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Once you’re done celebrating the good news, what’s the smartest thing to do with that extra amount in your monthly paycheck?

 

If you recently got a pay raise, congratulations! It’s always nice to be recognized for your efforts in the workplace—especially when that recognition comes in the form of cold hard cash.

 

Financial basics are not widely taught in school, so we often let intuition guide us at such auspicious moments. Unfortunately, that intuition can lead us in one of two directions: Either towards our financial advisor or straight to the mall. In short, the world is divided into two kinds of people: Pleasure delayers and those who go in for immediate gratification. 

 

The marshmallow test

Well-meaning financial planners are pretty tough on the immediate gratification camp. “If only you had more self-control you would be in better financial shape and on track for a comfortable retirement,” etc. I think these finger-wagging planners should be a bit less judgmental and a little more understanding about behavioral economics.

 

A famous psychological study, the Stanford marshmallow experiment, revealed that poor self-control is a fairly fixed trait that some people display from childhood and throughout their lives.* In the experiment, children were offered a choice between one marshmallow (provided immediately) or two marshmallows, if they could just wait 15 minutes for them. Those kids with the willpower to wait and delay gratification went on to lead more successful lives—and presumably knew how to deal with pay raises wisely.

 

Temptation bundling

The key is to understand your personality type and work with it. For the weaker-willed, that may mean “temptation bundling,” a recent concept in behavioral economics which involves tying together two activities—one purely pleasurable, such as getting a spa treatment, and one you should do (such as raising your contribution rate by 1%).

 

Two ways to reward your future self

  • A raise that is beyond inflation often leads to a corresponding lifestyle adjustment (“I deserve it!”) without an automatic adjustment to savings levels. Sure, you may be deferring a percentage of your salary rather than a flat dollar amount, and your contributions will rise in line with your salary, but there’s still more in your paycheck each month. Why not use that extra cash to reward your present self (spa treatment) AND reward your future self—by bumping up your 401(k) or 403(b) contribution rate or maxing out your IRA.

 

  • Also, look at your extra money as an opportunity to become debt-free sooner. Paying off credit card debt should be your first point of focus. Shop around for the lowest possible interest rate you can find and transfer your debt, unburdening yourself faster and for less. Even if debt repayment is a big issue for you, make sure you set enough aside to get the full employer match on your workplace retirement plan first, then focus on the debt reduction.

 

Simultaneously paying down debt and saving for retirement is a reality for a lot of people, but a pay raise makes this juggling act a little easier.

 

* Source:  Mischel, W., & Ayduk, O. (2004). Willpower in a cognitive-affective processing system: The dynamics of delay of gratification. In R. F. Baumeister & K. D. Vohs (Eds.), Handbook of Self-Regulation: Research, Theory, and Applications, New York, NY: Guildford Press

 

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