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Saving is a bit of a boring word: most people want to earn well and live well, spending their hard-earned money on the newest car, phone, or gadget. While that lifestyle can certainly be tempting, it’s hardly the way to retire early.
That’s where saving comes in. It may be seen as one of those things you do when you’re worried you may be about to lose your job, but saving is the foundation of your financial security.
When you have a secure financial base, you can afford to take more risks with your money, which in turn, should yield a higher reward. This is the combination that can help you retire early, or even become a millionaire.
How early? Well, that depends on your percentage of savings rate, the aggregation of your marginal gains, and how brave those savings allow you to be when it comes to investing.
Be brave with your investments
First things first: clear any of your debts and get a cash emergency fund in place. After that, you can afford to be braver with your money, take greater equity risk, and buy into the stock market.
The braver you are, the higher your expected returns should be.
Be brave with your career
With savings, you can be braver in your career/your business, too.
As you get promoted up the ladder, you’ll need to accept more career risk: a higher salary makes you a juicier cost-saving for an incoming CEO, after all.
Beware the boss that knows you’re desperate. Beware the salesman with debt commitments and a flashy lifestyle to support. They need the next sale and the next commission too badly to be ethically scrupulous.
Money is the power to control your own life, and you can’t be truly fearless without some degree of financial security - especially if you’re providing for a family that depends on your income. Higher earnings should translate into greater saving, not flashier spending habits.
The importance of savings
Your percentage of savings rate is the most important number in personal finance, and it’s the most important metric for you to track.
Let’s say you move half of your salary (after tax has been deducted) to your investment account each month - that would work out to a 50% savings rate. You can make it more complicated than that, depending on how you treat pension contributions and so on, but it’s better to be roughly right than precisely wrong.
Remember that debt repayment (e.g. the capital element of mortgage payments) counts as savings. You can increase your net worth either by reducing debt or by increasing your assets.
Here’s the graph that demonstrates the power of your percentage of savings rate:
The Y axis shows the time until the person reaches retirement - or, more accurately, financial independence (the position where work is voluntary).
The X shows the percentage of savings rate, or the proportion of post-tax salary that a person is able to save and invest. As we go from left to right, the savings rate goes from 5% of post-tax income (68 years to financial independence) up to 50% (where it takes 17 years to get to financial independence) and beyond.
Isn’t it strange how your percentage of savings rate is far more important than your percentage of investment returns, and yet returns are what people most often focus on? After all, it’s much easier to get decent investment returns with a global equities tracker than it is to save consistently.
Remember, there’s no point in earning a higher income if that doesn’t lead to a higher percentage of savings rate. Your income doesn’t directly affect when you can retire - higher income just allows you to save a higher percentage of your income without extreme frugality.
To show you how these numbers are built up, here’s the maths for the 50% savings rate (~17 years to financial independence). This is a fairly old example, but the numbers scale: it’s the percentages that matter. A 50% savings rate means it takes 17 years to get to financial independence, regardless of the actual amount you earn.
In the example above, our investor reaches financial independence in year 17 when their invested net worth exceeds 25x their annual spending, and their withdrawal rate is below 4%.
This means that you can bring the finish line closer either by saving more and spending less.
If you’re just starting out, don’t let the high percentages put you off. For a lot of people, saving 50% of their annual income simply isn’t achievable - not without a frankly unimaginable level of frugality. Nevertheless, these numbers illustrate a powerful concept: the more you’re able to save, and less you spend, the earlier you can afford to retire and achieve financial independence.
What’s interesting about the shape of the graph is that it’s curved: the time taken to get to financial independence falls rapidly as the percentage of savings rate is increased. The jump from 10% to 20% brings the age of financial independence much closer. The jump from 50% to 60%, however, shows a less stark improvement.
If that marginal increase in savings rate makes your life miserable, then it would be a mistake for you. Everyone has to discover their own “sweet spot”. Everybody’s circumstances are different, and a 10% jump in savings for one person may be far more manageable than for another. Simply put, there is no right or wrong answer, but the graph illustrates how effective these trade-offs can be.
Don’t forget that what seems impossible for you right now may be possible for you in a few years time. Where attention goes, energy flows. Or something like that.
What are your assumptions?
Models are simplified versions of reality that illustrate important concepts. The assumptions that sit behind these illustrations are:
- you never do any more paid work;
- you never get any state pension or other benefits;
- 5% real (excluding inflation) investment returns; and
- a safe withdrawal rate of 4%.
These calculations are all based on the idea of a safe withdrawal rate. In many past scenarios, this has meant that the retiree actually ends up dying with a large pot: there’s no de-accumulation where investment returns are 5% and you are only spending/withdrawing 4% per annum. For people who want/expect to run down their pot during retirement, these calculations may be too conservative.
Saving doesn’t equal deprivation
When faced with graphs and guidance like we’ve shown above, the most common refrain is: “But I don’t want to sacrifice all the fun in my life!”
We have a tendency to assume that everyone’s spending efficiently and mindfully, but that’s simply not true. We can all think of an example of someone in our lives that has bought a needlessly expensive luxury when they could have settled for a far cheaper one.
Buying a refurbished phone when your old one gives up the ghost, rather than investing in the newest iPhone the day it releases, for instance, is not deprivation. It’s just cheaper, and more economically sensible.
Make saving sustainable
Saving is a wonderful thing, but as with anything in life, it can still be taken too far. Your savings plan has to be sustainable and you have to enjoy the journey.
Pinching every penny and saving everything you earn is the fastest way to retire early, but that’s no way to live: if you’re not enjoying your day-to-day, not heading to the cinema when your favourite movie gets a sequel, going for a meal with a loved one, or investing in yourself through books, online courses or gym memberships, you’re setting yourself up for a fall.
Not everyone can be a high earner or reach financial independence by 40, but everyone can learn to get better with money: after all, the tools of financial independence are for everyone.
This article was written in partnership with Barney Whiter of The Escape Artist.
