In the bi-weekly Stuff Our Parents Never Taught Us series I will introduce and clarify basic financial concepts in an attempt to increase the level of financial literacy among my Millennial peers. For some bizar reason, the majority of our parents didn’t think it necessary to teach us the 101 course of personal finance. If you’re over 18 and have no idea what stocks and bonds are, or how interest rates and dividends work, this is for you!
The first three parts of this series focussed on compounding interest, inflation and the 4% rule. If you’ve read those posts it should be clear to you by now that you should invest often and early on in your life to take advantage of the magic of compounding interest and to offset the effect of inflation eating away at your nest egg, from which you can safely withdraw 4% of capital each year after reaching your retirement goal.
What you don’t know yet is how long it will take you to get there! Say you want to leisurely retire on €40,000 every year, which is rather high when you’re living a frugal lifestyle, but not too extreme either depending on your personal situation. Applying the 4% rule to €40,000 requires you to build a retirement fund of €1,000,000.
Whoa there, Mr. Evil. One million euros sounds like it will take a very long time or is even completely out of reach. It is and it isn’t. Enter the savings rate.
Imagine you earn nothing at all, live off berries you find in the woods and sleep in a mouldy yet cozy cave. You’ll be financially independent, retired or free – whatever you want to call it – from day one. Since you spend €0 to maintain yourself, you’ll need an investment portfolio of exactly 25 times zero to apply the 4% safe withdrawal rate.
Now imagine you are the CEO of a Fortune 500 company, make 10 million euros every year and live a luxurious life that costs approximately 10 million euros on a yearly basis. Even though you live in the biggest and nicest house in town, you’ll never be able to stop working since your portfolio is worth an abysmal €0 instead of the necessary 250 million euros.
Even though both examples have a net worth of exactly nothing and nada, person one enjoys a worry-free retirement, while person two will never be able to sustain his current lifestyle without continuing to work.
Living on €0 is, of course, just as implausible as the fact that you take home a €10,000,000 salary. But the above logic gives us a clear idea on how the math behind saving works. If you spend everything you’ll never be able to quit your job. Conversely, you’ll instantly be able to retire when you don’t spend anything at all.
Let’s take the example of someone who makes €25,000 after taxes, follows the average Belgian savings rate of almost 10%, has a 5% return on his investments after inflation, and plans to apply the 4% rule when he retires. It will take that Belgian 51.4 years to grow his portfolio to a retirement-worthy nest egg.
That’s over six years longer than the standard retirement age in Belgium!
For the average Canadian (5% savings rate) building a retirement portfolio would take over 65 years. A US citizen (4.1%) following the advice of his peers needs almost 70 years. Swiss retirees (13.1%), the most avid savers of the OECD countries, also need to work well past their sixtieth birthday to comfortably quit their jobs at 45.4 years.
Math never lies of course, which you can check out for yourself with the retirement calculator. The table below gives the years until financial independence based on the 5% return on investments after inflation and the 4% withdrawal rate taken in the examples above.
|Savings rate (%)||Years Until Retirement|
Save as much as you can! It’s not about how much you make or how well you do on the stock market, but how much you pocket every month.
Even though I wrote about how the highest income tax in the west impacts reaching financial independence, the truth is that it doesn’t really. Yes, you’ll earn less because of your higher contribution to society, but financial freedom is not about earning more. It’s about balancing your income and spending.
If Mr. Evil needs his one million euros to retire within a 20-year time frame on a €40,000 budget every year, he better earn at least €80,000 to hover around a 50% savings rate. Otherwise he’s not going to make it.
Saving that much sounds like a chore or like you have to make a lot of sacrifices, but the truth is that a lot of personal finance bloggers have savings rates well above 50% without losing out. Will saves over 85% of his income. The Frugalwoods keep 82% of what they make. Jason from Dividend Mantra manages to save almost 60% of his income, even after quiting his full-time job. Kipp normally doesn’t spend around 65% of his paycheck. I can go on, and on.
Of course, saving or frugality shouldn’t be a goal in and of itself, but a way to improve the quality of your life, both now and in the future. Time is money, which means money can buy you time. If you save enough of your money, it will allow you to buy time by retiring early.
That’s why I aim to save and invest at least 50% of my paycheck on average. Knowing I’ll be financially free in about sixteen years is the best and most liberating feeling in the entire world. I’ll literally be able to do anything I want, whenever I want.
Which savings rate do you aim for and why?