In a recent post, I argued that there is a flaw in the most common approach saving for a big goal like college education.
I argue that in some cases, saving for a goal should be done the way you would if you were to begin training for a road race. If you begin to exercise today and have a goal of running in a marathon twelve months from now, you won’t just start running 26.2 miles per day. You’ll burn out or get injured.
Instead, you are more likely to come up with a plan where you gradually and systematically increase the difficulty of your exercise regimen over time. By gradually increasing the workout, you mentally condition yourself and can prepare for longer, harder, and more difficult exercise routines in preparation for the race.
While we mostly think about saving a set dollar amount per month, that may not be realistic or possible for many people who have limited cash flow. Saving for a goal could be done the same way by using a saving strategy referred to as the serial payment. Here is what makes this strategy different – the amount saved increases by a set percentage each and every year. For example someone who saves $150 a month for one year, would increase it by a set percentage (we’ll say 4%) each and every year. In year 2, they would be saving $156/mo ($150 * 1.04). In year 3, they would be saving $162 ($156 * 1.04).
Let’s compare these two strategies. Assume that John and Andrew each want to save $90,000 for college education in 18 years. They plan to save a portion of their paycheck and will invest it in the market where they are expecting an 8% rate of return. John plans to invest $2400 at the end of every year and will do so for 18 years. Andrew will fund $1,825 at the end of the year but will increase the amount by 4% per year thereafter.
The result: they both reach their goal of $90,000 by the end of the 18th year. Below is the breakdown of how much each of them has to save each year:
Andrew is able to begin saving a lot less early on but will have to make up for it from the 9th year and on. By then he will likely be in the peak earning years of his career and will have more cash available to fund the goal.
This strategy does have some drawbacks. Making less contributions in the early years reduces the effectiveness of compounding interest which means that Andrew would have to save an extra $3500 more than John over the 18 years. And that figure would be much larger if we adjusted for inflation.
If you are exploring ways to save for a goal, run the numbers assuming a flat/fixed amount first. Saving more earlier is almost always preferable thanks to compounding interest. But it may not be possible. If you can’t afford that, try using a serial payment strategy.