People always talk about investment return like it’s the only thing that matters when it comes to saving for retirement. And of course, it’s a pretty big element as it’s one of the defining factors when it comes to your ability to retire early. After all, for most of us, the ones that don’t make hundreds of thousands of dollars a year and can live on 50k, a return of 1%/year from a savings account just won’t cut. However, there’s another factor that merits more consideration than it typically does and that is your own personal savings rate.
Simply defined, savings rate is just what it seems to be – the amount of money you save each month as a percentage of income. The easiest way to calculate it is to compare your savings rate against your take home pay or in simpler terms to use the formula below.
Savings Rate = Savings*/(Savings + Expenses)
This formula works because it’s simple to calculate and covers everything as savings + expenses are essentially your take home pay. The expenses side of things will include everything that comes out of your paycheck including medical/dental/vision plan costs and any life expenses like rent, food, etc.. The savings side of things is anything left over from your monthly paychecks that hasn’t gone to bills or other items but is instead put into savings via 401k/HSA contributions, Roth IRA contributions, savings accounts, taxable accounts, bonds, etc.
*Employer matches are a bit more tricky as they’re technically savings in the numerator but not savings in the denominator since they’re not an out of pocket expense on your part. It’s really a personal decision as to whether or not you want to include them within your savings rate. Including them will make your savings rate look better. Excluding them is a more conservative approach as a 401k/HSA matches may not be guaranteed forever and/or may change if you change jobs so including them in your savings rate adds a bit of risk within the calculation we’ll talk about soon.
We’re excluding taxes on purposes because they are not a cost you can avoid either now or in retirement and while you can somewhat control them by adjusting your spend and tax-advantaged account contributions, for the purposes of this discussion, we’ll assume they’ll remain relatively static for now to simplify things.
As an example, let’s look at the below data and how we can use the formula above to calculate our savings rate without spending a huge amount of time tracking our spending.
What I’ve outlined above is a simple estimated example of a paycheck and savings plan for a random person making around 60k/yr. Savings are italicized and expenses are bold. Savings(italics) make up the numerator in the calculation above and Savings+Expenses(italic+bold) make up the denominator. As I’ve mentioned above, you can either include or exclude employer paid benefit(matches) within your numerator depending on how conservative you’d like to be in your projections.
Now that we know how to calculate this – why does this matter? Why should any investor care about this and go through the trouble of tracking it?
There are a variety of reasons for keeping track of your savings rate.
It’s the only thing in investing you can effectively control. Want to up your savings rate? Reduce your spending and save more!
It’s easy to figure out without even tracking your spending. For most people you can simply figure our what you save and assume the rest is going out the door as expenses.
In most cases, it has an even bigger impact on your ability to retire early than anything else you can do as an investor
It allows you to get a grasp on your spending habits and get an idea of what your comfort level is when it comes to expenses which will be extremely important in early retirement
Let’s take a look at some of these using a handy little online calculator.
The important thing to consider when it comes to savings rate is the relationship between how much you’re saving and how much you’re spending. Intuitively, you can deduce that the less you spend and the more you save, the earlier you can retire.
On the extreme range of things. If you spend 100% of your income and save nothing then technically your retirement will never happen because you will continue to have to work and get income to cover your expenses. If your expenses are 0% or near 0% somehow then your working career is either a hobby or will be very short.
For most of us – these numbers are merely theoretically and we all fall somewhere in the middle so what does that mean for us and how much benefit does a person get from a higher savings rate?
To get an answer to that question – we can utilize a handy little calculator like the one seen below. Let’s take a look at a variety of scenarios using a person making 60k/yr post tax with a 45% savings rate(inclusive of employer matches). That’s slightly higher than the personLet’s start with a 5% ROI and a 4% withdrawal rate. The lower ROI rate is used to account for inflation.
Not bad – if this guy saves 45% of his income(lower actual savings rate before matches if those are not available) – he’ll be able to retire after 19 years assuming his expenses stay the same. Not bad right?
Now there’s a lot of assumptions here as there are with any retirement calculator but the point of this is not to give you an extremely accurate retirement calculation, it’s to show the power of savings rate – the one item in your investment arsenal you can control completely.
Let’s take a look at the same calculations but with varied savings rates.
