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:
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:
- 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.
- 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.
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!
Photo courtesy of Peet Sneekes