The Dual Benefit of Increasing Your Savings Rate

It's a double rainbow all the way! What does it mean!

It’s a double rainbow all the way! What does it mean!

My friend Pauline wrote an excellent article yesterday touching on an incredibly important point that I almost never see mentioned: the dual benefit of increasing your savings rate. You can read the full article for yourself here: Where will your savings rate take you?

So what is this dual benefit and why is it so powerful? Let’s take a look.

Benefit #1: More money saved

The first benefit of increasing your savings rate is pretty obvious: the more you save now the more money you’ll have later. Pauline gives some excellent examples of how much you’ll end up with at different savings rates, but honestly this point has been discussed many times. It’s a very important reason to save money, but it’s nothing new.

Benefit #2: Less money needed

The part she gets into that’s really unique is that fact that an increased savings rate not only gives you more money, but it also means you require less money to live on. That in turn means that you don’t need to save as much or for as long to accumulate the money needed to retire.

I’ve modified Pauline’s examples a little bit for my purposes here to create the chart below, but the point is the same. These numbers assume a 40 year investment period, a 6% annual return, and a 4% withdrawal in retirement:

savings rate

In both cases the individual has a $4,000 monthly income. In Scenario 1 the individual saves 10% of his or her income, and in Scenario 2 the individual saves 15% of that same income. There are a few things here that I would like to draw your attention to:

  1.  In Scenario 2, not only is the Monthly Income After 40 Years much larger, but the monthly expenses are lower because the individual is used to saving more. This compounds the advantage of that extra income, giving the individual some extra cushion in retirement that could be used either as protection from outliving his or her money or simply as extra money available to enjoy life a little more.
  2. The Year Retirement Possible rows displays how many years it takes for the investor to have enough money from investments to cover the monthly expenses. There is a 7 year difference between a 10% savings rate and a 15% savings rate. Part of that is attributable to having more money saved, but part of it is attributable to having lower expenses.

The point here is to recognize that there are two effects working together that accelerate your ability to reach your retirement goal.

The research backs it up

A 2007 study by Jonathan Skinner, an economics professor at Dartmouth College, comes to this exact same conclusion. The paper looks at many aspects of whether baby-boomers are prepared for retirement, but one of his conclusions is that individuals with a 15% savings rate require 34% less money at retirement than those with a 2.5% savings rate. In other words, not only are they saving more, but they will need less. He describes the phenomenon like this (emphasis is mine):

One puzzle is why wealth requirements at retirement are so much larger for the household saving 2.5 percent (5.8 times income) instead of 15 percent (3.8 times income). After all, the saving rate might not seem to matter once households reach retirement. The resolution of the puzzle is to note that the high saving household has gotten used to a lower rate of consumption while working, so less is needed to smooth consumption through retirement. Raising saving rates therefore yields a “double dividend” in life-cycle saving by stimulating asset accumulation and attenuating future required consumption.

Conclusions

Clearly increasing your savings rate is beneficial, not just because it allows you to save more money. It also makes you accustomed to living on less, which then decreases your actual retirement need. These dual benefits work together to make retirement easier to achieve.

Other articles I think you’ll like

My Money Design: I love the message here. Money is just a tool that gives us more flexibility to spend our time the way we truly want to. Time is the real resource of value.

iHeartBudgets: Jake reminds us that the purpose of a budget isn’t to limit your ability to spend. A good budget actually increases your ability to spend on things you actually care about by removing the wasteful spending on things you don’t.

Frugal Rules: Fitting in with some of what’s been written here recently, John reminds us that investing in the stock market doesn’t have to be difficult.

Debt RoundUp: Some good thoughts here from Grayson on how multi-tasking can hurt when dealing with finances. I definitely agree that trying to do too much at one time can make you unproductive.

Cents and Sensibility: Lindsey reminds us that we need to be responsible for our financial decisions. If we can’t hold ourselves accountable, we’ll never really have control over our lives.

