Early retirement, Finances

What’s your savings rate and are you getting it right?

Image result for savings

The savings rate is lauded as one of the most crucial bits of information in the FI armoury, and I can see why. Simply put, this is the proportion of your take-home pay that you save or invest potentially towards FIRE (financial independence / early retirement).

In fact, I estimated my savings rate when I first started this blog, based on the an ‘aspirational’ amount I put aside each month combined with my work pension. The amount I actually ‘put aside’ varies and it seems that rarely do I simply ‘pay myself first’. There’s a lot more ‘noise’ going on than that. I try to be pretty frugal but I don’t force myself into a budget.

The savings rate – the most important FI metric?

Reading about FI concepts over the last year, it didn’t take too long to learn a few things about the savings rate among the FI community. A quick run-down:

  1. The savings rate is a nice, concrete metric to track your progress to FI and a tool for considering ways to increase your savings. I’ve found it a helpful way to think about savings.
  2. With no universally agreed calculation, you can’t necessarily compare each others’ savings rates. They can sometimes differ quite a lot. The crucial thing though is using the same way you calculate it each time if you want to track progress.
  3. FIers can get very excited and competitive about the savings rate and wear it as a ‘badge of honour’, which I guess may be due to the sheer self-discipline involved.

So, to point 2, all is not quite as simple as it looks with the humble savings rate. When I passed it all by the other half, he couldn’t fathom why it’s not just as straightforward calculation. I know that a lot has been said about this already in the FIRE community*, so this is just my personal take and the rationale behind it.

My real savings rate

So, after checking my bank statements for the last 4 months of spending, my monthly savings rate has been *drum roll*… 48.22%.

I’m okay with that, although it’s slightly lower than my aspirational savings rate. Also, this is rate only achievable as we’d previously worked hard to pay off our mortgage. I now notice that it means my spending is more than I estimated in my Life Design! However, my spending has been a bit higher recently** and my previous savings rate estimation hadn’t taken into account childcare vouchers that come out of gross pay – d’uh! Also, once I achieve FI, certain costs will disappear or reduce.

This is the formula I used:

Savings rate = (Net income saved + pre-tax pension) divided by (net income + pre-tax pension) x 100

Net income saved‘ = Amount put into long-term savings (hopefully just a single figure or two in your bank statement, but could also refer to income sources other than the main job).

Pre-tax pension‘ = If you have a workplace pension that takes your pension contribution at source (i.e. from gross pay), how much do you contribute? (A figure on your payslip).

Net income‘ = amount of income gained after paying tax and national insurance (payslip or bank statement).

After pondering the formula for some time, I think this suits me. But I get that what you take as your savings rate must depend on your own financial circumstances and how you plan to use the savings rate information. What you probably don’t want to do if you’re aiming for FI is to overestimate your savings rate significantly. Also, you may like to credit yourself with tax relief* and for this to positively affect your savings rate to recognise your FI-savvy choices. Here are considerations I made in coming up with my formula…

1. Expenses versus net income

While my formula is similar to the esteemed Firestarter’s formula (below), his looks simpler and is focused around ‘total savings’ and ‘expenses’ (i.e. calculating what’s spent and saved), while I prefer to use ‘net income saved’ and ‘net income’.

Savings Rate equation

There are two points here. First, Firestarter seems to assume that anything that’s not an expense is saved. So the total pot that the formula is out of (the bottom figure) is all expenses plus total savings. But this is sometimes not the case. Using only these two categories means I’ve not accounted for the income that I’ve not spent nor put into long-term savings. Only once the money’s been ‘put to work’ in long-term savings or investments is the money not an ‘expense in waiting’. The point of the FI savings rate is that you’re saving toward ‘early retirement’. Saving for an emergency fund or for a house deposit are very positive financial moves, but these are not really savings that can be used toward FIRE.

This is not only a safer way to look at it, but also – and this is my second point – the calculation can be done without having to work out your expenses. Firestarter makes a good point about not needing to know actual income for the formula to work (especially in relation to using the savings rate to calculate years to FIRE for relying on withdrawal rate). But, unless you’re constantly tracking expenses, this is a much easier way to go about tracking your savings rate. For me, the key to using it to track progress is to keep it simple.

2. Pension contribution and tax relief

My view is that your pension contributions should be included since they will go toward FIRE. For so many FIers, pensions are an important segment of their strategy, even if tied in until a certain age.

The reason why pensions are complicated to take into account is because they attract ‘tax relief’, some types from source (gross pay) and others after you’ve been paid. If your pension contribution is taken from gross pay, then clearly it needs to be in the bottom as well as the top part of the formula.

If you get tax relief that’s added to your personal pension, then I can see merit in using the actual amount saved as opposed to your contribution (in the top part of the formula). That is, if you put £200 into a SIPP (private pension), then your pension investment is £240 due to basic rate tax relief. The fact you ‘claw back’ that extra £40 that would’ve gone in tax should in my mind give the savings rate an uplift. Therefore, unless you’re putting a tonne of income into tax relief vehicles, which could then end up giving you a savings rate over 100% as Firestarter says, then I really think it’s fair enough.

It’s not as straightforward to ‘credit’ tax efficiency when pension is taken pre-tax, but one option would be to take the estimated post-tax income had you not got a pension to use as your bottom pension figure.

Yet on the other hand, I totally get that, for many, your savings rate is strictly what you have saved and that tax efficiency will see its way to growing assets. After much thought, I decided to simply have my pre-tax pension contribution in the bottom part of the formula..

