Salary Curve

study hard, get a good job, save money in bank fixed deposits, and live happily ever after” – traditional middle class mantra.

Most people choose employment as the means for earning a living. The words, “steady job” conveys a sense of security to friends and family. The initial years of experience in a job do add value so that rise in pay in the first few years is pretty good. However, salaries are ultimately dictated by the law of supply and demand. Unless the person develops a skill that is highly in demand, the law works in favor of the employer. The older employee cannot bring higher value to the table, and so the salaries flatten out after about age 40 [‘pay goes nowhere after 40’]. A plot of a annual salary versus age in a particular year will look like Figure 1. Notice there is an initial high premium commanded for the initial years of experience.

Note: I believe this curve will hold true even where job skills change frequently, such as in information technology, because such variable job skills are a small part of the overall experience for which employers are willing to pay a premium. But like heart attacks, perhaps salary flattening might show up at earlier ages than before.

 

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Figure 1: Annual salaries versus employee experience

For an employee starting out in a career, this fact of life is useful to know. Penelope Trunk has sound advice  on how to delay the post-40 flattening. However, Figure 1 is based on data of a large number of employees at a particular point in time. Can one draw a similar curve for a particular person’s 40 year work span? Yes, but one additional factor needs to be taken into account for such long duration: the effect of inflation that changes the value of currency from year to year. For a more meaningful analysis, all salary amounts should be in terms of currency value of a reference year (i.e. discounted for inflation). For example, if salary increases the next year by 10% but rate of inflation was 6%, then real salary increase is only 4%. This leads us to Figure 2. The curve drops to zero at retirement.

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Figure 2: Real salary history for a particular employee

I view this curve as half the financial story of the middle class life. The other half involves looking at annual expenditures for the employee and his or her dependents. A prudent family makes sure the expenditure curve stays below the take-home pay. See Figure 3 below.

Although salary drops to zero at retirement, notice that the expenditure curve continues much longer. The point to note is this: The area between income and expenditure in earlier years = savings (marked in green), is the buffer that has to be preserved and grown in order to meet the expenses for employee and dependents for the remaining years (shown in red).

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Figure 3: Income, Expenditure, and Savings

Would it suffice, then, to make sure that the savings (area in green) is larger than the later year expenses (area in red)? Unfortunately, the situation is more complicated than that. Over such a long duration, inflation plays a major role. If savings are not protected against inflation, they will lose most of their original value by the time they are needed.

Bottom line: the traditional middle class mantra, “study hard, get a good job, save money in fixed deposits, and live happily ever after”, stopped working — several years … nay, several decades ago.

[PS: Thanks Ketaki T, Sumit K for your feedback]

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2 thoughts on “Salary Curve

  1. […] of the important issues discussed in a previous post, Salary Curve, is how to make savings last beyond retirement. This is obviously tied to how much the income […]

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