The importance of your savings rate in wealth creation
How to almost double your retirement nest egg with only an extra $5,000 in savings per year
Like most Jewish boys growing up in North America I went through my rite of passage into adult responsibility at the ripe age of 13 with the celebration of my Bar Mitzvah. Aside from symbolic recognition of a Jewish boy taking responsibility for his moral and spiritual conduct, the Bar Mitzvah can also be a relative cash bonanza for a young man. How the young man decides to manage their Bar Mitzvah cash windfall is the first real test of the young man’s moral conduct. Many proud parents will leave a portion of the Bar Mitzvah cash gifts, after putting some away for university or towards some other noble cause, available for their newly minted young man to manage. It is the first real encounter a Jewish kid has with the freedom money can bring. To spend or not spend (and save) is the question. My parents went a step further and invested my Bar Mitzvah money in GICs until I was old enough to decide what to spend, or invest, it in. It was a great lesson to watch the power of money growing over time and to develop self-discipline, putting off instant gratification for long term gain. It also provided a great foundation to one of the most critical insights for anyone that is truly serious about wealth creation:
While many believe to the contrary, the simple fact is that it is your personal savings rate that is the most important determinant in growing sustainable wealth over time
A surprisingly controversial statement, this axiom can make it seem for some that investing performance doesn’t matter. Of course it does. Certain extreme investing strategies, such as buying penny stocks, will have a materially negative impact on your net worth. Plus, the idea that we have to do a lot of the heavy lifting ourselves by making sacrifices today so that we can save and invest for our future can be annoying to say the least. Realistically speaking though, for most people, it is the truth. Unless, of course, you have Warren Buffet's investing prowess or you are the next Mark Zuckerberg with a can’t miss business idea.
Looking at the table below from Pension Partners you can see my main point. This table assumes a net income of $50k and no taxes or inflation. If you achieved the 5.5% saving rate per year over 30 years in the top right of the table, you'd only need a 1% return to exceed the amount accumulated over the same 30 years with a 9% return on a 1% savings rate.
The other objection I’ve heard towards this idea, that your savings rate is the most determinant factor of most peoples long term wealth, is the belief that if you just find the next Netflix or Amazon and ride those stocks for the next couple of decades you wont need to worry about savings. Sure, if you can hit the bulls eye with your picks savings wouldn’t matter. Alas, it is not easy picking stocks that deliver 4,000%+ returns like Netflix did during the last bull run (2009-2019).
The reality is that most of us will realize a more "typical" annual average return of 8% to 9%. Can some people do better than the 8% to 9%? Absolutely. If you have the time to learn and research, a long investing horizon and the risk tolerance you should try to beat the average. But 8 to 9% is "most likely" based on historical stock market performance.
In the most likely scenario of an 8% to 9% annual average stock market return, your savings rate will make the biggest difference in wealth accumulation. In case you were wondering, I believe asset allocation is the second most important wealth creation determinant for the typical investor.
Determining the savings rate that works for you
With so much riding on what you set as your personal savings rate (the percentage of your income that you put into savings) then, what is the right amount? There are three primary questions for you to answer to help you determine what the right savings amount is for you:
How much do I need to live on each year in retirement?
How much do I need to accumulate to finance this standard of living in retirement?
How much of a sacrifice am I willing to make today to realize my retirement goals?
A good financial adviser can help you answer these questions and build you a customized plan to reach your retirement objectives. In the meantime, here are some good rules of thumb from best-selling personal finance authors that can help inform what savings rate is right for you.
The average Canadian household is only able to save 3.2% of their income (as of January 2019). The US savings rate as of January 2020 was 8.4%.
My general philosophy on setting a personal savings rate is to not over think it, the key is to get started and adapt to the new adventures life will bring along the way.
The payoff of boosting your savings rate
To help you determine what is the right savings rate consider the following scenarios. In the first scenario, an average investor saves and invests 10% of their annual income of $80,000 over the course of 40 years. Assuming a typical return of 8.5%, this high saving investor will see their portfolio grow to $2.3 million by the age of retirement. In the second scenario, this same investor only manages to save and invest 5% of their gross income each year. Instead of investing $8,000 per year as they did in the first scenario, they are only able to invest $4,000 (5% of gross income) each year with an assumed return rate of 8.5%. By the time of retirement, their $4,000 per year contributions will have grown to $1.2 million. The difference between a 5% and 10% annual savings rate, or an additional $4,000 invested per year, has an almost doubling impact on your retirement net worth. That seems like a reasonable sacrifice to pay today for a $1.1 million incremental gain in retirement. Now imagine stretching yourself to eke out an additional 5% in annual savings - using the same parameters as above but substituting a 15% savings rate results in a retirement nest egg of $3.5 million – an incremental $1.2 million on top of what 10% saver is able to retire on.
It is easy to see the compounding effect each additional percentage point in saving today can have on your future lifestyle. As you go through your career and benefit from salary increases, bonus, and employer retirement savings contribution matching programs, it becomes even easier to increase your annual savings rate.
Accepting this idea that your savings rate is the most important factor in long term wealth accumulation does not necessarily mean that you need to make extreme sacrifices that impede your enjoyment of life today. As outlined in my Top money saving tips for wealth accumulation post, there are money saving practices that can be used without feeling a major squeeze. It is the difference between being cheap and being frugal.
Make it automatic - Pay yourself first
I believe most people have intentions to save but inevitably life gets in the way – whether it’s that unexpected car repair, a desire to take an unplanned vacation after a stressful few months at work, or some other valid excuse; human beings just aren’t wired to deprive themselves today for the promise of a great retirement in the future. So, if saving can be hard what is the answer? The most tried, true and often espoused by so called financial guru’s is rather simple – Pay Yourself First!
The most fail-safe and effective way to build up savings is to set up pre-authorized biweekly or monthly contributions that automatically transfers money from the deposit bank account for your paycheck into your registered savings plan
Paying yourself first through an automated cash withdrawal from your bank into your registered savings plan protects you from your poor savings habits. Getting money into your tax protected investing account (RRSP, 401k, or TFSA) before you have a chance to spend it helps ensure you stick to your savings goals and results in you adapting your lifestyle to fit this new financial norm. A small price to pay today for a big return in your golden years.