What Your Savings Rate Says About When You’ll Retire
Retirement is the ultimate goal in personal finance. When most people think about retirement, they think about the specific dollar amount they need. You might do some math and find out that you need $1 million to retire. While figuring out how much you need for retirement is important, tracking your bank account’s value to that number can be difficult and sometimes it’s hard to see yourself making progress. Instead, tracking your savings rate is an easy way to get an idea of when you can retire.
My savings rate is something I just recently started thinking about. Investopedia provides a pretty good definition of what a savings rate is:
A savings rate is the amount of money, expressed as a percentage or ratio, that a person deducts from his disposable personal income to set aside as a nest egg or for retirement.
This one simple stat can tell you a lot about your financial well being. It’s important to note that the money that counts toward your savings rate is money put towards retirement. Money that you’ll use in other situations isn’t counted. The second part of the definition, disposable income, is essentially your post-tax income.
Savings rate isn’t something most people think about, so to get our bearings straight let’s take a look at the average savings rate in the U.S. over the years. The Federal Reserve Bank of St. Louis provides access to the Federal Reserve Economic Data (FRED) database which tracks a whole bevy of economic data. One of those things just so happens to be savings rate. As you can see from the graph below, the savings rate used to be up around 10% and even shot up as high as 17% at one point. Today, the savings rate hovers at a measly 2.5%.
So what does this mean for Americans? At 2.5%, Americans are only saving $25 for every $1,000 earned. At that rate, if you don’t have any other source of income, you will be able to retire for about the last 6 months of your life. Not exactly the easy life.
So what about back in the 1970’s when people were saving around 12% of their earnings? Let’s assume someone starts working at 25, will live to be 100, and keeps the same savings rate until retirement. If you have the same expenses in retirement as you do pre-retirement and put 12% of your income in the bank, you could retire after working 72 short years at the age of 97.
With numbers like these how is anybody able to retire? In the examples above, the money was just sitting in the bank earning next to nothing. It actually lost value due to inflation. If we take that same 12% and invest it, we could retire at the age of 56. Not too bad.
But keeping a constant savings rate takes some conscious thought. Let’s look at an example with our friend Tommy. She starts out her career making $50,000 per year after taxes. After paying her bills, she’s able to save $7,000 and she’s on track to retire at the age of 54. Tommy worked hard and after a couple of years her boss recognized that she’s a valuable asset to the company and gave her some generous raises. Her take home pay is now $80,000 per year. As Homer Simpson would say, “Woohoo!”
With Tommy’s income rising, she increased her savings to $8,000. By doing so she delayed her retirement by 5 years.
Yes, you read that right. She delayed her retirement by five years after increasing her savings. That’s because she actually decreased her savings rate. Even though her savings increased by $1,000, her expenses also increased by $29,000. After all, if she’s saving $8,000 of her $80,000 income, she’s spending $72,000. Her savings rate was 14% back when she was making $50,000. Now that she’s a high roller making $80,000, her savings rate is only 10%.
As Tommy’s income rose, so did her expenses. Since your expenses in retirement are directly related to your expenses before retirement, raising expenses as you have more income just means you need that much more money during retirement.
Let’s say instead of increasing her spending, Tommy decided to keep the same lifestyle she had when she was making $50,000. At $50,000, she was saving $7,000 and had $43,000 in expenses. Now she’s making $80,000 and has those same $43,000 in expenses. This means she’s saving over 42% of her income. By doing this, she just dropped her retirement age from 54 to 40!
As you can see, just because you’re saving more money doesn’t mean you can retire sooner. If your expenses also increase then you’re not getting any closer to retirement. You need to at least keep your savings rate constant if you’re going to stay on track for retirement. Ideally, you will increase your savings rate as your career progresses. Your savings rate not only takes into account how much you’re saving but also how much you’re spending. After all, if you’re not saving your money, you’re spending it.
So how can you increase your savings rate? One thing my father-in-law did was slowly increase his savings rate with each raise or after paying off different items. For example, after he paid off his car, he continued to put those payments towards retirement. This is a double benefit since his expenses decreased and his savings increased. You can also increase your savings rate by cutting unnecessary spending. Try eating out less or buying generic and putting that money towards retirement. If your employer offers a 401(k), consider increasing your contribution rate. If you do contribute to your 401(k), add your contribution amount to your savings to come up with a more accurate savings rate.
Now all the numbers above assume that you won’t have any other income in retirement. The reality is most people will have some sort of additional income, such as social security or a part-time job. But understanding when you can retire free and clear can help you better plan for the future. One of the most important things to do is to invest your money so you don’t lose value to inflation and can actually grow your money. If you’re not investing, you have to have an extremely high savings rate to be able to retire.
So take some time to figure out what your savings rate is. Whatever your rate, figuring out a way to increase it will pay off when you get to retire in comfort.
