Calculating your Savings Rate: Debunking the Myths
Welcome to part III of my financial independence planning series. You can view parts I and II here:
How to calculate your savings rate?
As we discussed briefly here, and ad infinitum on PF/FI blogs, your savings rate is the key factor in determining how long it will take before you can cut the cord and set yourself free into the wild world (or finally watch your box-set of Breaking Bad back to back, whatever waxes your board!).
On the face of it you’d think it was a simple equation. And I have good news for you… the conclusive formula to calculate your savings rate that I arrive at, at the end of this post, is indeed very simple. As often is the case though, the journey in getting to that point was a bit of a bumpy ride. For those of you who are short on time or are simply impatient you can skip to the final answer by clicking here. For those that want to dive into a bit of theory and myth debunking* shenanigans, strap yourself and prepare for the ride 🙂
Myth One – Mr Money Mustache’s calculation
My first stop in trying to work out how to calculate my savings rate was obviously over to The Early Retirement Commander in Chief Mr Money Mustache, who in his post on the shocking simple math behind early retirement, had this to say on the subject:
Well, I have a surprise for you. 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 payIf you want to break it down just a bit further, your savings rate is determined entirely by these two things:
- how much you take home each year
- how much you can live on
From those words I would derive an equation along the lines of something like this:
Savings Rate SR = Amount saved / Net (Take home) Salary * 100
Example: If you took home £30,000 after tax, and you saved £15,000 of it into your savings account, your savings rate would be 50%. Easy… end of article.
Oh but hang on just one minute… This may have worked well in times of yore, before the world of personal finance became complicated with supercharged retirement vehicles such as SIPPs, ISAs, Employer matched pension contribution schemes, or 401Ks, Roth IRAs and the like if you are a US reader. Nowadays thought this clearly won’t do, and for all of us and for our lab rat, theFIRErat (please see post II in the series to view the rat’s financial figures and assumptions for all calculations), things are more complicated than this.
If we plug in the initial example figures for theFIRErat, who is making good use of the tax advantaged SIPP, into the same equation we are now looking at:
SR = £24,000 / £34,763 * 100 = 69.03%
Now you know they say when something sounds too good to be true… Well it certainly sounds like that is unfortunately going to be the case here for our unsuspecting rat.
*SPREADSHEET ALERT* At this point I could see this whole thing was gagging for a spreadsheet**, so please take a look at the column “Scenario A” in this theFIRErat Savings Rate Comparisons spreadsheet. Here is a screen shot if you can’t be bothered to load it up in Google Docs.
As we can from my see a 69% savings *should* see our rat out of the race in around 9 short years, in which time the £24,000 a year contributions would compound to just £269,075 estimating a 4% real rate of return (which I am pretty sure it what the MMM post is using in his table and graph)
Now I’m no Nostradamus but even I can predict that our rat could be up the creek without a paddle if he quit with that retirement pot, and looking at the bottom row of that table “Would last X years with given expenses” we can see that yes indeed, it would only last approximately 19 years with his expenses of £20,037
Myth Two – Over 100% savings rate?!?!
Things get even more ridiculous when you consider our rat could actually pump the £20,000 into an employee retirement account before the tax man even gets his grubby hands on it. This would end up giving him a take home pay of just £20,073 (can you see why I chose that number for his expenses now people? Huh? Bueller? 😉 – There is method to my madness you see. Sometimes).
Let’s look at Scenario B in our table:
This is obviously wrong, and we can now be sure that comparing anything to take home pay just won’t do for our savings rate calculation as it just doesn’t take the tax advantaged retirement vehicles into account properly.
Myth 3 – Monevator’s calculation
Next stop on our magical mystery tour would naturally be to the excellent Monevator blog, who has this post on How to work out your own financial independence plan. The highlight for our purposes here is the following:
You probably know this number already, but just to make sure you’re getting as full a figure as possible:
- 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 the return assumptions that follow.
