You’ve heard of the latte factor, right? It’s the idea that trivial purchases add up over a lifetime to a massive wodge of could-have-been.

David Bach’s The Automatic Millionaire coined the term 15 years ago. Never one to miss the chance to make himself a million, he even published a book last year centered on The Latte Factor.

Bach is very readable if you enjoy that can-do American style, so it might be worth reading if you’re new to not flushing your money down the toilet.

Seriously: US financial guru Suze Orman made headlines last year when she said drinking a regular coffee was like “peeing $1 million down the drain”.

As Orman sees it:

Let’s say you spend around $100 on coffee each month.

If you were to put that $100 into [tax-sheltered account] instead, after 40 years the money would have grown to around $1 million with a 12% rate of return.

Even with a 7% rate of return, you’d still have around $250,000.

Orman told CNBC:

“You need to think about it as: You are peeing $1 million down the drain as you are drinking that coffee. Do you really want to do that? No.”

Too graphic? It could be worse.

A few years ago the latte factor was recast for millennials as the avocado toast factor.

We really don’t want The Accumulator drawing one of his blackboard illustrations of that…

The latte factor: Semi-skimmed

I’m not against the latte factor as a concept. It’s a useful check against careless spending, and I’ve shared it with friends in the past.

The latte factor also puts a more respectable veneer on what my friends see as me simply being a tightwad!

However it’s always been easy to unpick the latte factor, even on its own terms.

Bach stated someone in her early 20s could save $2,000 a year by skipping a $5 daily coffee. This lucky and decaffeinated lady would then earn 10-11% a year to reach $1 million by retirement in her 60s.

Sounds good. But problems abound:

• Even 15 years on from The Automatic Millionaire, lattes still don’t cost $5. (Nor £5, in the UK. Try £3.) A latte from Starbucks in the US is $3. So that’s more like $1,095 a year saved.

• Bach’s 10-11% a year is a very punchy expected return. My co-blogger has long touted a 5% after-inflation ¹ expected return for equities. Maybe with inflation, a generous 8%. Does Bach think that foregoing a daily coffee will also turn you into a super-investor?

• Most people won’t want to have all their money in the highest risk-return asset (shares). They’ll want to sleep better at night. This is especially true as they get older. Holding bonds and/or cash to dampen portfolio volatility will bring your return down. Let’s call it a still-heady 5% with inflation, to stay consistent with Bach’s numbers.

• Compound $1,095 at 5% for 40 years and you get just $139,000. (Same in £s, of course).

$139,000 is a useful sum, sure, but you’re not even nominally ² a millionaire after giving up all those lattes.

Extra cream on top

I don’t want to bash Bach too badly. (Although it’s alliteratively appealing…)

The latte factor is meant to be a high-level concept and teaching tool, not a financial calculator. (Ahem – although Bach did create one of those, too. But his latte factor calculator enables you to tweak the variables to something more realistic).

The latte factor is one of those things that’s blindingly obvious when you get good with money – step forward all the regulars in the Monevator comments – but it can be mind-blowing if you’re not.

Try it out on a young friend or family member if you don’t believe me.

I’ve known people who will never spend £10 when they can spend £20. Showing them how small sums add up always produces a reaction – although sadly not so often a lifestyle revolution.

In fact, the world could probably be divided into those that understand the latte factor deep in their bones, and those that don’t.

I’ve been on dates where the other party over-orders wildly (and we were always going Dutch, so let’s have none of that) and I’ve died a little inside.

Years later I realized (or more likely was told) that they saw the careless abundance as a demonstration of how into making the date a great time they were.

Whereas what I saw was an unfinished bottle of wine and half a pudding – not just on the table, but also on the bill – which I then compounded over a long and never-to-be lifetime together.

My million pound coffee

With all that said, last Saturday I had a very visceral reaction to the latte factor.

Or maybe a moment of detente with the anti-latte factor.

I was meeting one of my best friends, for the first time since lockdown began. He was the first friend I’d seen away from my own home since mid-March.

We decided to get a takeaway coffee from the recently re-opened Gail’s Bakery ³ near his flat.

I was early, so I queued for our coffees, six-feet from the nearest customer. The normally rammed shop contained just two staff and me. When our coffees were ready, they were brought outside and placed like two unstable hand grenades on a little table by a woman wearing a mask and blue gloves who immediately stepped back – smiling with her eyes, but very properly treating me like I was a leper.

The third place of a 1990s ad man’s dreams this was not. I’ve been to more welcoming GUM clinics.

But you know what? That coffee was magnificent. The whole shebang: Walking and sipping it from its environmentally dubious cup. Consuming the 10p of product and the £2.90 of taste, marketing, and nostalgia. Chatting – even at volume, at a distance – with my friend.

I knew I’d missed decent coffees on the go and obviously I’ve missed conversation. When lockdown began I noted how the streets seemed weird because nobody was walking with coffees.

