The Quest for the Perfect Savings Rate
In the realm of personal finance, the quest for the perfect savings rate is akin to seeking the Holy Grail. The balance between current enjoyment and future security is a tightrope walk that demands careful consideration. The central challenge lies in determining the proportion of income that should be saved, after all, veering too far towards immediate gratification might jeopardise future security, while excessive savings can reduce present happiness.
As we embark on this journey, it's important to recognise that personal finance is, well, personal. However, there might be a sweet spot, a savings rate that strikes a balance, positioning for present happiness and future financial freedom.
What is a Savings Rate?
A personal savings rate (or savings ratio) is a measure of how much income is saved rather than spent. It is the ratio of savings divided by income over a given period and is typically written as a percentage.
The higher the savings rate, the stronger the personal financial situation; a savings rate of 0% means that all income is spent, on the other hand, a savings rate of 100% means that all income is saved.
In the post ‘Surviving the cost of living crisis with the 50/30/20 budget’ we discussed saving 20% of income, but this is not a ‘hard and fast’ rule. Some proponents of The FIRE Movement save 50% of their income to achieve financial independence within 16 years!
How Much Do You Need to Save to Become Financially Independent?
FIRE: Financial Independence Retire Early (Retire early is optional!). This is your end goal. To be able to live off the passive income from your investment portfolio without the need to work - or with the freedom to do whatever type of work you want without worrying about the salary it pays.
As a guide, The 4% Rule states that you can withdraw 4% from your investment portfolio as income in your first year of retirement and adjust that amount for inflation for every subsequent year without risking running out of money for at least 30 years in 90% of historical models.
So, you will need a portfolio of £500,000 if you want to retire with an income of £20,000 (4% of £500,000). Once your assets are 25x your required income (£20,000 x 25 = £500,000) then you are financially independent and able to retire at any time.
How Long Will It Take to Become Financially Independent?
Mathematically, your time to reach FIRE depends on only one factor: your savings rate, and your savings rate is determined by how much income you need to spend to live.
If your savings rate is 0%, then you will never save up enough to retire, as you are spending 100% of your income. Conversely, if your savings rate is 100%, then you spend none of your income and you would be considered Financially Independent already.
As soon as you start saving and investing your money, it starts earning money all by itself. Then the earnings on those earnings start earning their own money. Your savings grow exponentially due to The Magic of Compound Interest. As soon as these savings/investments are enough to pay your living expenses while leaving enough of the gains invested each year to keep up with inflation, you are ready to FIRE.
• You earn 5% investment returns after inflation during your saving years (8% rate of return with 3% inflation). If this is increased by small margins, the effect of compounding can be significant.
• You will live off the 4% safe withdrawal rate after retirement, with some flexibility in your spending during recessions.
• Not taking into account any taxation issues on income pre-FIRE (income tax, tax benefits of pensions, employer contributions, etc), and post-FIRE (income tax, some of which can be mitigated by saving into pensions and ISA’s).
• A constant savings rate (some big expenditure changes over time, such as your mortgage being paid off, children! and the state pension).
If you drew this savings rate story into a graph, it would not be a straight line; it would be a nice curved exponential graph, like this:
The curve is steepest from 0% to about a 30% savings rate, and beyond a 30% savings rate, it becomes roughly linear. The big takeaway from the graph is that the largest improvements for time-to-FIRE are at lower savings rates. Increasing your savings rate from 10% to 20% speeds up your time-to-FIRE by 15 years, while going from 50% to 60% only gets you 4 years closer to FIRE.
This insight uncovers 2 critical principles:
1. Not all savings rate increments are equal. The lower your current savings rate, the more profound the impact of additional increases.
2. The number of years to reach FIRE and the savings rate (%) are directly linked without the need for real cash numbers.
So, if someone earns £100k and someone earns £50k, if both have a 15% savings rate, both will reach FIRE in 42 years; it doesn’t matter whether they start at age 25 or 45, it will still take 42 years.
By living intentionally, cutting out unnecessary spending, and increasing the savings rate to 20%, they can reach FIRE 6 years earlier (36 years).
By increasing the savings rate to 30%, the time-to-FIRE is reduced even further to 28 years; so, if you start at age 25, you will reach FIRE by age 53!
If want to retire within 10 years, the formula is right there in front of you – live on 35% of your take-home pay.
How Much Should I Save?
How do you strike a balance between enjoying life now and enjoying it later? this is one of the biggest challenges in personal finance; figuring out how much of your income you should be saving.
It is a question that drives at the heart of the dilemma of living for the present moment and delayed gratification, because if you go too far in either direction, you are either sacrificing your current happiness for the sake of your future self, or vice versa.
This might be obvious, but it is much easier for someone who earns £100,000 per year to save 25% of their income than for someone who earns £50,000 per year. They may have the same timelines for retirement, but the former person earning twice as much is going to have an easier time because the remaining 75% of income that they get to spend is just higher. This is important because the FIRE number (i.e. total value of your savings and investments at FIRE) that you are saving toward is only going to be able to support your existing spending habits.
Also, we have to acknowledge the tremendous benefit from the exponential nature of compound interest as savings grow; with a savings rate of 25% it might take 32 years to be financially free, but the first half is going to be a much longer slog than the second half.
There is a point at which saving additional income does not meaningfully impact future happiness, but it does begin to negatively impact present happiness. So ideally, we want to walk right up to that point and then stop short of it.
What is the Perfect Savings Rate to Achieve Financial Independence?
Because we are talking about percentages, it doesn't actually matter how much income you have, the answers are all proportional. Your savings rate is the only thing you need to know in order to solve the number of years between you and FIRE. If you know your savings rate, that means you also know your spend rate; they're just two sides of the same coin. If you know your spend rate, you know your FIRE number - assuming you are going to use the 4% safe withdrawal rate in retirement.
As we have seen on the graph, the time to FIRE v saving rate is not a straight line, more a curved exponential line. The more you save, the quicker you reach FIRE, but with a tail off after a point.
To strike a balance between enjoying life now and also giving yourself maximum flexibility later, due to the diminishing rate of return, the optimal or perfect savings rate is between 30% – 40% of income.
Depending on how much you earn and your expenses, this might be relatively easy to do with a few tweaks. Or focusing on increasing income or cutting back on expenses, might be the right place to start; whichever path makes the most sense based on where you are.
Most people do not begin earning enough at graduation to save 30-40%, so this really is the optimal blue sky version, but remember when you start is irrelevant to the total number of years it takes. Starting earlier just means you are going to complete the timeline earlier in life. If you want to strike a personal balance between enjoying life now and also giving yourself maximum flexibility later, you could save a lower percentage over a longer period, or you could start later and save a higher percentage….it’s all in the maths!
The higher your savings rate, the faster you can achieve FIRE. What is a perfect savings rate depends on your individual situation and how much you are able to save. While you should strive to maintain as high a savings rate as possible, you should still allow yourself to spend enough to enjoy life. By understanding your spending, being intentional with your spending, and having a Financial Plan for your future, you will undoubtedly go from Grad Rags to Riches.