This article on the importance of your savings rate is by Budgets and Beverages from Team Monevator. Check back every Monday for more fresh perspectives from the Team.
I have a new hero in life. His name is Tony Stark.
You might know him as Iron Man.
Tony Stark is a superhero and plays a key role in The Avengers. He’s witty, confident, driven, ambitious, and at the top of his game.
What’s not to like?
Sure, I know he’s not real. And that I’m about ten years late to The Avengers.
But I’m currently going through a marathon of watching the huge Marvel catalogue of films. This after revealing to my partner I’d never seen one of them during lockdown last year.
(Apparently that’s quite the sin.)
And while I can’t be Tony Stark, I can aim to emulate him – sort of.
Spoiler alert! This article won’t include images of me in tight, bright, superhero pants. Nobody needs to see that.
Rather, with my first year of investing ended, I want to tell you about my own superpower: the savings rate.
It ain’t new
So the idea of zeroing in on your savings rate isn’t novel.
In fact, it’s one of the pillars of financial independence.
But used well, your savings rate is arguably the best financial superpower you could ever have.
In one of his many brilliant articles, Mr Money Moustache describes the savings rate as follows:
… simply the percentage of your take home pay that you’re not spending.
Yes, straightforward, but most people still treat savings as an afterthought. Whatever is left over at the end of the month is shoved into some low-interest, easy access savings account.
Earning nothing – yet so many of us do it believing it’s a good thing!
Few of us save enough, either. There are always demands on our money.
Before Covid, the average UK savings rate was between 7.5 and 8.5%. Measly.
Yet it has been estimated that in lockdown at the end of 2020 UK households had an average of 19.9% available to save from their gross disposable income. That’s much higher than before the Covid pandemic, thanks to less temptation – and ability – to spend money.
It was proof that a higher savings rate was achievable for many people.
Not easy. But possible.
One rule to rule them all
But why do all these numbers matter? Well, the higher your savings rate, the sooner you can reach financial independence.
“It’s not that simple!” I hear you cry.
It really is.
As Mr Money Moustache’s famous article The shockingly simply math behind early retirement stated:
It turns out that when it boils right down to it, your time to reach retirement depends on only one factor:
Your savings rate as a percentage of your take-home pay.
It’s that powerful.
So what’s a good savings rate percentage to aim for?
10%? 15%? 25%?
If you can get to a position where you can save half your pay packet, then you can retire in 17 years. Save even more and achieving financial independence gets ever closer.
You could start at 21 and be done before you’re 40.
For many Monevator readers, that’s exciting. But still, so many of us struggle to pay ourselves first.
The savings rate in the UK fluctuates a lot. Methodologies vary as to how to measure it. Some studies have found that the average household savings rate for the UK has been as low as 2% at times.
At that pace it would take 61 years to retire!
No wonder so many of the population seem set to work into their 70s.
How then do you reach your target?
Well, as The Accumulator says:
Hitting your target comes down to how much you can save and the returns you earn on your investments.
The second part of that statement can really accelerate your journey.
Because, while saving 50% of your pay is amazing, putting your savings back into money-making assets catapults you to a new level.
Compounding the rate
As soon as you start saving and investing money, it starts earning money itself.
Those earnings then start earning, too.
That’s the beauty of compound interest. (If I really were a superhero, I’d want compound interest to be my trusty sidekick.)
Time for an example.
Let’s say Gary saves 50% of his pay every month, without fail. That equals an annual saving of £30,000.
Gary could put that into an easy access cash savings account, which right now would earn 0.1% on average in the UK:
After a year, Gary would have made £13.75 extra.
At the end of five years, he would have saved £150,000, with £382 interest on top.
At the end of ten years, he would have saved £300,000, with compounding interest giving him an extra £1,518 on top.
Yikes. Nobody is likely to achieve financial independence ever – let alone early – this way.
Gary could instead put his savings into low-cost global index funds. These have historically earned a real return of around 7% a year.
And at 7% the maths is very different:
At the end of the year, Gary would have made £1,162 extra.
After five years, he would have saved £150,000, with £30,026 on top.
At the end of ten years, Gary would have saved £300,000, with compounding giving him an extra £135,236.
“I am Iron Man”, says Gary with pride.
Even Hawkeye can get in on the action
Sadly, a 7% annual return from the stock market isn’t guaranteed. But there are enough studies and examples to trust that history is on your side if your time horizon is long enough.
The power of the savings rate isn’t discriminatory, either.
If someone earns £200,000/year and their friend earns £50,000/year, but both have a savings rate of 50%, then they will be able to retire around the same time and at the same (relative) standard of living.
There really is no excuse not to get started.
How do I work out my savings rate?
The savings rate maths is easy.
Says Mr Money Mustache:
(Take home pay – spending) / (take home pay) x 100 = savings rate %
Or, more wordily, from The Accumulator:
- Take your annual net income
- Subtract your annual expenses
- Add all your other income streams including rentals and bank interest
- Add pension contributions and employer matches if pensions are a factor in your plan. Gross them up to account for tax relief.
- Don’t add investment income and gains. These are accounted for in your return assumptions.
However I’m too much of a control freak geek to wait a whole year to work out my savings rate…
So I calculate my savings rate monthly and update that figure each month.
I direct a big chunk of my payslip towards the following destinations:
- 10% to cash savings (I’m forever paranoid about my emergency fund)
- £333.33 into a LISA (to ensure I max it out at £4,000 over the year)
- The rest into low-cost index funds in a Vanguard ISA
I first aimed to put away a challenging 50% of my income. But I was fortunate enough to discover I could save even more.
I upped my target to 55%, and then to 60%. As the year came to a close, I found I had an average savings rate of 61%.
And although I’m self-employed, one of my clients pays into a pension for me. This means my effective savings rate is actually even higher!
Track your savings rate
For me, tracking my savings rate has been key. By following my numbers monthly I can see if my percentage goes up or down.
If it’s down, I’m furious with myself.
If it goes up, I want to challenge myself to up it again.
Yeah, I’m rather competitive.
But then again, so is Tony Stark!
But you don’t have to go so big. Find out what is right for you.
Start with 10% or 20%. That’s still so much better than doing nothing – and at the top end far better than average.
If you can save 20% rather than 10% of your income, you could take up to 14 years off your future retirement date.
Now that’s what I call a superpower.