Almost as if it was the 1980s. As if Friends had never happened!

Something bigger than a £2.95 coffee had vanished from my life.

Of course, I love coffee – and maybe you hate the stuff, or at least the mass-market escapism ritual that coffee has become.

But I bet you have your own ‘frivolous factor’, too.

Spontaneous sessions in the pub? Gym membership? Seeing films at the cinema alone on a weeknight? A serious National Trust and cream tea habit? City breaks via short-haul flights?

Did you only notice how much they mattered to you when they were gone?

Fool’s gold

It was always obvious you can take frugality and compound interest to extremes.

I once called it Buffett’s Folly, in honour of Warren Buffett’s house of the same name.

Even as he bought his property in 1957, Buffett calculated the $31,500 home cost him at least a million dollars.

That was on the back of what Buffy believed he would have generated with the money if he’d invested it in stocks instead, given his prodigious rates of return.

But Buffett still lives in exactly the same house, 63 years later. If the shingle still reads Buffett’s Folly, it’s with an ironic twist today.

By all means let’s save our pennies where we can (and avoid spending pennies, Orman-style, into the bargain. Boom boom!)

But we’ve just had a taste of what it’s like to be a monk in seclusion for the past eight weeks.

I rather enjoyed lockdown, truth be told.

But I wouldn’t trade it for meeting a friend for a decent coffee, on a whim, for the rest of my life.

Not for a million pounds. Not even for £139,000.

(Besides, coffee is really good for you!)

1. i.e. A ‘real’ return.[↩]
2. i.e. ignoring inflation[↩]
3. A mostly London-located upmarket bakery chain.[↩]

Many Monevator readers will be reaping generous tax breaks on their pension contributions made available through salary sacrifice schemes.

But what’s less widely understood is that salary sacrifice can work against you if it lowers your salary below critical thresholds, or if your employer hasn’t been transparent about what your salary officially is.

Badly administered schemes operate in a grey area that leaves employees in the dark about potential downsides – such as the risk of reduced redundancy pay, sick pay, and other benefits – whether by accident or unscrupulous design. (Delete as applicable, although we can do without either in the midst of a worldwide recession).

What is salary sacrifice?

Salary sacrifice schemes are a contractual agreement between you and your employer to give up part of your salary in exchange for a non-cash benefit such as pension contributions, childcare support, bicycles, and ultra-low emission cars.

The upside is you do not pay tax or National Insurance Contributions (NICs) on your foregone salary.

Your employer doesn’t pay National Insurance on your sacrificed salary either. They can pass on their savings on to you, or they can sneakily trouser it for extra profit.

HMRC doesn’t seem to mind a bit so long as certain boundaries are observed.

What is the downside of salary sacrifice?

The downside of salary sacrifice is that it lowers your salary – and you’ve signed a contract saying that you agree to it!

Reducing your salary can reduce your entitlement to a slew of benefits that are related to your earnings level, including:

• Redundancy pay
• Notice pay
• Pay rises
• Overtime and bonuses
• Holiday pay
• Sick pay
• Employer pension contribution levels
• Life cover
• Maternity / paternity pay
• State Pension
• Unemployment benefits
• Incapacity benefit
• Mortgage borrowing levels
• Credit card borrowing levels

All of the above depend on your earnings level to some degree – or to your earnings clearing certain thresholds.

Your employer is under no obligation to measure those benefits against your pre-sacrifice salary (unless they’ve contractually agreed that with you).

In some cases it’s entirely out of their hands anyway. You shouldn’t be on a salary sacrifice scheme if it drops you below the National Minimum Wage (unless you’re exempt). It may also not work out for you if you’re subject to the tapered annual allowance. Hint: HMRC are alive to this caper and sacrificed salary is just added back to calculate your threshold income. It’s like shooting at the Borg.

Salary sacrifice: how it could cost you

Everything is okay if your employer clearly explained the issues to you before you signed your new contract sacrificing salary.

(Yes… of course they did.)

Alternatively, everything is groovy if your employer is completely trustworthy and not prone to doing over its own employees when cashflow is tight.

(Is it just me, or is it suddenly a bit hot in here?)

Things are still on a relatively even keel if your employer explained that you would retain a notional salary or shadow salary. In this case your pre-sacrifice salary counts when your employer calculates your right to contractual benefits that it controls, namely:

• Redundancy pay
• Notice pay and holiday pay
• Pay rises
• Overtime and bonuses
• Contractual sick pay
• Employer pension contribution levels
• Life cover
• Contractual maternity / paternity pay

If you don’t have a notional salary agreement then employers are perfectly within their rights to use your lower post-sacrifice pay to calculate these amounts – although they should have mentioned it before signing you up to salary sacrifice. I say they’re within their rights – obviously you work for ScuzzBucket plc if your employer does this kind of thing… can I interest you in a prospectus?