Mr. Money Mustache: An incredibly enjoyable take on what a Utopian society might look like if everyone saved enough money to become financially independent at an early age.

Cash Cow Couple: Vanessa writes about the most important financial decision you will make in your lifetime: your spouse.

Budget and the Beach: Tonya spends a day just enjoying the city she lives in. When’s the last time you stopped and just appreciated the area in which you live?

Thanks to these carnivals for including me along with some other great posts!

Aspiring Blogger Personal Finance Carnival
Carnival of Financial Independence
Carnival of Money Pros
Finance Carnival for Young Adults
Lifestyle Carnival
Yakezie Carnival

Photo courtesy of Peet Sneekes

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40 Comments... Read them below or add one of your own
  • JW_UmbrellaTreasury July 19, 2013

    This is a fantastic reminder on the importance of keeping expenditures low. The more I spend now, the more I am likely to keep spending into the future, even once I’m retired. Great analysis!

    • Matt @ momanddadmoney July 19, 2013

      Very true. Habits are harder to change the longer they exist. Might as well form some good ones now so you don’t have to break bad ones later.

  • Holly Johnson July 19, 2013

    Needing less is one of the best things about saving a lot of your income. If you can learn to live on half of your earnings, then you can reach FI that much sooner!

  • DC @ Young Adult Money July 19, 2013

    Great illustration and I really liked how you included some research to back it up. The more you save the more you can plow into income-producing assets (there is risk here that I am leaving out for simplicity sake) and the sooner your 9-5 income can be replaced by those income-producing assets!

    • Matt @ momanddadmoney July 19, 2013

      Definitely true. There’s always risk involved. But I’d rather take the savings and the accompanying investment risk than the other way around.

  • Alexa Mason July 19, 2013

    Yes, I agree. I have gotten used to living on much less over the past year and it’s not so bad. Saving all bonuses, raises, etc. is a great way to increase your savings without succumbing to lifestyle inflation.

    • Matt @ momanddadmoney July 19, 2013

      That’s a great tip about bonuses and raises. I used to feel weird when I got a raise and was immediately excited about how much more I could save, but now it just feels like the norm. Like you say, once you try living on a little less you will usually find that it’s really not bad, and in a lot of ways pretty nice.

  • Grayson @ Debt Roundup July 19, 2013

    Increased savings is a good thing. Just the mentality to save will lead you to a brighter future. Thank you much for the mention Matt. I hope you have a good weekend.

  • Brian @ Luke1428 July 19, 2013

    Cool stuff! That research is very interesting. The practices of saving more and needing less basically evolve from the same basic principles – the desire to be prepared and not overindulge.

    • Matt @ momanddadmoney July 19, 2013

      The research is definitely interesting. I’m glad there are actually people looking into things like that. Hopefully the word gets out!

  • Rita P July 19, 2013

    More you save the more you earn. I have practiced to contain my needs and adjust with less, which has actually helped me to save more over a period of time

  • Budget & the Beach July 19, 2013

    The numbers don’t lie! I’m constantly looking for new ways to increase savings. Challenging on a low income, but must be done. Thanks for the link love!

    • Matt @ momanddadmoney July 19, 2013

      It is definitely tougher on a lower income. There’s just less fluff. You seem to be doing a good job getting creative with it though.

  • Thank you Matt for the spotlight and for explaining it much better than I did 🙂

    • Matt @ momanddadmoney July 19, 2013

      Haha, I don’t know about that. Just wanted to highlight what I thought was a really great point you made. Have a great weekend!

  • Jacob @ iHeartBudgets July 19, 2013

    This reminds me of Mr. Money Mustache. They got used to a frugal standard of living, and didn’t need $3 Million to retire, because they just didn’t need that much money. I’m hoping for the same, as I hope to need even less than I do now (with a paid off mortgage and such) in retirement. Great post.

