Save more efficiently and spend less

In previous a article, I discussed tax-efficient investing and the merits of Mr. Money’s preference for maximizing private or employer-sponsored pension plan contributions. Several people have asked that I write about the merits of contributing to an employer-sponsored pension plan. First, let us keep in mind that pensions, regardless of which organization sponsors them, are not benefits but rather deferred income plans.

In previous a article, I discussed tax-efficient investing and the merits of Mr. Money’s preference for maximizing private or employer-sponsored pension plan contributions. Several people have asked that I write about the merits of contributing to an employer-sponsored pension plan.

First, let us keep in mind that pensions, regardless of which organization sponsors them, are not benefits but rather deferred income plans. Employers treat expenses as being in different envelopes, wages and benefits being the single highest and more important expenditure that they have to manage. When you contribute to a pension plan, you are giving up income today in favour of income in the future — your retirement — and your employer is providing you with a great opportunity to build a retirement nest egg.

This might seem obvious, but this differentiation between calling a pension a benefit and its true function as a deferred income vehicle is important, especially when many of us have trouble sticking to a financial plan that involves saving for a long-term goal.

The inability to stick to a financial plan is referred to by psychologists as “hyperbolic discounting.”

That’s a fancy way of saying that when faced with two choices, a reward received today and a reward received in the future, we as humans tend to be more oriented towards the immediate reward, and thus not motivated to save for a long-term goal, such as retirement.

Employer-sponsored pensions can be a great way to avoid spending today in favour of saving for the future. By having your employer automatically deduct money from your paycheque you reduce the magnitude of the financial impact that immediate gratification can have on meeting your financial goal(s).

There are two types of pension plans: contributory and non-contributory. Non-contributory plans essentially allow employees to become members of a pension plan without sacrificing current spending patterns. In many ways, non-contributory plans allow you to eat your cake and have it too.

In other words, you can continue to be one of those hyperbolic discounters and use someone else’s money (your employers) to save for the future.

However, as Mr. Money points out, eating your cake today means giving up an important benefit of contributory pension plans, compared to non-contributory plans — the matched contribution.

For example, if you contributed 4four per cent of your pay to a contributory plan, your employer could potentially match this contribution to a maximum of four per cent. So a $40 employee contribution on $1,000 in pay would be matched by an additional $40 employer contribution.

For sure, contributory plans do force you to give up at least some of your cake today, but in many ways they turn hyperbolic discounting on its head.

From Mr. Money’s point of view, buying something today that costs $40, whatever it is, will no doubt give you some level of satisfaction, but at what cost? Forty dollars? Or is it perhaps costing you $80 — forty-dollars for the item you are considering buying and the opportunity cost of earning an additional $40.

Understanding the true costs of savings avoidance is perhaps the best protection against not achieving your financial goals. Maximizing matched contributions in a contributory pension is a sure method of efficiently saving for the future. It allows you to maximize your long-term savings, and potentially have a much larger piece of the economic pie in the future.

Remember, you are in control of your financial destiny.

Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.

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