Savings Rate: An Income and Saving tug-of-war

And how I look at improving mine

Hi!

When trying to track when I can reach financial independence, a simple metric to track is my savings rate. It’s fairly straightforward - increase my savings rate, and I can reach financial independence faster.

Calculating Savings Rate

Calculating savings rate is simple:

Savings rate = Savings / Income

From the perspective of financial independence, savings takes the form of how much I invest out of my income. Anything else is practically an expense from that view, because it’s not going towards retirement.

Defining income is where things get a little complex (or how much we can make of it).

A simple method is to use the income that hits our bank account. This is income after deducting direct taxes, and compulsory contributions like EPF. This is simple to track, and is the money that we have control over on how to spend and invest.

If we want to go full nerd, we can classify income as the pre-tax income from our jobs. Now everything that’s deducted is an expense, like income tax and other direct taxes. This is more comprehensive, but provides more holistic view on the theoretical “inflow” and "outflow” of the money we earn.

Choosing which one to use is a matter of convenience and insight, because in the end savings rate is just an indicator and what matters is the moolah in my retirement corpus. My recommendation is to pick one and stick to it so that the change in savings rate can be tracked over time.

The complex method is more insightful in the way that it treats taxes as another expense, and not an inevitability. If it’s just another expense, we can start thinking of how to optimize it and boost our savings. For example, investing in PPF can help with deducting up to Rs. 1.5L from our income when filing taxes. But one drawback is that we need to perform a lot of accounting and tracking to calculate the savings rate. Sure it’s comprehensive, but is that effort worth it?

Personally I go with the simpler method of (investments) / (take-home income). Sure it’s not comprehensive, but I just need it as an indicator to see if I’m continuing on the right path for achieving financial independence. And it saves a lot of time.

How much savings rate is a good savings rate?

A simple rule of thumb for achieving financial independence is to invest at least the amount that we spend. For example, if I spend X over a month, I need to make sure to invest at least X for that month. That’s a savings rate of 50%.

Assuming that my investments grow with the pace of inflation and I don’t change my expenses drastically, I can be confident that when I retire I have the expenses for a month socked away. It also helps me spend my money guilt free and not keep track of my expenses because I know that I am not “stealing” money from my future self by spending it all today.

If I can at least do this, I only need to work for half of the rest of my life. Assuming I live for another 60 years, I only need to work for 30 more years. Well, if I want to achieve financial independence quickly, this is not enough. But it was a good starting point to get my financial life in order, and what I tried to do when I got my first job. I tried to keep at it even when I had major expenses like replacing my laptop, and paying my security deposit (which I considered an expense to be absolutely safe) for renting a place.

My experience with savings rate

To achieve financial independence quicker, I decided I would save twice the amount I was spending (66% savings rate), or even three times (75% savings rate). So in effect I could cut the time I need to work by saving more. Imagine, with 75% savings rate I only need to work for 15 years out of the next 60 years! The easy way was to cut expenses and invest more.

This might have been possible when I was at the start of my career and most expenses were indulgences. But slowly it kept cutting into how I would buy things. For example, I could have bought a better bed with a more comfortable mattress that would last longer, but I chose to go with a much cheaper alternative which started creaking soon after purchase.

I soon realized that this was not sustainable. I could cut costs and boost that savings rate, but in a way I’m reducing my quality of life in the present. It’s not realistic that I could life a comfortable life with such kind of purchases during retirement, considering I will estimate my expenses taking my current expenses into account. And hey, money is there to be spent. I can’t take it with me after I die. So might as well spend some of it to make me my life better.

I find it better to focus on increasing my income to boost my savings rate. Once my expenses are stabilized and I know they are not extravagant, I can work on gaining expertise in my career to increase my income.

I find increasing income easier than cutting costs and trying to increase the returns from my investments. I like to live a little comfortably, and don’t have the ability and time to outsmart professionals in the market to get better returns than the index. So the easier metric to optimize is my income.

Wrapping up

To increase my savings rate and get financial independence faster, I am focusing on getting ahead in my career and working on promotions.

Promotions = more cash = less time I have to work for money.

Until next time!

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