The number you’re left with is how much you should be saving a year. Divide by 12 for the monthly amount. Compare it to your gross income to find your savings rate. Then ratchet up the rate if you want out quicker.
OK… sounds a bit better. There is mention of Grossing up the pension contributions to tax into account tax relief! So we are now looking at a calculation of the form:
Savings Rate SR = Amount saved / Gross Salary * 100
SR = £24,000 / £50,000 * 100 = 48%
This sounds entirely plausible to me, however I will of course add a column to my spreadsheet to verify that everything checks out:
Here we can see our rat needs to save for a shade over 18 years to amass a portfolio of £650,000, and the number of years this will last him in retirement is that special magical number “Forever!”***. Not to be sniffed at! However by simply using the 4% rule on our rat’s expenses we can see that we are condemning him to a few extra working years unnecessarily:
Retirement Pot Needed = Expenses * 25
Pot = £20,073 * 25 = £501,825
Back to the drawing board!
Myth 4 – Including Mortgage Principal Payments as Savings
I was wondering whether to include my mortgage principle payments in my savings rate, and having read through this post on the ERE forum here I have whittled down the arguments to as follows:
- The argument for is thus: If I made any overpayments on my mortgage, I would definitely consider this as savings and include it in the percentage, so why not the actual part of my mortgage payment that goes to the principal?
- The argument against it is that whatever money you put into your house, it is not an income generating asset, so it will never support you.
The extreme example to prove that the argument against including it is if we consider someone who earns well and lives in a nice big McMansion. They could end up paying 40% of their “savings” into the mortgage principle, building up a nice amount of equity but never anything that actually produces passive income. In 22 years our table says they can retire but they could end up with £500,000 equity in the house and nothing to show on the retirement accounts front. This will obviously not do! They could just sell the house and live off the proceeds but I think we are safe to assume that someone who has bought such a house does not want to sell it to retire. Conversely someone who rents a much cheaper place, saves 40% into retirement accounts and builds up £500,000 in a retirement pot after should be good to go after 22 years and see no change in their current lifestyle.
There is definitely a significant value in paying off principle on your mortgage, and I will talk about that in more detail in the next part of the series when we cover Net Worth, but for now all you need to know is don’t include mortgage payments in your savings rate calculations, because the bottom line is, it totally messes them up. Spreadsheet column not even needed on this one 🙂
Myth 5 – Done by Forty can explain it to me properly 😉
So it seems I finally stumbled across the correct calculation at my blogging buddy Done by Forty’s post on his February Budget.
However even Done by Forty had a hard time explaining it to me in the comments:
Hey FIREstarter. So our method of calculating savings rate is to take our total savings (including both pre-tax and post-tax savings and any employer contributions to savings) divided by: (gross income minus all taxes). So those pre-tax savings amounts are the untaxed figures
“Gross income minus all taxes” sounds a lot like Net Income to me, which we proved was incorrect in Scenario A. However I looked at the figures in the post and it all made sense:
Total Spending: $1,620Total Savings: $10,000Savings Rate: 86.06%
Working back from that 86% figure I got the following:
86% = 10,000 / ( 1,620 + 10,000) * 100
This impressive savings figure would see DbF retire in less than four years if he keeps that savings rate up! (See Scenario E in the spreadsheet, I thought I’d add it in there for a bit of fun)
So it seems DbF knows exactly what he is doing, even though it may have come across a little muddled in the explanation he gave me in the comments. Thanks to DbF for finally showing me the way!
The only Savings Rate Calculation you will ever need!
Ok so thanks to Done by Forty I have finally found the holy grail of savings rate calculation formulas:
Where totalSavings is all of your savings whether post or pre tax, depending on whether the amount saved was post or pre-tax, and if you get tax rebates into your savings account then you count that as savings as well. So if you save £6,000 into a SIPP and get a further £4,000 rebated into it, your total savings (for that SIPP) are obviously £10,000.
In our initial example for theFIRErat this give him a savings rate of… drum roll pleeeeeeeease!
