It is no secret that I think “front-loading” your savings is a good idea. The four most important words a medical student or resident can hear are “Live Like A Resident.” In order to front-load your savings, you must have a high savings rate early in your career.
6 Reasons Why Should You Have a HIGH Early Savings rate
# 1 Choices, Choices Choices
Perhaps the most important reason to save early is to allow for more choices later on. By getting a good size nest egg in place early, you will have the option to cut back or even fully retire early. You may wish to change careers, or choose a less lucrative practice option. These are all options someone who waits to save does not have. It affects your investments as well. If you start saving early, you can choose whether to be aggressive or conservative in your investments. If you start too late, you may no longer have that option.
College savings is similar to retirement savings. If you start early, your kid will have additional options that might not have been affordable if you started late. That doesn't mean you have to send the kid to the fancy-pants school, but at least it's an option.
# 2 Less Hedonic Adaptation
It is no secret that, behaviorally-speaking, it is far easier to avoid growing into your income than to cut back on your standard of living. Hedonic adaptation means that you are not any happier just because you spend more money. Studies suggest that there is little additional happiness to be had once income hits a reasonable living standard, about $75K per year in the US (up to $120K in expensive areas like Manhattan and The Bay Area.)
If you start off saving a big chunk of your money, you may NEVER reach the highest levels of hedonic adaptation. Not only does that allow you to accumulate a larger nest egg, it also lowers the size of nest egg that you need. This is easily seen with this chart:
|Years to Financial Independence|
|Net Savings Rate||Years|
This is a very simplistic calculation. To keep it simple, I used a “net savings rate” which means how much you save, adjusted for taxes (so using some theoretical discounted rate for tax-deferred accounts), divided by your after-tax income. But the point of the chart (and the calculation behind it) is very clear — when you spend less, not only are you saving more, but your need to save is dropping. You're burning the candle (years of working/saving) at both ends, so it gets short very quickly.
# 3 Much Cheaper Insurance Costs
Despite what insurance agents would like you to believe, on average, insurance costs are a net drag on your financial life. Since insurance is unlikely to make you particularly happy (kind of like utility bills), it seems silly to spend more than you need to on it. The key factors in determining your life and disability insurance costs are how long you will need it and the size of your expenses.
Agents like to sell you as much disability insurance as you qualify for. But if you're living on 40-50% of your income, you hardly need to insure it at all. Plus, if you can become financially independent early in life, you can take advantage of “deals” like graded premiums, where your premium is low early and high later. Since you're financially independent, you simply surrender the policy before the premiums ever get high. Term life insurance is similar. It is ridiculously cheap for someone who doesn't need it after age 50, and you never even have to consider expensive permanent insurance.
# 4 The Portfolio Does More Lifting
Even if becoming financially independent or retiring early isn't your goal, by starting early you give your portfolio the chance to do more of the heavy lifting. Less of your eventual nest egg will have to come from brute force savings.
Most readers of personal finance books have seen the example that shows if you save $10K a year for 10 years, ($100K total) and then allow that money to compound for another 20 years without additional contributions, you will end up with the same amount of money as someone who waits ten years to start, then saves $15K a year for 20 years ($300K total.) The examples are a little misleading since most authors don't make any adjustments for inflation. If you actually do that, then a better example would be saving $10K in inflation-adjusted dollars a year for the first 10 years ($100K total in today's dollars) vs saving $10K in inflation-adjusted dollars a year for the last 20 years ($200K total in today's dollars.) Still, it's better than a kick in the teeth.
# 5 Avoid Hard Choices
Many investors struggle with deciding which types of accounts they should use to save. Others struggle with the pay off debt vs invest decision. However, if you're saving a ton, you can just do everything at once. That's the whole point of “living like a resident” for 2-5 years after residency. You don't have to choose between paying off your loans, maxing out your retirement accounts, and saving up a down payment. You can do it all at once.
# 6 Acquire Important Knowledge Earlier
The sooner you learn about how to manage your finances properly, the longer you will be able to reap the benefits of that knowledge. I was chatting with a doc who came out of residency about the same time as me a few months ago. He was frustrated with the underperformance and fees of his 401(k). So we talked about how mutual funds, advisory fees, and investment costs work. It was all new information to him. It's great that he is learning it now while he is still in his late 30s. But imagine if he had learned about that stuff in his early 30s — he might have twice the net worth, and over time, that knowledge could be worth $1 Million or more.
What do you think? Do you think it is worthwhile to try to front-load your retirement and college savings? Why or why not? What other benefits or drawbacks are there to having a high early savings rate? Comment below!