The origin of the 70% saving rate
In the financial planning world, there is a consensus that everyone should have a saving rate for their income. Where there is deviation is the question of how much. More precisely, what percentage of our income should we save? The latter question is more difficult because it depends on how long we anticipate living and how much we will need to spend in the future. The amount we anticipate spending in the future, in turn, depends on our future lifestyle and other unforeseen events (such as illness and a general decline in health).
Good: start with 10% saving rate
Most people start out saving 10% of their pay and live off 90%. This percentage is chosen because it’s achievable. Or a more historical explanation is that it’s what The Richest Man in Babylon says to save. Whatever its origin, saving 10% of our income is very easy. We don’t really miss the 10% and it causes us no pain. This is what most people are comfortable doing.
But there is a quiet movement behind the scenes that is encouraging people to save at a much higher rate. This is the group of people achieving FIRE – Financial Independence, Retire Early. Mr Money Moustache has this blog which explains it well. The higher saving rate isn’t just a bit uncomfortable. It actually pushes us beyond our comfort limit into the realms of extreme discomfort. If we want to play with FIRE, we must step outside our comfort zone.
Better: increase the saving rate to 70%
The idea is that if we save a higher amount, we reach our magic number for financial independence a lot earlier. Converts of the higher saving rate tend to gravitate towards a 70% saving rate. Why 70%? My take on this is that the table on MMM’s blog post shows this is the lowest percentage that allows us to be financially independent in less than 10 years. Psychologically, the idea that we can stop working for money reasons alone within 10 years is very enticing. This is especially attractive for someone who is in their 20s – imagine saying to someone that you’re financially independent at the age of 30 (which incidentally, is what MMM did)!
Is it 70% of pre-tax or post-tax income
Now that we’re onboard with a 70% saving rate, a common question is: are we saving 70% of pre-tax or post-tax salary? Pre-tax salary is the salary that we were offered when we got the job, without any taxes taken out. Post-tax salary is the amount of pay we take home in our bank account after taxes are taken out by the employer.
Generally, the saving rate is a post-tax saving rate.
This makes sense because a pre-tax saving rate has an uncontrollable element, being the tax rate and we don’t control the tax rate, the government does. In most countries where this movement is gaining momentum, the tax rate alone is very close to 30%, leaving not much for saving. So to be clear, the 70% saving rate is generally the percentage of post-tax income that is saved.
What about salary sacrifice?
This becomes a bit tricky if we work for an employer who offers salary sacrifice. The salary that is sacrificed comes out of pre-tax pay. So how do you work out 70% of post-tax pay if the salary that is sacrificed is out of pre-tax pay? This is where I think we tend to lose sight of the forest for the trees. The forest is the idea that we want to save 70% of our income. The tree is the exact amount we should save. How we calculate the pre-tax amount so that it is equivalent to 70% of post-tax income really doesn’t matter because if we are saving at least 70% of post-tax pay, then anything above and beyond that is simply extra. Whether and how we account for the extra is inconsequential.
One way to calculate how much salary should be sacrificed so that we are still saving at least 70% of post-tax pay is to work out the net annual salary (that is, gross pay minus tax). Divide this amount by the frequency of the pay and take 70% of that amount. This is the minimum amount that should be sacrificed as salary. To use hypothetical numbers, say my salary is $100,000 and the tax that is taken out of this annual salary is $30,000 (for simplicity I’ve used a flat tax rate of 30%). The maths for this would be:
Net after-tax salary = $100,000 – $30,000 = $70,000
Fortnightly pay = $70,000 / 26 fortnights = $2,692
Save 70% of pay = 70% x $2692 = $1884
So if I sacrificed $1884 of salary every fortnight, I know I’m saving at least 70% of my income. This is not an exact science, but don’t forget the forest for the trees.
What constitutes ‘saving’ anyway
Another common question that gets asked is: what constitutes saving? If I have a mortgage and I am putting the extra money into paying off the mortgage, does that count as ‘saving’? The rationale being we’re ‘saving’ up for our home.
Short answer: No.
A mortgage is still an outgoing that we need to commit to every month and that money goes into someone else’s bank account (in this case, it’s literally the bank’s account). When we save our money we have a choice to vary the amount or stop the saving altogether. Paying a mortgage does not give us the choice to vary the amount or stop altogether. So anything that we don’t have discretion on whether to keep paying and that does not increase the balance in our bank account is not saving. In addition, a saving is an amount that we are at liberty to withdraw and use at any time.
