“Sometimes the questions are complicated and the answers are simple.” – Dr. Suess
Saving is by far the most important first step in any investment plan. Without a solid savings portfolio your investment decisions don’t really have much of an impact. Here are 3 additional benefits to saving more money.
1. Replace Less Current Income in Retirement
The general rule of thumb from financial advisors is that you will need enough money to replace roughly 70-80% of your pre-retirement income. And from that 70-80% the next rule of thumb is that a 4% withdrawal rate each year from your portfolio, adjusted for inflation, increases your probability of not running out of money.
Morningstar’s David Blanchett found that this rule of thumb varies considerably depending on your household saving rate. This from MarketWatch:
So, for instance, a household with income of $150,000 where pretax expenses equal 6% of income (the average amount contributed to a 401(k)) and where post-tax expenses equal 12% would need to replace just 65% of their pre-retirement income to maintain their standard of living in retirement. But a household that saved twice as much (pretax expenses equal 12% of income) would need only replace 55% of their pre-retirement income in retirement.
It seems fairly obvious that the higher amount of income you save now should lead to a lower proportion of income needed in retirement, but many people take these rules of thumb as being set in stone.
The average person doesn’t save 10, 15 or 20% of their income. If you do, either you won’t have to replace nearly as much of your income in retirement or you will be able to take higher distributions to spend more from your portfolio.
Either way, saving more now gives you more options with your money come retirement time.
2. Make up for Lower Investment Returns
There have been some rumblings in the past few years that future returns to investors could end up being lower than they have been in the past for a number of reasons (lower interest rates, slower economic growth, demographics, etc.)
Rob Arnott of Research Affiliates recently discussed this possibility:
People think that it’s a horrible thing to suggest lower returns. No, it’s not. If you’re expecting lower returns, you’re simply going to save more aggressively, spend more cautiously, work a couple years longer. Is that a disaster? Not compared with saving too little, spending too much, retiring too early, and running out of money halfway through your retirement.
Arnott is spot on here.
You have absolutely no control over the returns that the capital markets give you. You do control the amount of money you save to participate in those returns.
I have no idea what the future performance of the markets will be. We’ve had periods of underperformance in the past and there’s no reason that it can’t happen again. This is how market and economic cycles work.
But if you are relying on earning ever higher returns to achieve your goals you could be in trouble if they don’t pan out.
I still believe in the innovative growth engine of capitalism to churn out long term returns over time, but I don’t want to rely solely on those returns to build wealth. That’s why I save a large percentage of my income.
But what if investment returns are lower going forward? Save more and you don’t have to worry about it nearly as much. Investors were spoiled in the 1980s and 1990s with higher than average returns on both stocks and bonds so the savings rate slowly declined.
It’s time that trend reversed.
3. More Savings Makes You Happier
Another reason to save more is because it can actually lead to more happiness. Ally Bank released a study that broke down the percentage of people that reported to be extremely happy based on the amount the had saved.
They found that close to 30% of people with less than $20,000 in savings considered themselves extremely happy while almost 60% of those with more than $100,000 in savings said they were extremely happy.
And happiness improved as the amount of savings increased from the $0-20K range up to $20-100K in savings and even more above $100K level.
Ally also measured the happiness of people at different income levels. They found that happiness increased with more earnings up to $75-100K, but actually declined slightly for those making more than $150K.
The moral of the story is that the amount you have saved has a greater impact on your level of happiness than the amount of money you earn.