Pay Yourself First
Updated: Nov 18, 2022
This article is part of our "The Stoic's Arbitrage - A Personal Finance Journey" series. This series will empower your Personal Finance success.
Personal Finance and general financial literacy are critical for making the most of your financial resources. It is very doable!
In our article, Budgeting like a stoic, we introduce the "short version" of the attitudes and behaviors necessary for wealth building. [iv] If you can implement these, you will build wealth.
#1 - Being content with yourselves and NOT spending money you don't have, NOT buying things you don't need, and NOT impressing people.
#2 - Having a long-term focus (and long-term is NOT two or three years). Wealth and security are built over decades, not months.
#3 - Very simply:
Another stoic budgeting attitude and behavior is "pay yourself first." [vii] There is a bit of psychology to this aphorism. Here is the thing, typically, your monthly income is fixed. Most of your bills and expenses are fixed. (needs) Next comes your fun money (wants) and your savings and investments. This order is called a "payment hierarchy." If your savings and investments are last, like a leftover, you may never save anything. It is amazing how quickly fun spending can suck all the air out of your investment intention. In fact, most Americans save very little, as this Federal Reserve graphic shows.
Why? Because most Americans do NOT pay themselves first. [viii] This means, their payment hierarchy needs to be adjusted. Pay yourself first by setting up auto savings and investment transfers from your paycheck. Next, your bills are the priority, with fun money wants being the leftover. [ix] Just changing payment priorities and attitudes can make a HUGE difference in your savings and long-term wealth. By the way, the little psychology trick is the auto transfer. If you never see the money in the first place, it is both harder to spend and will likely not even be missed. This is like a "forcing function" to ensure your savings are at the top of the payment hierarchy. Richard Thaler, the Nobel Prize-awarded Behavioral Economist, made his career on a similar concept for 401(k) retirement savings. [x] It works!
Now that you are paying yourself first, how much should you pay yourself? Start with maximizing your company match for the 401(k). Many companies will match up to 5 or 10%. This is free, pre-tax money! Do as much of this as you can! After that, build after-tax savings. Your savings should generally be geared toward an investment fund like a robo-advisor. There are many good robo-advisors, please see the notes section at the end of this article for some suggestions. [xi] Choose a robo-advisor with an auto transfer. I would save and invest 10-20% after tax (or more if you can). By the way, I'm not a huge fan of the large “6-month” emergency funds that many advisors suggest. I'd rather get a higher investment yield than a low-yielding checking account. You can always use your after-tax investments in a pinch. I’d say, keep no more than 1-2 months of salary to manage your liquidity needs in a checking account. Then, transition your savings to a robo-advisor or similar low-cost investment vehicle. During this transition process, I recommend a high-yield savings account as a 1-2 month buffer. [xii] You may see our approach in the following "Savings Waterfall" graphic.
Also, when you get an annual salary raise, take it off the table. In other words, increase your retirement and after-tax savings by an amount similar to your raise. Why? Your expenses are generally fixed and you have already managed your budget to pay your existing bills. As such, additional "raise" money should be directed to savings and investments. This is a cornerstone activity for "Pay Yourself First!"
The following "Savings Waterfall" graphic shows our framework for transitioning this month's "Pay Yourself First" savings from your checking account to your long-term savings and investing.
Our "Savings Waterfall" helps you implement point 3 from the wealth-building approach we discussed earlier. As a reminder:
This is best facilitated by setting up auto transfers between the waterfall buckets. The best part about it is that the robo-advisor does the heavy lifting "Invest → Evaluate → Re-balance → Repeat" part. All you need to do is "Save →" and transfer the money - the robo does all the rest! This is easily done in commonly available financial apps and bank accounts. Robo-advisors have super low minimums and are easy to set up. Start small and build! After starting, you will discover more options. Most robo-advisors also have special accounts for different life "buckets." These are accounts such as 529 College Plans, Roth IRA's, target date investing accounts for specific needs, and others.
Please note: We discuss how to budget in our Budgeting like a stoic article.
[vii] George Clason is credited with the suggestion to "pay yourself first," from his personal finance classic:
Clason, The Richest Man in Babylon, 1926
[viii] There is still an open question about why Americans do not save as much today. It is well known that past generations of Americans had less income and saved more. It is also known that other countries today have less income and more savings than the U.S. So we know it is not because today's Americans do not have the income capacity to save more. They absolutely do. In a 2022 interview, Yale University Economist James Choi expressed his theory:
Choi Savings Theory 1: "Our financial system is more developed now. And so you can get loans in a tough spot. You get better insurance than you did before. And so there’s less of a need to engage in precautionary savings now than you did in the ’50s."
Choi Savings Theory 2: "Another perspective is, hey, we just made it a lot easier to tap your home equity. We made credit cards a lot more available. Companies have gotten a lot better at marketing their goods than they used to be. And so maybe it really is about greater temptation in the economy now than there used to be."
