Most fail to stick with a traditional zero-based budget where you track every dollar.
Forced savings is an alternate method to control spending. It’s a 90% solution to budgeting that can help you meet your future financial goals.
Learn about the benefits of forced savings, the psychology behind forced savings and two ways to implement forced savings.
Table of Contents
What is Forced Savings?
Forced savings, also called paying yourself first, is when you transfer money to a savings or investing account as soon as you are paid. You then proceed to spend everything that’s left.
Transfers from your paycheck can be done in a few ways:
- Manually from your checking account on payday.
- Through pre-authorized contributions timed with your payday.
- Through your employer, where money is automatically deducted from each pay.
Forced Savings Example
Cady makes $4,000/month after tax. She receives two paychecks each month of $2,000 each.
To implement Forced Savings, Cady sets up automatic transfers of $500 to her investment account. The transfers are timed to take place on each payday.
This leaves Cady with $3,000/month to spend. Cady is pretty clever. She knows that expenses naturally creep up to match her income.
Therefore, Cady sees that forced savings will set an artificial income ceiling of $3,000. She doesn’t budget this $3,000 and simply lets lifestyle creep do its thing.
What to fund with forced savings?
Forced savings “forces” a gap between your income and expenses. Then you can use this gap to progress along the personal finance journey.
Inspired by Dave Ramsey’s baby steps, the personal finance journey is displayed below. As you move through the journey, you reduce stress and enhance freedom.
Money skimmed off your pay (forced savings) can be allocated in the following order:
- Pay down debt using the debt snowball method.
- Build an emergency fund worth 3-6 months of essential expenses
- Fund short-term savings goals with a sinking fund of your choice; or
- Fund an investing (brokerage) account.
Notice that all of these tasks fund your future self. You are paying yourself first.
Debt paydown reduces future interest payments. An emergency fund prepares your future self to absorb shocks associated with life. Saving and investing for future goals is self-explanatory.
Are You Already Using Forced Savings?
I bet you are already using forced savings in some form. Here are two common examples:
Pension contributions. Pension payments are automatically deducted from your pay for pension plans. Such deductions are a form of forced savings.
Mortgage payments. A portion of a mortgage payment goes toward your home’s principal – increasing home equity and net worth.
For many, their home is the only form of wealth because of the forced savings imposed by the mortgage.
I believe this is why many (falsely) believe a home is the “best investment.” Learn more by reading about the rent vs buy assessment.
The Psychology Of Forced Savings: Why It's Effective
You may wonder, “why is forced savings effective?” Forces savings is effective due to three psychological attributes.
First, forced savings puts the mental accounting bias to work in your favour. Second, forced savings is a smart way to control lifestyle creep. Finally, hedonic adaptation can help you reduce spending without impacting your wellbeing.
1. The Mental Accounting Bias
The mental accounting bias is the tendency to treat money with specific labels differently.
For example, you likely label money in an investing account as “for the future.” It feels wrong to use this money to fund present-day consumption.
On the contrary, winnings at a casino feel like “free money.” People are far more likely to blow this money relative to money labelled as “hard-earned.”
The mental accounting bias makes it harder to remove money from savings and investing accounts.
By using forced savings to fund savings and investing accounts first, you put the mental accounting bias to work in your favour.
2. Lifestyle Creep
Lifestyle creep is the reason why so many high-earners are not wealthy. Over 51% of American consumers earning over $100k lived paycheck to paycheck in December 2022 (source).
To grow wealth, you must control spending to produce a gap between income and expenses to invest in assets that undergo compound growth.
By paying yourself first, you leave behind a lower artificial income ceiling. You can then let expenses creep up to your reduced income ceiling.
There is no need for a detailed budget; you can live paycheck-paycheck with your reduced take-home pay.
For example, consider George, who earns $100,000 per year. He uses forced savings to contribute $18,000/ year to savings and investing accounts.
He is then left with $80,000 per year. George lets lifestyle creep take over, spending the remaining $80,000/year.
With forced savings, lifestyle creep is not all that bad. Your future is already funded.
3. Hedonic Adaptation
You may say, “won’t my expense reduction from forced savings reduce my well-being”?
Forced saving is not expected to impact your long-term well-being, provided you can fund the essentials like shelter, food, transport and clothing.
If you upgrade your car, you’ll feel a temporary spike in happiness. But it will quickly fade, and you’ll revert to your baseline level of happiness.
Similarly, downsizing from a BMW to a honda will make you miserable in the short run (thanks to loss aversion). But you quickly revert to your baseline level of happiness.
Humans quickly adapt to their circumstances and revert to a baseline level of happiness. This effect is called hedonic adaptation.
