How to Save for Retirement: Pay Yourself First

how to save for retirement

One of my favourite personal finance books is The Wealthy Barber written by David Chilton.  Chilton weaves his financial advice around a story of a barber named Ray who is independently wealthy.  While detailing Ray’s story Chilton incorporates advice that Ray dispenses to his clients.  Of the plethora of valuable advice in the book the first tenant to developing a personal financial plan and how to save for retirement is to pay yourself first.

The premise of this strategy is that you automate a 10% deduction of your take home earnings.  This 10% is put into an account that is not your primary checking or savings account and will be used to save for your retirement.

 Save for Retirement with the Magic of Compound Interest

In an article I wrote earlier this year, How to Quit Smoking Cigarettes I touched on the magic of compound interest (interest gained on principal and interest).  After adding things up I figure spent somewhere around $20,000 – $22,000, perhaps more, over ages of 18 to 35 on smoking.  This number shocks me, but what shocks me even more is that if I had invested this money and let compound interest do it’s thing – WHOA!

If I had saved $1,200 annually (instead of buying smokes) when I was 18, by now I would  have $43,180 if the rate of return was 8%.  Moreover, if I kept that money invested, and continued to funnel that $1200 per year ($100 per month) into saving, by my retirement age goal of 58 I would have $349,100.  $1200 x 40 = $48,000 so you can see the magic of compound interest can really help you save for retirement.  The earlier in life you can get started the more you can take advantage of compound interest on your savings.

How can you save for retirement then?

This compounding interest phenomenon grows exponentially if you can contribute more money monthly while you save for retirement.  But how can you save when budgeting seems to work for so few?  Chilton’s rule: pay yourself first.  The concept isn’t complex – you find a way (your bank, your employer) to deduct 10% of your take home pay and have this money automatically deposited into an account that is difficult for you to access.

The primary point is that you never see the money in your primary bank account and your spending habits will adjust to deal with only the money you are cognizant of. Your standard of living should not be changed.  To save for retirement you essentially make yourself a bill payment – much like the rent/mortgage debt , utility or telecom bill.  In this case, you bill will be your future.  As your earnings grow so will your contribution to your retirement savings.

 To Save for Retirement, Be an Owner, not a Loaner

The key behind being an owner and not a loaner is that you shouldn’t squirrel money in a bank (loaning to them) getting lousy, low interest rates.   When you deposit money into a “savings” account your bank low balls you with a low interest rate while it uses that money to invest at a much higher rate (and subsequently earn tons of profit).

Instead, you should strive to be an “owner”, as in, buy equity.  You can own stocks, commodities, real estate or mutual funds.  Personally, aside from our buying a home (real estate), I avoid those types of investments.  Instead I prefer dividend stock investing (where the stocks can increase in value coupled with a nice dividend yield).  For our dividend investing we target the major dividend aristocrat companies that we trust will be around, and be successful, for decades to come.

You can also consider investing in the index via Exchange Traded Funds (ETFs) which mirror many mutual funds sans the ridiculous MER (management expense ratio) fees actively traded funds incur.  Index investing has a low PITA factor – pain in the ass factor.  You are putting your money against an investment vehicle that has holdings in numerous stocks – the index.

Now all that being said, invest in what you’re comfortable investing in!  There is no “right” or “wrong” way to go about investing as long as you know what you’re doing.  If researching and learning the small cap market is your cup of tea, sip away!  The important thing is you have decided to save for retirement.

If you have 20-40 years until retirement you can likely afford to take a long term perspective on the market. If you are considering early retirement you may need to adjust this perspective.  This does not automatically mean that you should adopt the buy and hold approach, but it is a valid investing strategy when you save for retirement.  The market will go up, and then go down.  Nature of the beast.  If you wait it out until you close in on retirement you reduce our brokerage fees and avoid trying to time the market which I read is pretty darn difficult to do.

Regardless of the path you take, if you pay yourself 10% first and keep the money invested with a decent rate of return you are well on your way to save for retirement.  Just remember, the best time to save for retirement may have been 10 years ago but the 2nd best time to save for retirement is right now.

What do you do to save for retirement?

30 thoughts on “How to Save for Retirement: Pay Yourself First

  1. Great article. I take a very similar approach and have money automatically deducted and put into various investment accounts – mainly a 401K, a high interest money market account (not touch except to buy stocks/bonds if I see a good deal), IRA, and two emergency fund accounts (these get touched only in an emergency). All in all I think I save about 30% this way. Based on my experience, I would suggest the method you outlined in your article to anyone.

    1. 10% is a suggested minimum. We save much more than 10% but I recognize that 10% can be a major part of many peoples monthly budgets. But if you can start at 10% you’re well on your way.