Choi, Dubner, Are Personal Finance Gurus Giving You Bad Advice?, Freakonomics Podcast Interview, Interview 515, 2022
My personal favorite is Choi's second "greater temptation" theory. Using our stoic-derived discipline and knowledge will help us overcome the temptations Dr. Choi mentions. The point of the "Stoic's Arbitrage" is to use our stoic-informed knowledge and stoic-enabled discipline to make sure consumer financial products serve us.... instead of us serving financial services product companies!
Hulett, The Stoic’s Arbitrage: A survival guide for modern consumer finance products, The Curiosity Vine, 2020
[ix] Do not confuse higher-priority bills with fun money. Just because a credit card statement comes, it does not mean all the transactions should be part of a higher priority bill. Check out the transactions. If they are more in the "fun money" category, be sure to treat them as such and adjust future spending. Do your best to pay off your credit card bill every month. If you are having trouble doing that, reduce the credit limit on the card and pay cash for your wants.
[x] Thaler, Sunstein, Nudge, Improving Decisions About Health, Wealth, and Happiness, 2008
[xi] I am a big fan of robo-advisors. They generally have very low minimums. Almost anyone can start building wealth. Setting one’s risk profile is an important part of setting up a robo-advisor account. Investment risk management is a function of time. I.e., the longer the time period, the higher the properly managed risk may be realized to maximize return. A 7-plus year timeframe should be invested in higher risk profile equity portfolios. (This time period is roughly equivalent to the typical business cycle) Shorter-term time horizons should be in cash or appropriate bond and/or bank-like investments. When in doubt, choose a longer time frame. Timing needs for money are almost always further in the future than you think.
The great thing about robo-advisors is the automation of regular rebalancing and tax efficiency strategies (e.g., tax-loss harvesting). The setup is straightforward, with the risk profile handled by answering a brief set of yes/no questions. Finally, as interested, robo-advisors generally have a rich set of educational resources and helpful tools.
Robo-advisors I am currently active:
In the past, I have used:
I have considered but did not use:
Schwab Intelligent Portfolios **
in terms of robo-advisor costs, there are 2 main costs to consider.
AUM fee - most robo-advisors charge a fee as a percentage of the assets they manage. Currently, the market is around .25% annually. (Or, $2.50 for every $1,000 they manage.)
The loads of the underlying funds the robo-advisor manages - Most robo-advisors use ETFs, which generally have very low loads (< .1%). In the case of FidelityGo, as of this writing, they charge .35%. However, they only use Fidelity funds and they do not charge fund management fees. So, the FidelityGo fee is on par with a robo that passes through ETF fees. (.25% + ~.1% = .35%)
**The Schwab approach lacks transparency, at least at the time of article writing. In my understanding, Schwab does not charge any stated AUM fees. Yea! Great news. So you may ask, how do they make money?
This is the part with a transparency challenge. Based on their example, Schwab sweeps about 8% of client AUM into a low-interest-bearing bank account. Schwab uses this very cheap money to make loans and other investments for itself. In today's world, the bank account rate they pay customers is extremely low, less than .5%. If the long-term yield on the other ETFs is 10%, that means the effective AUM fee is .76%. [(long-term yield – deposit yield)*cash sweep %] Also, this AUM fee opportunity cost money is not available for the long-term time value of money customer benefit. Other robo-advisors invest 100% of client funds in the investment strategy. This lacks transparency because:
The effective AUM fee is hidden in the cash account and is 3x other robo-advisors.
From a liquidity standpoint, you would never use a robo-advisor to hold cash because the account, by definition, is illiquid in the short term. It would be the worst of both worlds of getting a super low yield and not having direct access to the cash.
*** The JP Morgan approach lacks transparency as they 1) charge a higher .35% AUM fee but do NOT disclose which funds will not have the backend fees rebated. 2) They sweep 2% of AUM into their own checking accounts. While less than Schwab, it is still consequential.
The challenge with Robo advisors associated with larger broker-dealers that manage their own funds and have a bank appears to be they have more tools to potentially reduce transparency. This may be a good reason to utilize monoline robo advisors. Also, at some point, I’m hopeful a law similar to the Truth In Lending Act / Reg Z for lending will make it unlawful for broker-dealers not to disclose “effective” AUM fees and to help make robo advisor fees comparable. Until then, caveat emptor!
We provide a slightly different example with the additional context in our article Is it time for “Truth In Investing?” – The next Robo-advisor evolution
[xii] See our article for getting the best yield on your short-term accounts. We provide a shopping approach and a number of high-yield savings accounts as examples:
Hulett, The sleeping bank deposit customer - It is time to wake-up, The Curiosity Vine, 2022