee's Journey to FI and commented:
    Read TEA’s post on achieving Fi and the problem of lifestyle inflation. I was amused by the interview where the interviewers who were obviously on wonderfully high salaries couldnt retire.
    It is surprising what an impact lifestyle inflation has. People do not realise it creeps up on them. They circulate with friends and family that expect status indicators that they have stepped up the ladder. The trappings of success – bigger house, expensive objects and holidays, etc…

    I was once in that mode. I was living with an ex-partner and we had good jobs, bought a large house in a ‘well-to-do’ area and seemed to ‘have it all’. Our families were proud of us, my ex-partner’s family more hung up on ‘keeping up with the Jones’ that mine was.

    They didnt like me to start as my family lived in a small, humble home and that rubbed right from the start. But with my good job and status, my family history was wiped out and I was accepted even put on a pedestal and ‘shown off’ to the rest of the family. I had a good job, company car, etc..etc…travelling abroad for work… ticking all the boxes.
    My expenses increased, my partner started working as a contractor (although not really earning his keep – had more time not working than working!) – anyhow.

    I did try to kerb my spending and did save a bit more than 10% and we snowballed our mortgage. We split and he went on to buy a big house and continue the status trip.

    I downsized and started to increase my saving – I didnt realise how much I was spending on lifestyle inflation aspects. I started filling my NISAs and savings. Before I knew it I had snowballed my little mortgage away.
    I have learnt that money does not buy you happiness. I am more content now that I was when I was with my ex. I have money in the bank and my FI honey pot is growing nicely.

    According to the FI-o-meter I am either 2 years away – or THERE! If I am conservative with my spending an expense needs – I could escape. Hurray!!!!!!!!

  16. I love pay rises and my bonus as it gives me more to stash

    As for whatever other people think, who cares as long as your happy and the people most important to you are too

  17. This is very interesting, thank you. There are some fantastic quotes in here!
    I have a few friends who are sever sufferers of Lifestyle Inflation, but try as I might, they just can’t see the damage they are doing. Or perhaps more accurately, the opportunities they are missing by falling into the consumerist lifestyle.

    Re: the spreadsheet. A large chunk of my FI war chest is hidden in a DB pension. Do you have any advice on how to account for the value of that in the spreadsheet?

    1. Re the DB pension, you could illustrate this by netting off the annual pension income from your annual spending…that will allow you to calculate the spending that is not currently covered by the DB pension and hence how much additional stash you need. As well as having enough overall, you obviously also need to be able to fund the gap before you are able to access your pension.

  18. As the artist and I worked in the same industry (and I am an investing fool / phobe so still work) I can’t help speculating whom the artist met as he will be well known to me. I recall chuckling over lunch with him about 2 years prior to his retirement when he explained the FI philosophy and experiencing similar reactions. Now I read his blog….

  19. Hey yo, you makin a lot of assumptions here b. Did you just bring up bein independent outta nowhere? Dude was prolly like, “why this fool lookin for a job then just to brag?” What that got to do wit the position you interviewin for nahmean. If you didn’t want the job jus don’t go to the interview bruh, and stop wit all this interviewin jus to make people feel bad.

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