SR = 24,000 / ( 20,037 + 24,000) x 100 = 54.46%
Let’s see it on the spreadsheet one final time shall we?
This means he should have his F-You money pot of £501,825 in approximately 15 years and 3 months, using a rate of return at 4%. This pot will provide him with his £20,073 yearly expenses in passive income perpetually, for the rest of his life.
It’s strange when you first see this equation as it turns out you don’t really need to know what your income is at all, or at the very least, you don’t have to directly plug it into this formula at all. It turns out that this is because years to FI and savings rate (%) are directly linked without need for real numbers, hence the whole point of MMM’s table and graph in his post in the first place, which you will notice did not have any hard cash numbers in it.
For those that want the equation that links the two, here it is:
Where savingsRate is a fraction or decimal greater than 0 and less than 1. So if savingsRate is 60% it would be 0.6, and 1-savingsRate would be 0.4. Please note this formula cannot factor in compound interest in it’s basic form so it is not really much use to you, but I thought it was worth including to illustrate how inextricably linked that the fractions you save compared to the fractions you spend are to the number of years until you can retire.
MASSIVE DISCLAIMER ALERT: I am still a relative newbie to this and clearly am not a financial advisor or any such thing. This article is simply running through my methodology of how I have tried to work out these formulas and on how I came to my conclusions. If anyone has any better information or can spot an error in what I have said please do let me know and I will update the article, giving credit where it is due. Thanks!
Heaven must be missing a spreadsheet
I appreciate this was a very long article so if you made it to the end, well done and thanks for reading! I also hope you appreciate that I wanted to show the why and wherefore’s of the formula rather than just tell you it straight up and send you on your merry way, especially seeing as there seems to be a bit of confusion about it out there in internetland, even on other big name PF blogs.
As a little reward I would like to share another spreadsheet which I am calling my FI Calculators Suite
This has a sexy “compound interest calculator+” which not only calculates retirement pot growth over a given number of years, but also how long that pot would last given a certain expenses figure. I’ve included four columns so you can compare different estimates of rates, savings, and so on very easily as well. It’s pretty neat!
There is also a “Years till FI” calculator in which you can add your various yearly savings figures for various accounts (SIPP, ISA, and so on) and it will tell you the number of years it should take you to FIRE (I guess the name might have given that away?). Anyway it’s pretty cool as well, there are also four sets of columns so you can compare and contrast estimates once again. I will also be adding more tabs over the coming weeks to this!
As always drop me a line in the comments to voice your thoughts!
Thanks again! TFS.x
*I use the word “Myth” in the most light-hearted way possible here. I am not suggesting that MMM, Monevator et al are perpetuating ridiculous Myths around the internet about savings rate calculations, nor misleading any folk deliberately in any way. I freaking love both of those websites so would never say anything bad about them and actually mean it! Back ↑
**Some quick notes on how to use my spreadsheets…
- They are all publicly viewable, but you can’t edit them, so you need to save a copy to your own google drive (File -> Make a copy) or download (File -> Download As) to be able to edit/update them. If you don’t have your own google drive yet, get one now! It’s free and possibly the best productivity tool I have ever used.
- The big bright Yellow cells are the ones you can mess with and add in your own figures (or you could play around with mine to see how this affects things first, to get an idea of things)
- All other cells you generally need to avoid editing, as they’ll like contain formulas and so on. You can actually edit them, I can’t and wouldn’t stop you anyway, but I can’t be held responsible for the consequences
- On some spreadsheets I have tried to use colour coding to denote where one figure is used somewhere else, to give you an idea of what figures are linked to what. Back ↑
***A quick separate note on “Forever!” in the spreadsheets: This is not just something I’ve made up. The formula used in this cell returns an error when your retirement pot will never deplete to zero given the variables you supplied (It could just return infinity years if it was to be super useful, but for some reason it doesn’t and returns an error instead). So instead of showing an error, which makes my spreadsheet look broken, I decided to check for the error and output “Forever!” instead, which is actually much more useful to us 🙂 Back ↑