How Much Of Your Income Should You Save?

How Much of Your Income Should You Save?

By Rob Berger Contributor, Forbes

There’s no question more fundamental to personal finance than how much money we should save. Our savings rate is the cornerstone of virtually every other decision about money we make. It affects everything from buying a home to saving for emergencies to retirement.

Yet the guidance on this important topic is less than stellar. It usually takes the form of a rule of thumb, such as the admonishment to save 10% of our income. Some advise saving as much as 20%, as with the 50/20/30 budget popularized by Senator Elizabeth Warren. A “one size fits all” approach, however, is often not helpful.

How much one should save will vary considerably based on circumstances. A 20 year old with several decades until retirement can save a lower percentage of her income than say a baby boomer just starting to save for retirement. Charles Farrell’s work on money ratios went a long way to addressing savings rates based on age, income, and current savings. The one shortcoming to his approach is that it assumes a traditional retirement age. Many want to retire early.

A different approach to this question is one based on how long it will take to reach financial freedom. In other words, based on a certain savings rate and assumed rate of return, how long will it take to build up enough investments to fund annual living expenses? I call this the Financial Freedom Fund.

The Math is Easy

The math behind the Financial Freedom Fund is a simple two-step process. First, we need to calculate how much we need in investments to generate sufficient income to fund our living expenses. Second, we calculate how long it will take to reach this goal based on our current savings rate and an assumed rate of return. Once we have this information, we can then adjust our savings rate based on when we want to retire.

Using the 4% withdrawal rate rule of thumb, we can easily calculate the nest egg we need to accumulate. We start with our annual spending and divide by four percent. The result is how much we’ll need to accumulate to retire. For example, an individual planning to spend $75,000 a year (including taxes) would need to accumulate $1,875,000 ($75,000 / 4%). Those who think a 4% withdrawal rate is too rich can assume a different percentage and adjust the calculation accordingly.
Once we know The Number, we can determine how long it will take to reach financial freedom based on our savings rate, rate of return, and current savings. The math here gets a bit involved, so I’ve created a spreadsheet that does the work for you. It’s a Google GOOGL +1.47% Docs spreadsheet that you can view here (to edit your own copy, use this link).

There are several aspects of the spreadsheet, which I call the Financial Freedom Calculator, worth noting:

• Income is Irrelevant: How much you make doesn’t change the results. The length of time it takes to achieve financial freedom is a function of the percentage of income one saves, the rate of return and the withdrawal rate. If two people each save 10% of their income and earn the same rate of return, it will take them the same length of time to reach financial freedom even if one makes $50,000 a year and the other $500,000.
• Save More, Spend Less: The more we save, the less we spend. As our savings rate goes up, it impacts our years to financial freedom in two important ways. Of course, the first is that we save more, growing our investments faster. But the second effect is equally important–we spend less. Because we spend less, the amount of money we need to amass goes down.
• Every Percent Counts: The results are very sensitive to the rate of return. For example, a person saving 10% of income will need 50 years to reach financial freedom assuming a 5% return on investments. Increase the rate of return to 9% and the time to reach financial freedom drops to 34 years. This means, among other things, that investing costs must be kept to a minimum.

A one percent difference in returns can add five years or more to the time it will take to retire.

How Much Should We Save?

With this approach, we can set our savings rate based on our retirement goals. A 25 year old, for example, wanting to retire in 20 years and assuming a rate of return of 7% will need to save 35% of his income. Yes, saving 35% of one’s income is not an easy feat for most. Of course, retiring at age 40 may provide ample motivation.

If you take the Financial Freedom Calculator for a spin, leave a comment and let me know what you think. And remember to create a copy of the spreadsheet so that you can change the inputs (annual income, withdrawal rate, and current savings) to match your specific circumstances.