If there was one piece of financial advice I wish everyone was shown upon completion of their first year of working. It would be what were going to discuss today. The surprising relationship between your savings rate and your retirement date.
What Is Your Savings Rate?
Your savings rate can be broken down as follows:
Savings Rate = Total Savings / (Total Savings + Expenses) *100
This total savings rate includes any of yours or your employers contributions to investment accounts. The principle amount put towards your mortgage from you mortgage payments “the interest portion is an expense”. Plus of course any money saved at the end month. Leave a comment if you have any questions whether something counts towards savings or an expense when your determining your savings rate and I’ll do my best to help.
I believe this piece of financial advice would change a lot of lives for the better because when you start working, retirement seems like some distant event that at best is thirty to forty years away. You don’t give it a whole lot of thought because your saving 10-15% of your income. Your 10-15% savings rate is better then most your friends or at worst your saving the same amount. Both your financial advisor and the retirement calculator you punched some numbers into told you you’ll be fine upon retirement. And they’re right. A 15% savings rate will enable you to retire in 43 years. “with some assumptions we will discuss in a bit”
What If I Told You It’s Not Alright & It Doesn’t Have To Be This Way!
That’s right. You don’t have to work 43 years to be able to retire. You see, when you start saving and investing your money, some very interesting things start to happen. This interesting thing is known as compound interest. Some of the greatest math whizzes throughout history have referred to compound interest as the eighth wonder of the world. It is when your money that you saved and invested starts earning money on its own. Then that money starts earning money which earns more money. This earning money on money will continue at an exponential rate into the for-seeable future as long as you leave the money invested. Due to the exponential rate of money earning more money if you plotted it on a graph. It would look as follows:
The graph above is nice to look at and all but it doesn’t give us the most concise advice. So, to be able to break it down even further for you we needed to make some assumptions which were:
– You are able to maintain a constant savings rate throughout your saving years. It is very likely that your savings rate will not be constant as you may receive pay raises, bonuses, or a job loss throughout your savings years.
– You are able to keep your expenses constant throughout your savings years. I realize your expenses will vary from year to year but I suspect following the advice recommended at The Money Spot they will decrease over the years.
– During retirement you will use the safe withdrawal rate of 4% to withdraw funds from your investment portfolio. This 4% withdrawal rate will rise every year for inflation and you’ll have the sensibility to reduce your withdrawal rate during a recession.
– Your investments will yield an investment return of 5% after inflation.
Your Savings Rate & Retirement Date
Let’s say your current savings rate is 15% and you implement a few of the ideas discussed in Glen’s post 5 Ways to Ensure Your Family’s Frugality and your savings rate increases to 20%. Just by increasing your savings rate by 5% you have reduced the amount of time it will take you to reach financial independence by six years. It’s truly impressive stuff.
I imagine you have or are now calculating your savings rate. If you’ve calculated your savings rate and are unhappy with the results and are looking for ways to increase it. Stay tuned, as tomorrow I’ll explain why it’s better to focus on decreasing your expenses than focusing your time on increasing your income to improve your savings rate.
If you now cannot get enough about increasing your savings rate and this early retirement stuff. Check out Jason’s Early Retirement Calculator he created at Islands Of Investing!