Paying off the mortgage is not a ‘saving’
The argument might be that once the home is paid off, we’d be able to ‘withdraw’ the equity in the home by re-mortgaging it in the future. The locked up value is, therefore, a ‘saving’. Again this is flawed. Unless and until we re-mortgage the home, it is not an amount that we can withdraw at our discretion. The discretion to use the home equity still rests with the bank – if the bank doesn’t approve our mortgage application, we won’t have the funds to withdraw and use.
So we are saving our money when we put money into our bank account AND we have the discretion to withdraw it at any time AND we can decide to stop saving at any time.
When 70% works and when it doesn’t work
A 70% saving rate is an indisputably high rate. So how does anyone actually achieve this!? There are 4 possible scenarios, depending on a person’s income level and commitment to large sums of debt:
(A) Someone who is on low income and have committed to large sums of debt.
(B) Someone who is on low income and have not committed to large sums of debt.
(C) Someone who earns a high income and has committed to large sums of debt.
(D) Someone who earns a high income and has not committed to large sums of debt.
In order of easiest to most difficult to save 70%: D, B, C, A
It’s easy for some, not so easy for others
Scenarios A and C are often people who have discovered this movement later in life. This group of people are likely to have a mortgage, a family, a credit card, school fees, etc. This group will find it most difficult to save because the large sums of debt have inevitably tied up much of their post-tax income. The committed debts will continue to affect their saving rate unless and until the debts are paid off.
Scenarios B and D are often people who have either discovered this movement early (scenario D) or are fresh out of college or university (scenario B). This group will find it easiest to save 70% of their post-tax income just because they do not have much debt commitments to tie up their post-tax income.
So the short and sweet of this is that someone who has discovered the 70% saving rate early in life is going to find it easier to save compared to someone who discovers this later in life or has already committed to large sums of debt by then.
If we’re late to the game, how can we make this work?
If we’ve only just stumbled on the concept of FIRE (Financially Independent, Retire Early) or ERE (Early Retirement Extreme) or MMM (Mr Money Moustache) later in life are we doomed to work forever?
Nope. And this defeatist mindset won’t help either.
A high saving rate is dependent on two things: our spending and our income. Even for those of us who have entered this movement later in life, we can still achieve a high saving rate. It may not be 70% but it’s certainly higher than the conventional 10%. The way to do this is controlling our spending and our income.
By eliminating our spending, we can add to our saving rate. When we eliminate a dollar from our spending, we add a dollar to our saving. The keyword here is ‘eliminate’, not delay spending. Eliminating means cut it out completely. Forever. The end. Gone.
To start eliminating our spending, first make a list of what we’re actually spending money on. For six months, track your spending. List everything you pay for – and I mean everything. If you’ve never tracked your spending before, this exercise will be daunting. It will be overwhelming to constantly write on the list throughout the day. To make it easy, I suggest you initially focus on the big-ticket items – items that you pay for only periodically rather than the weekly or daily costs. You’re already geared up to take action so you may as well tackle ones that give you a greater return for your efforts. Big ticket items would include mortgage, rent, phone, TV, Netflix, insurance, school fees, etc.
From that list, work out what you can eliminate completely – this can include reducing the amount you’d pay periodically, such as your phone plan, insurance or interest rate on a mortgage. If you can negotiate a reduction in these costs, you’ve eliminated some spending on the big-ticket items.
After doing this exercise, put it in a diary to revisit these big ticket items every 6 months. Then move onto the more frequent expenses, starting with weekly or fortnightly costs (such as fuel), then moving onto daily costs (transportation, food, treats, etc).
Increasing our income will immediately increase our ability to save a higher rate provided we maintain our existing spending level. So how does someone increase their income?
(1) Reduce the amount of taxes you pay
Make sure you do this legally. Salary sacrifice is an effective way, for those fortunate enough to have an employer who offers this. Making sure you’re claiming the deductions you’re eligible to claim.
(2) Increase your existing income
When did you last ask for a pay rise that you know you deserve? How about putting your hand up for a promotion? Perhaps a change in employer may increase your income.
(3) Increasing your income source
Start a side-hustle, think of other ways you can increase your income, even for a short time. If you’re a tradesman, perhaps work a few extra hours for the next 30 days. If you’re a stay-at-home parent, offer to babysit for working parents. Maybe you have stuff around the home that you no longer want – sell those. If you like baking and cooking, make extra and sell to neighbours and friends.
So in summary, we can decide to continue saving 10% comfortably or we can challenge ourselves and push outside our comfort zone for that 70%. Just because we’re late to the game doesn’t mean it’s game over.