  2. That is such a crazy high number for smokes- I’m glad I never picked up the habit (the occasional cigar is as far as I go) though I often wonder how much I’ve spent on drinks over the course of 5 years – probably much more than I’d like to admit.
    Great article – currently, I pay my self a few different times, and have retirement through my work as well. I’ve also got a roth IRA that is almost maxed out for 2011

  3. Not smoking or drinking my entire life has really allowed me to save a ton of money for sure.

    My main strategy for saving for retirement is to use the RRSP matching plan of whatever company I am working for. My last employer matched 100% up to 6% of my income so that made for 12% right there. I need to up my game some and start investing more in TFSA and looking into leveraging the equity in our house if the right opportunity arises.

    One thing that helps a lot though is that I’m so good at stretching a dollar that I am confident I can live on a lot less than most people if need be and still have a good lifestyle. I do love to travel though and enjoy some luxuries now and then though so hopefully I’ll be able to find a good balance in retirement if I make it that long!

    1. If forced to Mrs. SPF and I could decimate our budget to bare bones. We grew up w/o much in our respective families. We (I) could stop drinking beer, we could down grade the cat food, buy less local food / goods, go to WalMart (ick), stop donating to charity (ick!), reduce our mortgage payments to the min, wear more sweaters in winter, grow more food etc etc etc etc etc. We are able to not do these things as we worked hard to get where we’re at. But on the drop of a dime we could change drastically and I don’t think our happiness (save for Friday nights when I love to have a few pops!) would decrease much. We have each other, and soon, Baby SPF!

  4. Great article. We have a similar strategy in place to you. We actually just sat down this week to reevaluate our current plan and see if there was any room for improvement. We have adjusted our budget a bit so that we can save even more per month.

    Currently we use a combination of index funds, TFSA accounts, and mutual funds to invest our money. We also use high interest savings accounts for money we will need in the nearer future.

    This time of year is also when we have finished paying our CPP and EI so we are going to use that extra raise in our paycheck for saving too.

  5. I have devoted a portion of my blogging income toward retirement. It has been an unexpected stream of income and I feel by doing this I am getting “ahead”.

    1. Great idea Daniel. I’ve been looking at our blog income and wondering what to do with it. To date we paid for a road trip vacation and (for us) a big ticket item on that trip. We’ve been buying some baby items too (crib on the way!) as well. I figure this was totally unexpected income so why not?

      But the extra money? Retirement seems like a great idea. Here in Canada we have RRSPs which when you use them to invest it lowers your taxable income on top of being un-taxed (until withdrawal) growth too. Perhaps the rest of our blog income for the year should go towards these … or, the Tax Free (ever!) Savings Accounts we haven’t optimized …

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  8. We max out our 401k contribution pre-tax. That comes out to about 20%? It’s necessary to start doing this as soon as you get a first job to get the good habit going. We also invest what ever is left at the end of the month as well. Investing early with auto deduction is the key to saving for retirement.

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  10. I guess if you would start investing for retirement when being young, imagine how much money you would manage to collect when you reach your retirement age….? Investing in retirement products is similar to taking investments. Your money would definitively grow as it stays governed by the retirement firm. Besides, there are many pension funds that provide retirement investments. Of course, such funds usually require higher premiums or fixed payments from members, but they are historically more trustworthy.

  11. Hi all

    Paying down the mortgage vs. “paying yourself first” towards retirement…

    This is a dilemma that all Canadians face.

    In my opinion, because of following conventional Canadian “financial advice”,
    all to many Canadians may be forced to fund their retirement with their home equity –
    assuming the real estate market holds…

    To combat this scenario, I’ve written a new report entitled,
    “The 10 Top Myths Of Canadian Home Ownership – Exposed”
    and was wondering if I missed anything…

    You can pick up your free copy at: HowToGetRidOfYourMortgage.com

    I would welcome your thoughts and comments.


  12. I’m sure am thinking differently about my retirement – I’m thinking I will most likely will die before I retire. :(
    I used up my retirement accounts when I was laid off in 08′. I’ve been able to replenish a small amount since I got a new job in 09′, but it is nowhere near the savings I had before. All my new retirement savings are in Credit Union CDs, not the stock market, just can’t afford to lose any, but the return rate is dismal. We don’t live high on the hog – our house has $100K in equity which we haven’t touched – no car loans – put money weekly into our savings as much as possible, but with prices ever on the increase, it gets harder and harder.
    Plus I have 2 teenage boys at home: one who will be starting college this fall and the other just going into HS. They already know that they will have to help pay off college loans, we can’t do it ourselves. We are having our oldest apply locally to save on room & board and maximize his “free” $: scholarships & grants. Luckily he has good grades, great SAT scores, & is involved in many activities (not sports, kills me how many scholarships are for sports and yet academics get little, really rotten priorities). He was offered a Merit Scholarship for one college that will knock off $21K/year, but even with that, it will still cost $15k/yr to send him. He might just end up going to CC for 2 years to save on costs & then transfer to finish.
    SSI will most likely not be around when I get to that age because we can’t seem to get our Representatives to do simple fixes like increase the income cap and means test. Instead, they complain about “Entitlements” while frittering away lost opportunities and ensuring SSI’s demise.

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