By now we’ve all heard about how compounding interest is the most powerful forces in the universe. It’s one of the most universally agreed on tenets among personal finance bloggers, right after spend less than you earn.
And although we sometimes take raises for granted, they can be a life changer in so many ways. Raises are the second most powerful force in the personal finance universe.
Changing the rules on raises
A friend of mine at church happened to mention how some pending pension reform legislation in the Illinois legislature would affect his retirement. You see, Illinois has a pretty serious pension liability issue on it’s hands. As far as I can tell, they owe way more than they could ever pay.
They’re looking to change the pension rule to decrease the amount they’ll have to pay out to retirees in the future. I’m not taking a stance on this political issue, but it was a useful topic to understand how raises, or lack thereof, would affect my recently retired friend’s future earnings.
So here’s how this might affect my friend. Right now, he’s got a sweet deal going. Because he worked for the state for 30 years, he now gets paid about $60K/yr (a pretty solid retirement plan if I do say so myself!). He’s also currently guaranteed a 3% raise each year, so in 10 years he’d be making $78K/yr and in 30 years he’d be pulling in an incredible $140K/yr! He didn’t get paid much as a civil servant, but man his retirement plan sure makes up for it.
But now the state congress is going to decrease those 3% raises to 1% raises (It’s a little more complicated than that, but that’s the gist)*. To his credit, he wasn’t too worried about it. He told me that he probably wouldn’t miss the $1,200/yr (2% of $60K).
When he told me about it, I did some mental math, and the figure I had in mind was much higher than $1,200. I thought’d he’d be missing out on much more than that. I figured I’d done the math wrong, and went on with the conversation.
When I got home I whipped out excel to see which one of us did our math wrong. The results, to my disappointment, supported my mental math and not his. Here’s how his pension would rise over 30 years (from age 60 to 90) if he got his 3% raises compared to just getting the new 1% raises. (We’re going to ignore inflation for now)
Income Over Time
Over 30 years, that’s $770K of income that my friend will miss out on because the State changed the rules of his pension. On one hand, I think that anyone who’s earning $60K/year to be retired has a sweet gig and should be thankful for what he’s got. But on the other hand, he toiled for the State for 30 years with the knowledge that this deal was there for him. He has a contract, and because the State has run out of money, they’ve decided not to honor that contract. It’s a sticky situation to be sure.
Raises are the second most powerful force in the universe
Not to kick my unlucky friend while he’s down, but I just had to go one step further and figure out how much money he’s missing out on if you include compounding interest – the unrivaled most powerful force in the universe.
I’ll assume that he spends $60K per year just for comparison’s sake, and he invests his excess money in an account that earns 7%. Then I’ll show you what his incremental net worth would be over the next 30 years in the two scenarios. I’ve got to say, it’s not pretty…
Net Worth Over Time
For those of your keeping track at home, because of the pension changes, my friend’s investment account at the end of his life will be $1.5M lower (when you add in compounding interest). Hot damn!
A few lessons about raises
I think there are a few lessons to take away from this story.
- Even contracts you’ve been working under for 30 years can be broken. It’s important to build multiple streams of income because nothing can really be guaranteed to you 100% except for, of course, death and taxes.
- Raises are an astounding force that can totally change your financial situation. I’ve been working hard on increasing the average size of my raises to accomplish my goal of financial independence a little sooner.
When I informed my friend that he’d done his math wrong, the blood drained from his head and his tone shifted noticeably. He was worried. Instead of missing out on just $1,200/year, I showed him that he’s really missing out on something closer to $30,000/year (if you average it all out).
But when we started talking about the bigger picture, and how he’ll still have plenty of money to do all the things he wants to do in his retirement, a little blood returned to his face and he chuckled. Sometimes you can only worry so much about events you can’t control. I think he’ll be just fine.
What average raise rate have you gotten? Have you ever heard of a state going back on a pension contract?
*It’s possible I’m wrong about how the cuts to the pension will work. I haven’t researched this pension system exhaustively.