Your Savings Rate: Why it is the most important metric in personal finance

euro notesA personal savings rate sounds like the most boring term in personal finance. It is something most people are not concerned about or have no idea what it is. However, I consider the savings rate as the single most important metric when dealing with finances.

Why it is important

Imagine that you are striving to achieve Financial Independence – a state in which you have assets generating income which exceeds your expenses. If you read this blog and follow the strategies, as a general rule you would need to have stock market investments which equate to at least 25 times your annual expenses. Such an asset base is huge and can take many years to build up.

As an example suppose your core monthly expenses are £1,000 and your monthly net income is £3,000. You would need an asset base of £300,000 to be Financially Independent (£1,000 x 12 x 25). At a healthy 50% savings rate (£18,000 per year) it would take 10 years to reach this goal as determined by the compound interest calculator below.

compound interest calculation example

300K accumulation at 50% savings rate

This calculation assumes a typical annual stock market return of 9.5%. As £300,000 is a lot of money it is easy to presume that the bulk of the amount would be raised due to investment returns. Surprisingly, this is far from true; compound interest, what Einstein called the eighth wonder of the world, only starts to kick in with a meaningful effect after a long time. Even this 10 year period is relatively short when thinking of investments.

Over 10 years the amount raised by savings would be £180,000, a proportion of 60%. If investment returns are less than 9.5% it would take a much larger proportion of savings to achieve the same goal within this time frame. It is entirely plausible for investment returns to be as low as 5%. At this rate the investor would need to save an astonishing £276,000, or 92% proportion, in the 10 years in order to achieve their goal.

Savings rate needed at 5% returns

Savings rate needed at 5% returns

These calculations prove that along with keeping investment costs low, avoiding debt and minimising taxes, a high savings rate is one of the sure ways to guarantee accumulation of reasonable amount of wealth.

Proportion of savings needed at a 9.5% return vs 5% return rate

Proportion of savings needed at a 9.5% return vs 5% return rate

You can not control or forecast investment returns but you can control how much you spend which directly impacts the savings rate.

Fascinating alternative scenario*

The above two investment return rates are very realistic. Just for fun, if we assume an overlay optimistic return rate of 20%, the size of nest egg generated would be truly astounding. I repeat that this is overly optimistic and would be in the world of the likes of Warren Buffett. Such a rate would result in a portfolio of nearly £600,000 over 10 years! This is very unlikely but to give yourself any chance at this the high savings rate would be key. The good old savings rate stops being boring here.

Portfolio value with very optimistic 20% savings rate

Portfolio value with very optimistic 20% savings rate

Calculating your Savings Rate

There are many ways out there for calculating a monthly savings rate. Here is my take on this. The savings rate has to be taken in context of net income which you can actually access rather than gross income. Therefore the savings rate would be the proportion of money which is put away in relation to the money which is actually made available. Savings rate = sum of savings / net income.

Sum of savings can include the following:

  • savings into cash accounts
  • investments in stocks and shares
  • personal pension contributions
  • employer pension contributions
  • government pension tax relief payments
  • income saved from other employment sources such as business proceeds

Regardless of which method you use, the key thing is to maintain a high rate. There is little point investing a tiny amount in even if you get exceptionally high returns. As this year has shown, market volatility is never far away. You can only control what you can and when opportunities arise it will be those who maintained high savings that will reap the benefits.

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