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My FI Journey » Investing, Reflections, Retirement » Savings Rate is the Key to Achieving Financial Independence

Savings Rate is the Key to Achieving Financial Independence

1064585_time_is_money_1Achieving financial independence requires only two things, a high savings rate and a descent rate of return.  But what constitutes a high savings rate?  What if you just want the lowest possible savings rate that will still get you to a comfortable retirement?  Can you really expect to achieve financial freedom faster if you load up on high yield stocks?  Answers to all of these questions are revealed as we explore the magical worlds of compound interest and savings rate below.

Compound Interest

You’ve probably heard some version of the apocryphal Einstein quote about there being no greater force in the universe than compound interest.  Compound interest is indeed pretty powerful.  In case you are unfamiliar, compound interest is interest that is applied not only to the principal, but to all the previously accrued interest as well.  And compound interest is made even more powerful by adding regular contributions of principal.

For example, if you invest $1,000 ONCE and let it grow at 10% interest per year, it will become $2593.74 after 10 years.

If you invest $1,000 per year and let it grow at 10% interest per year, it will become $15,937.42 after 10 years.

Of course, it doesn’t have to be 10% per year.  It could could grow at 5% or 1% per year.  So how do different growth rates effect your net worth?

Effect of Rate of Return on Net Worth

I’ve put together the following example to illustrate just how powerful compounding can be at growing net worth so that you can achieve financial independence.

We’re going to assume someone pulling in $70,000 per year.  He currently saves 20% ($14,000) of his income annually.  He will consider himself financially independent as soon as his investment income fully replaces his current expenses, $56,000 per year ($70,000 gross minus $14,000 savings = $56,000).  He can pick from a variety of different savings vehicles ranging from CDs earning a paltry 1% per year to a stock market index fund pulling in 10% per year.

For the purposes of this model we’ll assume that he lives in a very static world without inflation and that he never gets a raise.

The below graph shows how each of his different investment options will grow over time.  The red line represents $1,400,000.  The amount he needs in the bank in order to safely withdraw 4% per year.  A more conservative 3% safe withdrawal rate would shift the red bar down a bit.

Notice how only three (the 8%, 9%, and 10% investments) of his possible investment choices will allow him to achieve financial independence within a 30 year time horizon.  26 years is the earliest that he’ll be able to achieve financial Independence with this strategy.

Rate of Return Example

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Effect of Savings Rate on Net Worth

Compound interest doesn’t look so great if you want to achieve early financial independence.  It’s great, but a 26 year timeline is long for those of us who who with early financial independence in mind.

You might suggest that we start shooting for investments with a rate of return well past 10%.  Remember that interest or yield can also be a measure of risk.  So the higher the rate of return goes, the greater the chance that we might start losing money.  To be an investor, one must embrace risk, but I’m not a gambler, so don’t expect me to start speculating in penny stock futures anytime soon.

So what can we do to get to financial independence faster?  We can adjust our savings rate.

Your savings rate is simply how much of your disposable (after tax) income that you save.  Americans are abysmal savers, which probably explains why working longer is becoming the new retirement.

One very simplistic way to think about savings rate is to assume that you are just working, spending some money, and then shoving the rest under the mattress.  How long would you have to work in order to buy 1 year of freedom?

  • 10% savings rate – Work 9 years for 1 year of freedom
  • 20% savings rate – Work 4 years for 1 year of freedom
  • 30% savings rate – Work ~2.33 years for 1 year of freedom
  • 40% savings rate – Work 1.5 years for 1 year of freedom
  • 50% savings rate – Work 1 year for 1 year of freedom

Savings Rate Plus Compound Interest Delivers Early Financial Independence

We can all be a bit more sophisticated than shoving money under a mattress. We can invest in the stock market and couple the power of compound interest with aggressive savings.

For this example, we’ll start with the same fellow above who earns $70,000 per year.  He can either spend his money or invest it in the stock market for an 8% return.  But how much money should he be investing per year?  The graph below shows savings rates ranging from 5% ($3,500 per year) to 50% ($35,000 per year).

As savings rate increases, the crossover point decreases.  The crossover point is the point where your annual investment income is the same as your annual expenses.  Basically, the point where you’ve achieved financial independence.

The red lines on the graph below start at the crossover year and show continued portfolio growth should our example saver continue working and saving at his current rates.

You will notice that with a 50% savings rate and an 8% rate of return, financial independence is achieved in 15 years.  50% is kind of aggressive (I speak from experience on this), so how about 30%?  That leads to financial independence in only 23 years.

Savings rate graph

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Conclusions

Savings rate and rate of return are both very important components of your investing plan.  Save aggressively and, at a minimum, get yourself into a low fee stock market index fund.  You can win the early financial independence game with just an index fund or two.  There is much more to the world of investing like valuation, rebalancing, and diversification.  But if you aren’t saving money, adding all the investing bells and whistles to your portfolio isn’t going to amount to a hill of beans.

The other important piece of information to take away from this post is that if you are saving only saving 15% or less of his income, financial independence is basically an impossibility.  Did I mention before that most of America is screwed because they refuse to save? Maybe you’ll be able to retire on time or a bit late with the help of Social Security and maybe a pension. But it’s not going to be a very enjoyable retirement, since your standard of living will be forced down.  20% is the minimum that you should be saving!

Readers:  What’s your savings rate?  Have you thought about it?  Do you feel that you’re on track to financial independence or retirement?