State benefits are calculated using your post-sacrifice salary and that’s the end of it. These include:

• Statutory sick pay
• Statutory maternity / paternity pay / adoption pay
• State Pension entitlements
• Incapacity benefit
• Parental bereavement pay
• Jobseeker’s Allowance and Employment and Support Allowance

You can ensure you don’t come a-cropper with some of these benefits (such as State Pension) by ensuring your salary doesn’t drop below the lowest threshold for National Insurance Contributions, or that you’ve built up a sufficient record of payments already or through credits.

A particularly generous employer can make a non-statutory ‘top-up’ payment to employees, if they’d like to make good any shortfall in statutory pay entitlement.

(Good luck with that!)

Salary sacrifice: can I change my agreement?

You can change your salary sacrifice agreement, but your freedom of manoeuvre is limited.

Your contract should specify your cash earnings and your non-cash benefits. Non-cash benefits are benefits that your employer pays for.

Your contract needs to change whenever your salary sacrifice agreement changes, and if you switch between cash and non-cash benefits too frequently then you lose your tax advantages.

The Government has outlined certain ‘lifestyle changes’ which justify a swift opt-out of your salary sacrifice agreement.

Example events include:

• Changes to circumstances directly arising as a result of coronavirus (Covid-19)
• Marriage
• Divorce
• Partner becoming redundant or pregnant

It’s also worth noting that your employer can’t force you into a salary sacrifice scheme, just in case you were wondering.

Salary sacrifice: does it reduce my pension annual allowance?

Salary sacrifice should not have any negative impact on your annual allowance although, as always with tax, seek more qualified advice if you’re worried about this.

The problem goes something like this:

• Your pre-sacrifice salary: £40,000
• You salary sacrifice: £25,000
• Your post-sacrifice salary: £15,000

Does that post-sacrifice salary limit your annual allowance to £15,000 (less than you’re contributing!) because your tax relief is limited to 100% of your relevant UK earnings per tax year?

(I’m excluding those who’ve triggered the money purchase annual allowance (MPAA) or the tapered annual allowance.)

Your £40,000 pension annual allowance for defined contribution pensions consists of:

• Your personal contributions
• Your employer’s contributions
• Third-party contributions – anyone else who kindly chips in for you

If the combined total of those contributions goes over your annual allowance and your carry forward, then you’re in for a tax charge.

You get tax relief on your personal contributions up to 100% of your relevant UK earnings or your annual allowance, whichever is lower.

Your employer’s contributions are not subject to your relevant UK earnings limit, only your £40,000 annual allowance limit.

Old Mutual puts it succinctly:

Personal contributions can be limited by relevant UK earnings but employer contributions are not.

Meanwhile, salary sacrifice converts your salary into an employer pension contribution as explained by Pru Advisor:

An employee could also save income tax, and National Insurance Contributions (NIC), by using a salary sacrifice agreement.

This is where they have a contract with their employer to exchange some of their gross salary (before tax) for a non-cash benefit, such as an employer pension contribution.

So it’s okay if salary sacrifice reduces your salary below the level of your total pension contributions – because your sacrifice is classified as employer contributions, and those do not attract tax relief.

However, personal contributions above your post-sacrifice salary will not gain tax relief either.

All of this is apparently confirmed by the Government’s own pension annual allowance calculator which does not ask how much you earned during the tax year. It’s only interested if you exceeded the £40,000 limit or if you tripped the MPAA or tapered annual allowance.

Salary sacrifice in a crisis

I’ve been happily maxing out my salary sacrifice for years in order to hit financial independence. I didn’t know about the downsides, nor was I made aware of them when I signed up.

That makes me deeply uncomfortable about what will happen should I catch a bullet. Maybe it’ll be alright, maybe not.

I don’t like grey areas and – given we face a recession of biblical proportions – I’ve cut my salary sacrifice to the bone.

Take it steady,

The Accumulator

What caught my eye this week.

After compiling this list of the best money and investing reads for over a decade now, it’s rare I come across anything super new.

But I loved this fresh idea from Pete The Planner on how to borrow money from your own emergency fund.

Hold up – borrow your own money?

That’s right. Sort of.

Pete explains it’s down to one of those endearing tics of being human. Many people would rather borrow from a lender – and pay interest – because they prefer to see a repayment schedule in place, rather than raid their own emergency fund that they’d diligently saved for a rainy day.

Even when it starts to rain!

One reason is they don’t trust themselves. But research provides a possible solution, says Pete:

In a lab experiment, researchers found that when subjects were given the option of taking money from savings and entering into a “pay-back” agreement, they were more willing to use their savings rather than borrow money.

So simple. See Pete’s blog for a quick example with numbers.

As somebody who got a mortgage because I couldn’t bear to spend the money I’d socked away in ISAs for this very purpose (okay, and to lose the tax wrapping) I can relate.

Anyone else found any leaks in their mental accounting buckets?

Let us know in the comments below.

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