    And thanks for sharing my post 🙂

    • Matt @ momanddadmoney July 19, 2013

      That’s a great point about not needing as much in retirement, and one I just didn’t want to get into here. But you’re absolutely right that you can definitely cut down on expenses. Though we’ll see how healthcare costs turn out…

  • Andrew July 19, 2013

    Very interesting. The 2nd benefit of needing less money is less obvious, but also very true. Some articles claim that you need 85 to 90% of your pre-retirement income to survive during retirement. Really? I guess if you were living close to paycheck to paycheck. If you had a high savings rate, I would think you should need a lot less being that you no longer pay certain taxes and don’t have to save for retirement anymore.

    • Matt @ momanddadmoney July 19, 2013

      Yep, you hit it right on the head. A higher savings rate means you need to replace much less income in retirement. Most people have a low savings rate, so they need to replace more income. It’s a double-whammy.

  • Done by Forty July 19, 2013

    That’s a great way to frame the benefits of increasing savings rate. It also made me think of the 2007 Patriots or the mid-nineties Steelers: in each case the team’s crazy strength (offense or defense, respectively) made it so its counterpart didn’t need to produce as much for the team to be successful overall.

    • Matt @ momanddadmoney July 19, 2013

      Haha, you really know how to play to my heart! I agree with the football comparison, though the memory of the 2007 Pats is so bittersweet. Which I’m guessing might have been one of the reasons you brought it up, haha. Enjoy the weekend!

      • Done by Forty July 19, 2013

        It really wasn’t my intent, but hey, if I can bring up bad memories for a Patriots fan, then that’s just icing on the cake. 🙂

        You have a good weekend, too, Matt.

  • Aspiring Blogger July 19, 2013

    Thanks for the shout out! Keep up the great work over here!
    AB

  • E.M. July 19, 2013

    First, I love the double rainbow reference. Second, this just makes me excited to save more and learn to live on less. It will make my life a lot easier down the road! It’s crazy there’s a seven year difference in the age you’re able to retire. Just serves to put things into perspective.

    • Matt @ momanddadmoney July 21, 2013

      Yeah I was pretty excited about getting to make a double rainbow reference. And it’s definitely true for me as well that framing things in terms of how much earlier I could retire has a big impact on how my decision is made.

  • Funancials July 19, 2013

    One thing I try to stress to friends, family and bloggers is that “your savings rate is much more important than your asset allocation.” So many people stress out over where they should put their money, when they should be stressing over how much they’re putting away.

    • Matt @ momanddadmoney July 21, 2013

      Couldn’t agree more. Asset allocation, stock picking, etc. all feels a lot fancier, which means that they get focused on a lot more. But the amount you save is more important than just about anything. And best of all, it’s directly within your control!

  • Edward - Entry Level Dilemma July 19, 2013

    People who save more don’t need less, they want less. That is a big difference! While I’m known to confuse the two myself, the amount that I need to live on, even with a few wants bleeding in, is considerably less than the amount I would live on if I could.

    • Matt @ momanddadmoney July 21, 2013

      That’s a good point. Most of us probably “need” a lot less than we think we do. A big piece of this approach is re-framing the concept of “need”, which goes a long way to making those needs attainable.

  • Your Daily Finance July 20, 2013

    Saving more and spending less. Sounds so simple but most people screw it up completely. When you look at some budgets and see people spending 1k on just stuff and yet savings is 100$. Increasing the savings rate is one thing but we also need to make sure that the savings it adequate in the first place then we should double it.

    • Matt @ momanddadmoney July 21, 2013

      Yep, the more you can save the better. Hopefully people realize what they’ve giving up when they’re not saving.

  • Vanessa @ Cash Cow Couple July 20, 2013

    Thanks for the link! Have a great weekend!

  • Greg July 21, 2013

    Definitely save till it hurts!

  • Lindsey @ Cents & Sensibility July 22, 2013

    Thanks for the share, friend. It’s always flattering to be shared on your excellent blog. 🙂

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