In recent years, central banks have grappled with curtailing inflation and easing interest rates at a reasonable pace. At the same time, consumers have been feeling the impact of the rising cost of living. As investors, we may not be able to control whether rates go up or down, or how rapidly consumer inflation rises and falls, but we can improve our long-term financial prospects by carefully controlling our lifestyle creep. Twanji Kalula explains.
Headlines around the world have been proclaiming that many are in the grip of a cost-of-living crisis. Global energy shortages have led to surging electricity prices, and geopolitical shifts have impacted supply chains, increasing the cost of many day-to-day items. We do not need headlines or the inflation numbers to confirm that life is costing us more – we feel the effects of inflation as we buy our groceries and pay our bills.
But the effects of inflation – the increase in price of goods and services over time – reach much further than living expenses. Inflation erodes the value of our money over time and should therefore be a critical consideration for the long-term investor, particularly when it comes to saving for retirement. At a minimum, we should aim to generate returns that keep up with inflation to protect the buying power of our accumulated savings; over longer periods of time, we should target returns that outpace inflation to help us realise our goals.
Consider using a windfall to improve your financial position by saving and investing…
Inflation, however, is just one of the factors that affect our overall financial outcomes. Lifestyle creep is another. Simply put, lifestyle creep is the increase in our expenditure as we earn more money. Unfortunately, it tends to work against us, but on the upside, in contrast to inflation, it is largely within our control.
Lifestyle creep is insidious
Lifestyle creep tends to move slowly; it is often the product of numerous small adjustments to our spending over time, but it can also occur rapidly as a result of a significant life change (e.g. having a baby) or a large purchase (e.g. buying a home). These adjustments can increase our monthly expenses substantially as they are generally not once-off and are absorbed into our base costs.
While a degree of lifestyle creep is expected as we earn more, additional cash flow is often channelled entirely into funding new expenses, with little consideration for long-term investment goals. As products and services that may have been considered aspirational or out of reach become increasingly affordable, they may begin to feel like necessities – fuelling lifestyle creep. This impacts the amount we have available for saving and investing and therefore erodes our ability to build wealth.
Rampant lifestyle creep can derail retirement plans
One of the problems with lifestyle creep is that we often fail to account for it when we project how much money we will need to retire comfortably. We can unwittingly end up spending more on lifestyle-related expenses during the accumulation phase of our lives at the expense of saving enough to fund our expenses in retirement. Adding further complexity, lifestyle creep may also drive up the amount of money we will ultimately need to ensure a comfortable retirement – depending on what we envision for this phase of our lives.
... we should aim to build a nest egg that is large enough to replace 60-70% of our income in retirement.
When deciding how much to save for retirement as a percentage of regular income, it is important to take personal circumstances into account. We need to consider our age at the time we start saving (i.e. the amount of time we have to save) and the amount of money we will need to have accumulated by the time we retire. The longer we wait to start saving adequately, the more we will need to save.
As a rule of thumb, we should aim to build a nest egg that is large enough to replace 60-70% of our income in retirement. This will ensure that we will be able to sustain a comfortable retirement, bearing in mind that the nature of our expenses is likely to change as we get older. However, too often, we only calculate this amount when we first start investing. If we fail to revisit this calculation over time and do not account for the effects of lifestyle creep, we are likely to end up not having enough.
Managing lifestyle creep improves long-term financial outcomes
An unwieldy lifestyle creep can result in our expenses outpacing our income. At first we may find ourselves living from payday to payday, but left unabated, many of us then fall into a debt spiral to sustain our ongoing lifestyle costs. The compounded cost of expensive debt further fuels lifestyle creep and is one of the reasons many investors never meet their long-term financial goals.
Luckily, there are a number of things we can do to help keep the lid on lifestyle creep:
Manage overheads
Good financial planning should balance present needs with future wants. By tracking expenditure, interrogating expenses on a monthly basis and comparing costs from month to month, we can monitor how significantly our expenses are escalating. Armed with this information, we can make better spending decisions.
Resist the urge to splurge when times are good
We are inclined to spend more when money seems more freely available. For example, when interest rates are low and home loan repayments therefore lower, we have a little more wiggle room to spend more exuberantly. During these periods, our lifestyle creep rate can skyrocket. By keeping a handle on our costs during good times, we can move through more challenging times – like when interest rates and home loan repayments are higher – with greater ease and avoid feeling as though we are constantly moving between periods of feast and periods of famine.
Use windfalls wisely
Additional sums of money have the power to help us accelerate the pace at which we achieve our financial goals. That said, windfalls can trigger lifestyle creep when they are used to make purchases that increase our base costs. For example, getting a new car when receiving a bonus may seem like a once-off expense, but a new car may significantly increase ongoing fuel, maintenance and insurance costs.
A well-considered financial plan … can go a long way in keeping lifestyle creep at bay.
Consider using a windfall to improve your financial position by saving and investing: Build an emergency fund, make an additional contribution to a retirement product, such as a retirement annuity, or contribute to a tax-free investment.
Revisit retirement savings targets
As part of our ongoing financial planning, we should regularly recalculate how much we need to save for retirement. This exercise ensures that we remain on track to draw a retirement income that can support a comfortable lifestyle.
Increase savings rates
Reframing the way we see increases in our income can meaningfully impact our investment outcome. Income increases can be used to keep pace with inflation and increase investment contributions.
Invest in a fund that beats inflation
Retirement investments need to target and keep pace with inflation. Investors should select a fund that has a proven track record, takes on sufficient risk to generate above-inflation returns, and manages this risk appropriately across a range of asset classes and regions. For most investors, the Allan Gray Balanced Fund fulfils these requirements. To understand how our Balanced Fund achieves these objectives, see Nick Curtin’s article.
Keep track to keep on track
A well-considered financial plan, which is revisited regularly to account for changes in personal circumstances, provides an invaluable road map as we work towards achieving our long-term investment goals. It also provides a disciplined spending system that can aid in purchasing decisions, and can go a long way in keeping lifestyle creep at bay.
Explore more insights from our Q4 2024 Quarterly Commentary:
- 2024 Q4 Comments from the Chief Operating Officer by Mahesh Cooper
- Paying tribute to Gillian Gray by Craig Bodenstab
- Diamonds in the rough: A look at luxury by Jithen Pillay
- Where investors fear to fish by Rory Kutisker-Jacobson
- Orbis: President’s letter 2024 by Adam R. Karr
- In safe hands with the Allan Gray Balanced Fund by Nick Curtin
- How to maximise tax benefits in a two-pot era by Carla Rossouw and Lee Kotze
To view our latest Quarterly Commentary or browse previous editions, click here.