Because of hedonic adaptation, your long-term well-being is unlikely to take a hit from the lower spending levels “forced” by forced savings.
Learn more about hedonic adaptation and well-being in Money, Happiness, and Wellbeing: The Ultimate Guide.
Top Two Ways To Implement Forced Savings
It’s excellent to understand forced savings. But your knowledge has little value unless you execute.
Like everything, success comes when you take action and make things happen. I’ll cover two ways to implement forced savings.
Both methods require upfront efforts to set up. But after initial setup, the systems run on autopilot, mitigating demands on your finite supply of self-discipline.
1. Pre-Authorized Contributions
Pre-authorized contributions (PAC) allow you to set up automated transfers from a checking account at set intervals on your payday.
Let’s cover how PACs can be used to fund short-term savings and long-term investments.
Pre-Authorized Contributions To Sinking Funds
Let’s look at Fred, who has set up a high-interest savings account to buy a $12,000 car in two years. A specific account for an upcoming expense is called a “sinking fund.”
Using my free Google Sheets cashflow tracker, Fred sees he must sink $488 into his “new car sinking fund” each month.
Since Fred is paid on the 15th and 30th of each month, he sets up a PAC for $244 on the 15th and 30th.
After the initial setup, Fred doesn’t allocate more effort to his savings goal. He has the $12,000 to buy the new car in cash. Fred does not need to take on debt.
Pre-Authorized Contributions To Your Brokerage
To meet investment goals with forced savings, you can also automate transfers into an investment account of your choice at your brokerage.
Perhaps your account of choice is a TFSA (Roth IRA), RRSP (401K) or RESP (529). Learn which account to prioritize in this post.
To figure out how much to transfer, see how to size an investment portfolio for retirement.
The hands-off approach of forced savings at regular intervals can promote consistent investing, while conserving your time.
Benefits of Automated Investing
Here are three reasons why I love consistent investing via forced savings and automated investing:
- You naturally hit the market highs and lows. This reduces market timing efforts and smooths your returns.
- Human behavioural biases are reduced. The rigid system of investing removes emotional attachment to your portfolio.
- You invest as soon as money becomes available, maximizing market time. In turn, you maximize the power of compound growth.
2. Pension Plan Contributions
Pension contributions are another way to implement forced savings.
For example, at the time of writing, my defined benefit pension skims off 10.3% of my pay. The money removed goes into a pension fund that invests mainly in stocks and bonds.
You may have a defined contribution pension plan, where you can control your monthly contributions to a retirement account like an RRSP or a 401K (US).
In this case, you likely receive some form of an employer match. Free money!
An easy-to-implement method of forced savings is to increase automatic pay deductions made by your employer. Like PACs, this one-time effort can be left on autopilot to fund your future.
Timing Pension Contribution Increases With Pay Raises
Due to loss aversion, it’s painful to reduce your take-home pay. Therefore, increasing your pension contributions drastically often fails.
To mitigate this pain, you can time your increases with pay raises. With good timing, you will never see a pay cut. Your wellbeing will also remain relatively unchanged due to hedonic adaptation.
Credit Cards Can Derail Forced Savings
Excess credit card spending can undermine your forced savings efforts. If you overspend on your credit card before payday, you may have nothing to devote to pre-authorized contributions.
To mitigate overspending on the credit card, you can limit monthly spending at the beginning of each pay period. The key is to ensure the money is there before you spend it.
I see two ways to use a credit card to ensure money is available before you spend it:
- Create a negative credit card balance every payday. Then you use the card until your balance comes back to zero. You repeat and never pay credit card interest.
- Open a checking or savings account to cover credit card expenses up until the. When payday comes, you pay off the card and refresh the bucket.
Credit cards aren’t for everyone, as they require self-discipline.
If you struggle with credit card use, it may be worthwhile to consider placing the card in a shredder. After that, you could buy everything with a debit card.
The Downside of Forced Savings
Forced savings is a 90% solution. It offers sufficient control over your money and prioritizes your short-term savings and investing goals.
But what if you want to optimize for the 100% solution?
That requires that you track spending for multiple categories. From here, you can find areas where you spend too much. Finally, you can optimize these areas with habit changes or single decisions (like the type of car your drive).
Even if you are happy with the 90% solution offered by forced savings, conducting an expense review at least twice per year is good practice. The expense review will help you find categories where you spend more than you’d like.
Conclusion
Forced savings is a simple way to spend less than you earn to fund your future.
Between pre-authorized contributions and pension deductions, you can fund your future to reduce stress and enhance freedom.
Finally, automated forced savings and investing do not place large demands on your time and self-discipline. Simplicity enables consistency.
Jake out.