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<\/p>\nIt\u2019s that time of year again. Your performance on the job was superb. Your boss congratulates you and tells you that you\u2019re getting a hefty pay rise. You suddenly feel a lot richer. Your disposable income has shot up. Your living expenses are no different today than they were yesterday. So does it makes to spend all your extra income (after tax) on luxuries? In other words, should you use your entire extra disposable income to increase your discretionary spending?<\/p>\n
On the face of it, it\u2019s tempting. In fact many of us would do just that. We tend to improve our standard of living in line with our rising income, assuming that we\u2019ve covered our basic living expenses. But there are two things that make this spend-it-all approach questionable: inflation and retirement.<\/p>\n
Over time, the cost of living will inexorably rise, even if we don\u2019t change our lifestyle. Some of our pay rise will eventually be eaten away by increased costs that we can\u2019t avoid. That\u2019s why life\u2019s been so tough in recent years for many people whose wages haven\u2019t kept pace with inflation.<\/p>\n
Maybe you’ll be unwilling to make cutbacks when finances become tight, and you may borrow in order to maintain your lifestyle. This can be reasonable if it’s to cover a temporary blip in your cash flow; for example you may be confident of money coming in later to cover an expense today. But it can become a serious problem if you continually borrow in order to live beyond your means.<\/p>\n
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If you\u2019re in the fortunate minority, maybe you can look forward to a final salary pension. If so, your expected future pension should increase by some percentage of your pay rise. Even so, by using any increase in disposable income for discretionary spending, you\u2019ll find that you\u2019ll have to reduce your discretionary spending once you retire. This is because only a proportion of your pay rise will translate into an increased pension.<\/p>\n
If you don\u2019t have a final salary pension, then it\u2019s even harder. If you spend all of your pay rise from now until retirement, then all of this extra discretionary spending will suddenly be lost once you retire.<\/p>\n
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Nobody can predict the future with complete accuracy. However you have to make a trade-off between spending like there\u2019s no tomorrow and spending the bare minimum for fear of running out of money after retirement. This is not just retirement planning: it\u2019s whole-life planning.<\/p>\n
Any time you get a pay rise, it\u2019s a good time to revisit your whole-life planning. As an example, let\u2019s say you\u2019re only 2 years away from retirement. We’ll assume that you don\u2019t have a defined benefit pension plan. If you get a pay rise of \u00a35,000 per year after tax, then that\u2019s worth only \u00a310,000 in total, since you\u2019ll only benefit from it for 2 years. Suppose your average life expectancy is 25 years. Then, looking at your whole life, your pay rise is worth only \u00a3400 per year. This means that it makes more sense to increase your discretionary spending by just \u00a3400 rather than by \u00a35,000; the remainder should go into your retirement fund.<\/p>\n
The further away you are from retirement, the bigger the proportion of your pay rise that you can \u2018safely\u2019 spend. You typically want your discretionary spending pattern to be smooth, so that there\u2019s no cliff-edge at retirement. Falling off a cliff is the worst, as it means you didn\u2019t save enough while you were working.<\/p>\n
But if you over-save and under-spend, then you\u2018ll reach the bottom of a cliff at retirement, instead of falling off one. Suddenly you\u2019ll be able to spend more than before you retired. The main problem with this is that it assumes that you\u2019ll actually reach retirement, and that it will be a reasonably long one. Of course you hope for the best, but it\u2019s possible that you might not live long enough to enjoy the money you\u2019ve earned.<\/p>\n
![\"balance\"](\"https:\/\/evolvemyretirement.com\/blog\/wp-content\/uploads\/summit.jpg\")
<\/p>\n
The trick is to strike the right balance between not saving enough and not spending enough. Every pay rise is a temptation to start over-spending. Every sharp rise in the cost of living is a temptation to start under-spending on the good things in life.<\/p>\n