Each profession has its own collection of cliché jokes. After answering the “what do you do” question, I often hear “well if I give you $1000 can you turn it into 1 million?”. And while joking (I hope), it’s really just an amplified expression of what so many investors are actually seeking in their investment portfolio…unrealistic returns. Be it greed, or just a lack of knowledge regarding historical returns, many investors have hurt themselves by believing that an advisor or investment product can make up for their lack of saving.
According to the Bureau of Economic Analysis, the monthly savings rate for Americans currently hovers around 6%. And while an average doesn’t give us any insight into the savings rate of each demographic, the fact remains that most Americans aren’t saving enough. In fact, just doing a quick search on median retirement savings will show you just how wide the gap is between what people have accumulated versus what they need to reach their retirement goals.
So what should your savings rate be? Well…it depends.
This is part of the value of having a financial plan that is tailored to your goals. Your financial plan should take into account your current savings, current and future goals, as well as your expected investment returns in order to calculate a proper savings rate. And trust me, for most people it will be much more than 6%.
Absent a financial plan, a good rule of thumb is 15 percent of gross income. Depending on your personality, there are different approaches to achieving this rate of saving. I prefer to “rip off the Band-Aid” and adjust the budget immediately. We have an incredible ability to adapt to our income. That’s why there are people living paycheck to paycheck at all income levels. As our income rises, our spending tends to follow. By making the change all at once, it forces you to adjust your budget and spend less.
However, if such a drastic change would be too much of a shock (for you or your spouse), then try starting at 10 percent and increasing by 1 percent each quarter until you hit your target. While this approach will give you time to adjust your budget, you also run the risk of not making the needed adjustments in the future.
Whichever method you choose, the key is to get started now. As you can see in the graph below, a small increase in your savings rate can make a huge difference over time. Assuming a household income of 100k, a 7% rate of return, and a time horizon of 30 years, we can see how big of a difference a higher savings rate can make.
And the earlier you start, the greater these numbers become, thanks to the amazing power of compounding returns. In this scenario, the difference between the 6% and 15% savings rate is over $900k. Using a withdrawal rate of 4%, this translates into roughly $36,000 more a year in retirement income for our 15% saver!
But so often, investors tend to focus on investment performance as if it is something that is easily controlled. While investment returns are part of the equation, we have no way of knowing what they will be in advance. And betting your retirement on last year’s hottest mutual fund/fund manager is a strategy that has produced more losers than winners.
You are far more likely to reach your goals by implementing an appropriate savings rate than by hoping that an investment manager can turn your $1000 into $1,000,000.
No adjustment for inflation or salary increases were made. Additions were assumed to be made on a monthly basis.