First of all – let’s throw out the calculations that show a 80%+ savings rate as they’re hard to do on this type of income but they’re there in case you happen to make 200k and can live on 20k forever. You can retire in 2.7 years! Naturally, you’d want a bit of a safety buffer but the option is there for you in that situation.
Second of all – let’s be realistic about savings rate and the ability to achieve certain savings rates on a certain income. 60k in post tax income is a pretty solid salary. We’re talking 80-85k+ in gross income to net 60k and it might be higher depending on health care costs and not everyone can achieve that so right off the bat. In addition to that, expenses are going to be different depending on where you’re living. Some people may be able to get by with an annual spend of 30k and live pretty comfortable with some fun money while for others 30k may not be enough to pay for the basics depending on cost of living in your area.
This table isn’t meant to show you what you should be living on or anything like that – it’s designed to show you exactly how fare an extra 3k per year can go in the long run and perhaps make you look again at what you’re spending.
If I told you that spending 3k less could shave off 2.4 working years for you – would you be willing to make those cuts? If I go out to dinner twice a month and spend $100 per dinner then I’m almost there just by cutting that off. Now the question comes down to individual values and goals. Am I OK with working 2.4 additional years just to have those dinners twice a month? Maybe the time spent with people I love enjoying great food and conversation is worth it or maybe I’d rather work less and save some money.
It really depends on the situation. Our 60k/yr earner has a 45% savings rate which ties back to yearly expenses of 33k/yr. Does that mean he’s scraping by and saving every last penny he can while not enjoying life or is he in a very low cost of living area and still living a solid life? The situation is never clear cut and will change with each individual
I don’t think most people realize exactly how much their spending affects their future ability to retire. Let’s go deeper and save another 6k instead of 3k, that saves me 4.6 working years. That’s quite a bit of time. Now all of this assumes that I’ll continue living on that expense level constantly in the future which is a bit of a stretch but it certainly shows the impact that additional savings/expense cuts can have on your future retirement age.
Most people spend too much and save too little. If I earn 60k/yr and save only 10% of my income and expect the same level of expenses in retirement, I’ll have to work 51.4 years to make that happen. I don’t know about you but I certainly don’t want to work 51.4 years. Now this doesn’t account for social security which will lessen that number for most people but it’s still a rather bleak picture for those who don’t enjoy their jobs.
Now imagine if that 60k/yr earner saved just another 5% on top of that 10%. Their 51.4 working years becomes 42.8, a reduction of almost 10 years! If you look at the table, it’s pretty clear that the first few % make the biggest difference when it comes to savings rate but it’s not until you reach savings rates in the 45%+ range that early retirement becomes an option.
Now there’s another way to reduce your years to retirement as shown by the table and that’s to simply increase your ROI. If our employee wants to retire earlier but doesn’t want to save the additional 3k/yr to reduce his working years by 2.4 he can simply increase his ROI to just above 7% and he’ll be there! Not a problem right? I mean it’s pretty simple to raise your ROI by 2.1% and maintain that for 10+ years! While there are certainly ways to achieve it via smart trading or changes in asset allocation, it’s certainly no guarantee, might increase risk and is probably harder to do than simply bumping up your savings rate by 5%. They both achieve the same result but one is entirely in your hands and that’s the one you should try to achieve if you can.
The other bonus of a high savings rate is that it gets you accustomed to a life that doesn’t revolve around spending more than you need to spend. This certainly isn’t a be all end all savings guide as things change and your spending patterns may differ in retirement and even year over year but it’s a concept that you can use to supercharge your savings.
The simple fact is that an investor can’t control his return all that well. We can hope for 5-7% after inflation but it could very well come back worse than that and push our retirement age back a few years.
What we can control is our savings rate and this illustrates that concept very well with a number any investor can understand. If I save an additional 5%, I can potential reduce my working years by 2.4 and that’s a big deal. For some people, a few thousand extra saved a year means an earlier retirement and that’s not a bad thing at all.
There are those who take it to the extreme and live on 20k/yr and retire within a decade even on a sub 100k salary and this how they’re able to do it. It’s all about savings rate for those people and cutting expenses as much as possible to reach their desired freedom as early as possible.
It’s not for everyone but I think that even those who aren’t as thrifty as those early retirees can benefit from saving another 5-10% if they can spare it and reduce their working age by quite a lot. Just a few cut backs that you may not even miss that much might be able to get you there.
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