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22 Responses to "Savings Rate is the Key to Achieving Financial Independence"

  1. I’m saving 80%+ from my take home so far this year, although not all of that is going to investing. Although I’m still 75%+ for FI savings. With 8% more being taken out post tax for my ESPP and 6% pre-tax for the 401k, just to get the match. Of course a lot of this is due to my job and being gone from home. I’d be much more tempted to spend money if I were home all the time, but it’d still be 50%+ if I made the same amount.

    I like the charts. If you’re aiming for early FI, especially extreme early FI, savings rate is much more important than your return because you simply don’t have the years for compound interest to work it’s magic.

    1. Side note: You’re getting pretty close to sub 200k Alexa Rank. Keep up the good work!

      1. MFIJ says:

        Thanks! I think it’s moving along nicely for how new this blog is.

    2. greg says:

      I’m in your boat, JC, investing around 78% of post-tax income (assuming I don’t get cancer, etc.). Maybe the article can get an addition for the very real reality of high savings rates? ;-)

    3. MFIJ says:

      I wish I could get up to a 75 or 80% savings rate. But that’s not possible without either moving to a much cheaper area or significantly downsizing. Both of which aren’t feasible options.

      I am only calculating my savings rate based on my base salary. If I throw in my bonus, perks, tax refunds, gifts, dividend income, etc, my savings rate would probably be higher.

      Compound interest starts becoming crazy powerful around the 20-30 year mark. If I never retire and keep the same savings rate, I’ll wind up with more money than I know what to do with.

      1. Evan says:

        wow I am jealous of your savings rates! I have never looked at the savings rate = financial freedom. I’d love to see how that chart changes based on different income rates.

        1. MFIJ says:

          Evan,

          Thanks for stopping by!

          The chart actually stays the same based on income rates. It’s all about savings vs expenses. It does, however, get a lot harder to have a higher savings rate if you don’t make as much income.

  2. What a very thorough exploration! I did a post not too long ago that dug into a Money Magazine article that claimed that 16% was the optimal savings rate for retirement (assuming you were going to work for 30 years). Unfortunately I plan to retire much sooner than 30 years so I will need to resort to extreme savings and creatively if I am to be successful.

    1. MFIJ says:

      I think 20% is the minimum for retiring in 30 years. But then again I kept the expenses flat and didn’t account for social security. Most financial planners would drop the expenses to 80% and start adding in social security. So 16% might be about right given those modifications.

  3. Your savings rate is far more important than your rate of return. This is a hard concept for our younger generation to understand. With a high savings rate you don’t have to take a lot of risk in the stock market.

    1. greg says:

      To be pedantic, I would focus on the magnitude of expenditures required for happiness rather than “savings rate” since the latter implies the need to work to provide for basic essentials; isn’t being independent the end goal of FI?

      IMO half the battle is challenging the social assumptions that people work 50 more years (relative to my case) than someone gunning for real FI.

      1. MFIJ says:

        I think that the social assumptions are built around current spending and savings habits. If the average American is only saving around 5% of their disposable income, then yes, they’re going to be working for another 50 years. And if everyone is saving so little, then they will all be working for a very long time and that becomes the social norm. Once it’s the norm, then all advice is tailored around it. You can find tons of financial advisers who will tell you to save 10% of your income. Probably very few that would recommend 30%, 40%, or 50%.

    2. MFIJ says:

      The power of savings rate isn’t something that comes naturally. Perhaps it’s because saving in the 30-70% range is so far from ordinary that no one does the math or talks about it. If you’re only saving 0-20%, you’re going to be working for a good 30-40 years before hitting anything resembling financial independence.

  4. greg says:

    re: America is screwed:

    “According to recent census figures, Americans ages 55 to 65 had about $45,000 in savings and assets, not including their homes.”

    http://www.npr.org/2013/03/27/175262508/planning-for-retirement-when-savings-falls-short

    underlying data: http://blogs.census.gov/2012/06/18/changes-in-household-net-worth-from-2005-to-2010/

    1. MFIJ says:

      I remember reading that this morning. When we’ve got an average savings rate of around 5%, a $45,000 net worth after 30 years of working is about right.

  5. We’re saving about 50% without a lot of effort so I’m happy with that. Once our house is paid off, we should be able to save about 70-80% and then we will get ahead real quick!

    1. MFIJ says:

      That’s awesome! It sounds like you’ll hit financial independence in a few years. Keep it up!

  6. Thanks MYJI, these charts really illustrate the benefits of a high savings rate.

    A savings rate of 78% is amazing! I’m guessing you’d have to be mortgage free to achieve that. One of the big questions here is the age at which you start saving. There’s a big difference between setting a 30% savings rate at 20 or at 35. Personally, we are shooting for a 40-50% savings rate on net income.

    1. MFIJ says:

      I’ve got about a 50% savings rate at the moment. In order to get to 75%, I’d need free housing. Or a much more lucrative job.

      40-50% is solid. The real trick to extreme saving is not hamstringing your lifestyle in the process. If you’re miserable, you’re not going to be able to keep your savings rate up. Even at a 50% savings rate, you still need to be able to keep it up for a decade in order to hit financial independence.

  7. [...] Savings Rate Is The Key To Achieve Financial Independence by My FI Journey [...]

  8. Closeiy says:

    high savings rate + the necessary yield of the overall portfolio make it successful, thanks for pointing this out in so much detail. especially like the ‘saving rate effect on portfolio value’ chart. When looking round the web for something to calculate this for my specific situation, I stumbled over the financial independence calculator ficalculator.org, this gives me still 19 years to go for, so I should keep it up.

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