3. Pension employer contributions

Whether you include employer contributions seems to me to be largely dependent on the kind of pension you have. I can imagine that for many workplace pensions, it would make sense to include employer contributions that are essentially treated like your own money and, I think if you do, then they should also appear at the bottom of the formula.

My situation won’t apply to most but, as I’m fortunate to have a generous employer contribution (beyond a ‘match’), including this would increase my rate substantially. I feel this ‘over-inflates’ my savings rate. In fact, my defined contribution pension depends on the number of years contributed and my salary, not the amount my employer (or I) contributed. You could even argue a logic for not including my contributions to the equation, but this would dismiss the kind of pot I’m currently nicely accumulating precisely for retirement.

For me, the savings rate gives me a figure I can have a sense of control over! I think increasing my savings rate by ten percentage points to account for something essentially outside of my control (unless I quit the pension scheme) could be disempowering.

3. Mortgage repayments

Since you need to live in your home, it’s not an investment you can draw on for FIRE, so I’d not include it (whether ‘overpayments’ or not). Rather, it’s an asset and of course you can use to downsize and release equity at a later date. Since there are so many unknowns there (when will you downsize? How much equity will it release to be invested?), I’ve no idea how you might ever incorporate that into the savings rate, unless you were planning to move soonish (which seems to defeat the purpose of high mortgage payments).

I realise it’s easy for me to say all this as we don’t have a mortgage anymore. When we were making very large mortgage payments in previous years, my savings rate was virtually zero or even minus amounts some months. I was mindful of this as I’ve been a saver my whole life. Breaking even was not an easy thing for me. But if you’re in this kind of situation, then forget about the savings rate as a metric for now, focus on assets. It’s great seeing what you owe the bank decrease. You are building your assets and that’s the bottom line!

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Dreaming as your assets grow…

So, what helps decide what to ultimately include in your savings rate?

Overall, the savings rate is more a way of keeping tabs on saving a chunk of my regular income that’s not toward specific purchases. Others may prefer it as a way to see how fast they are accumulating assets. However, if you want to know how it might affect when you ‘retire’ and live on your investments, then the former is clearly more helpful. It doesn’t seem to make sense to be ‘over-inclusive’ with your savings rate – you’d only be fooling your future self!

I’m not using my savings rate to calculate when I’ll ‘retire’ (to live on investment growth/income) for various reasons, but still my savings rate will affect how many years off work I have ‘earned’ (using mainly the capital saved but also growth). This, of course, is all an estimation, and doesn’t take into account things like tax implications, inflation etc. 

The benefits of knowing your savings rate

A quick perusal of FIRE forums and you’d be forgiven for thinking that broadcasting your savings rate is a ‘thing’ that FIers do. I do actually find it intriguing reading on how others are doing on their savings rate. I just make sure I’m not exchanging consumerist egoism for FI egoism!

Ultimately, I enjoy pondering ways to see how dropping or introducing a recurring expense might impact on the percentage saved. It gives you clarity to focus on the big-ticket items and less on making small, difficult changes that may in themselves make a marginal difference.

Pushing up my savings rate examples: Once our 30 hours free childcare kicks in: 9.3%***(yeah!); leaving the gym (which we did 2 months ago): 2.3%; cutting out our weekly meal out: 1.4% (nope, let’s keep it).

For me, the savings rate is an empowering tool in the face of making a zillion financial and consumerist choices everyday. It’s also a great way of seeing how you’re doing over time as life circumstances and salaries change. And they will, at least for the vast majority.

But is the savings rate useful if you’re not working on investment and safe withdrawal rates?

Yes, ultimately, if my retirement costs remain the same (and assuming growth to match inflation), then each year I’m currently working and saving 51%, I’m funding pretty much one full year out of paid work.

If Life 2 incurs fewer expenses (e.g. substantially decreased childcare cost, no work-related costs such as work clothes, and less spending to help you ‘cope’ with work), then clearly I could ‘buy’ more time out of paid work. Say you got your expenditure down to 33% by living happily being more frugal in the right places and didn’t need to spend as much as when in work, then clearly each year you work, with the 67% put aside, you are buying 2 years of financial freedom.

So, the savings rate is most useful if I’m projecting something that is constant from your current income (future spending or future withdrawal rate), but for my purposes, future spending rate is also an important metric, albeit estimated from my current spending.

Just one more year of work!

I hope that from doing another year’s work – just one more year! – my future self will be grateful for being 2 years “closer to FI”. Or to extend my midlife gap year. 🙂 Of course, there are also tax implications and the like, which are not taken into account here. What this is is a rough estimate based on a number of sensible-ish but unknown assumptions that act as a tool for motivation – now.

How do you calculate your savings rate? Have you found this article helpful or is there something you strongly disagree with? What expense have you managed to cut out and how many percentage points did that increase your savings rate?

___________________________________________________________

*Three posts that helped inform my ideas about savings rate: Early Retirement Now (nice representations, though I doubt many use gross pay as a measure; takes some decoding for the UK audience); The Firestarter (impressively detailed with more possible scenarios and reassuringly UK-focused); Choose FI (the newest of the 3 posts, and tells a less prescriptive story).

**The last 4 months were at least a little more expensive than on average, since it included a week’s family holiday in Tunisia and also 2 months of gym membership for myself and Little Firelite (which cost 2.7% of my income), but we’ve now unjoined.

***These are all my personal savings; Mr Firelite will also save his ‘share’, as appropriate.

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