Paying Yourself First – Planning For Retirement

I’ve read a lot of articles and books over the last several years on planning for retirement, and one common theme among all of them is “Paying Yourself First”. That’s a somewhat unclear way of saying that you should save money for your future before spending on your current needs.

There are all kinds of suggestions for the best way to do this: writing a check to your savings account every paycheck, direct depositing a paycheck a portion of your paycheck to savings, saving all your dollar bills and depositing these at the end of the month, etc…

We (my wife and I) went all of these methods and more in our quest for regular savings, but I found them all wanting in one way or another. We embarked on a new system that I’ve been very pleased with.

Our system involves primary depositing all income directly to our savings account. That’s right, all of it. Our paychecks, any income from stocks or mutual funds, proceeds from stock options, bonuses, it all goes directly to our savings. We don’t actually use a traditional savings account, but rather the Prime Money Market at Vanguard which is currently yielding about 4%.

I got a link to this article from SparkleTeddy. It’s a good read, about the difficulty of saving money for those with low-income and the disincentives to save caused by the welfare system. Basically the article advocates a program that matches the savings of lower-income participants in retirement savings programs. I like that.

At the start of every month, I electronically transfer just enough money to our checking account to cover our budget items. This methodology results from several requirements:

  1. We wanted a predictable, steady stream of income; our income varies from month to month and from paycheck to paycheck for numerous reasons. We get bonuses in January and July. We sell stock in February and August. We get raises in April. We hit the 401k contribution and Social Security limits sometime in early fall. We get small cash awards periodically. To try to maintain a regular income in our checking account, I would have to recalculate how much to save every month. That’s awfully inconvenient.
  2. We didn’t want extra money to be available to spend; unpredictable money streams can wreak havoc on your sense of responsibility. One month we feel poor, the next flush. When extra money came in, I didn’t want to even see it in our checking account.
  3. Most of our finances operate on a monthly cycle, but we’re paid twice monthly; I’m sure everyone’s been in the situation where your credit card bill is due on the 17th and, because your bills for that month all seem to be “front-loaded” (i.e. due in the first half of the month), you have to wait until you get paid on the 15th to pay the bill. Then you have extra cash sitting in your account the second half of the month. By paying ourselves from our savings account, we can make our “paycheck” arrive whenever we want. I just transfer our month’s money at the start of the month, but you could do it twice monthly, weekly, or whatever makes sense for you.
  4. I didn’t want to maintain several savings accounts; a lot of people recommend that you open a local savings account for emergency money, a high-yield savings account online for short-term savings in CDs, and a retirement account somewhere. Then of course you have your checking account. I didn’t want all these accounts. We just have our Vanguard account and our checking account. Our Vanguard account has check-writing ability, so we can write checks and use it as an emergency fund. There is easy access to other investments when the money market balance gets too high. In a real emergency, we can easily sell some of the other investments and the proceeds will be immediately available.
  5. I didn’t want money sitting around in non-interest bearing accounts; now when we get paid, our paychecks start earning that money market yield as soon as the paychecks hit our account. This really starts to make a difference with our bonuses and proceeds from stock sales.
  6. Ultimately I want to abstract the income stream that we live on from its source; this is a little confusing and hard to explain. I don’t care where the money we live on comes from. We view our Vanguard account as just a “slush fund” where money goes in from various sources, and comes out to pay our bills. Whether or not we have a paycheck is ultimately not important — as long as some income stream provides enough income to the slush fund that it doesn’t start emptying out.

This last bullet, for me, kind of ties the whole strategy together. I no longer associate our living expenses with our income from our jobs. Our paycheck is just another income stream that adds to our wealth, but we live out of the slush fund, not from our paychecks. Of course, right now we need our paychecks for the slush fund to grow faster than we draw it down. But that won’t be true forever.

This strategy has worked splendidly for us, and I’d recommend it to anyone who has their finances in order. You do need the restraint to not spend all the cash in your slush fund, but that’s true of any savings account. If you are living paycheck to paycheck, it will be hard to take the initial hit of setting this system up. But if you’re already saving a substantial portion of your pay, this is a simple and natural way to do it.

My goal has been to keep the cash in our slush fund at about 6 months salary. This works out to about a year’s worth of expenses, but to be honest the actual size varies from half that amount to double that amount, depending on what kinds of events are going on. For example it will probably balloon in the next couple months as bonuses and stock sales come in, but then start to shrink as we move money into investments, take care of some home improvements, etc..

I’m extremely pleased with how this strategy has worked out. At this point there really is nothing I would change.