“Save 50% of your income and you’ll be retired in about 17 years”. Brilliant. But… have you ever actually tried to work out your personal savings rate? Do you use gross income? How does income tax factor in? What about pension contributions?
When figuring this out, no standardised approach currently exists that I am aware of. This causes endless debate across FI focussed boards and podcasts alike, thus producing wild and wacky results depending who you ask or listen to.
I think that consistency is key, so today I propose a model I’m going to dub “Investing Rate”. It’s simple, it’s easy to calculate and it shows just how much of your accessible money you’re truly putting away.
What is the need for a new model?
As I hope my intro suggested, this problem is not only rather frustrating but it’s a common question. Because nobody has suggested a clear cut way of calculating savings rate, it’s tough to use benchmarks and it’s even tougher to communicate on an even keel when talking to others. Search “Savings Rate” on the Bogleheads forums and you’ll see hundreds of topics, none of which seem to actually agree on an approach.
What’s more, for personal finance dabblers and newcomers to the FI movement, this can turn what should be a fun little exercise into a job that feels like pulling teeth.
I love this calculator by Networthify and I point people towards it on a pretty regular basis. It’s a very powerful way to visualise and demonstrate the power of increasing your savings rate. But, whenever I do so, I often get responses such as “Thanks for that, very interesting! …so how do I actually work out my savings rate?”. I used to respond by telling people something along the lines of:
“Savings rate, ah yes! Have a look at what you invest or save each month, divide that by your income and there you go!”A fairly typical approach to calculating savings rate, but it clearly has its downfalls.
After thinking more about this generic approach and playing with the numbers myself, I noticed some glaring issues.
What exactly was I telling people to divide their savings by? Did I mean gross income, net income or something else entirely?
Quite obviously, pension contributions are missing from this. These pose a particular problem within themselves. Many of us are on Defined Contribution schemes and have access to salary sacrifice, so we make our contributions before tax is calculated… Now we have the problem that some of our money is being saved from gross and some is being saved from net. See what I mean about pulling teeth now?
What do I want to achieve with a new model?
Simplicity! The two things I strive for most are simplicity and consistency aka the two key attributes of a successful passive investor.
I want to derive a standardised way of working out exactly what we’re putting away for retirement as a function of our individual incomes and expenses. As I’ve noted before rules of thumb are all well and good until we start to apply them and dig a little deeper. Savings rate is just another rule of thumb that cracks under the pressure of close examination.
Introducing my contribution to the problem: Investing Rate.
“Investing Rate” or IR.
I’m not going to suggest I’m the first person to come up with the approach described below. With that in mind, I haven’t seen anyone else coin this term specifically in relation to this and a Google search or two leads me to believe nobody calls it this. I might as well give it a name!
Investing Rate, which I’ll now refer to as IR, will show you just how much of your money that is eligible to be invested or saved, is actually being invested or saved.
This approach allows us to forget about factoring in income tax and muddying the waters with gross income vs net income, because this is already trimmed out of the equation to begin with.
To calculate IR we need to obtain two pieces of information:
- “Investable capital” or IC.
- “Investment total” or IT.
We then take these values, plug them into the formula below and voilá, the secrets of the universe are ours to behold… Or at the very least we can now see exactly how much of our available income we’re really saving for retirement. Whatever floats your boat.
The formula: IR = (IT/IC)*100
The values needed for the formula.
“Investable capital” or IC.
This value equates to everything you’re theoretically able to invest or save on a monthly basis, not the value you think you can save or invest. This includes:
- Your total pension contributions* (summing your and your employer contributions).
- Every penny you get in your account on payday.
- Every other bit of income you get on a consistent basis that you’d like to factor into the calculation.
*Defined Contribution only works for this. For our lucky friends on Career Average/Final Salary/Defined Benefit schemes your maths gets a fair bit more complicated that this article is going to address.
Note the “theoretically” – do not disclude money that is paid towards debt, mortgage, bills etc, because theoretically you could choose to invest this (though that may be a very poor choice!).
Ultimately, we need to know the total pot of money you have access to on a monthly basis.
This makes up your complete IC value.
“Investment total” or IT.
This is the part of your income that you actively choose to save on a monthly basis added to your monthly total pension contributions.
Told you this was easy to work out!
Putting it all together.
Time to whip out a little example to show IR in action:
Mike earns £15,000 a year as his gross salary. He contributes 5% to his pension scheme via salary sacrifice and his employer chips in 3%. This works out to be exactly £100 a month.
Factoring in the above and income tax, this leaves Mike with £1,102.15 net each month going into his bank account. (Cheat sheet: Use this calc to do the heavy lifting on the numbers for you).
His IC is therefore £1,202.15 a month.
Mike diligently saves £350 a month into his Stocks and Shares ISA whenever he is paid.
Adding this to his pension contribution we can see he really saves £450 a month.
His IT is therefore £450 a month.
Recalling the formula I gave earlier: IR = (IT/IC)*100
Applying this to Mike’s situation we can see this translates to:
37% = (450/1202.15)*100
This means that 37% of Mike’s available money to be invested, is being invested. Handy to be able to finally put a figure on it!
When Mike is looking at an early retirement calculator, such as the Networthify mentioned earlier, he now has a much clearer picture of what his true savings rate is. It’s still going to be inaccurate to a certain degree, but it will be of more use to him than no benchmark to follow at all.
I believe that IR serves as a standardised way of working out exactly what you’re putting away for retirement as a function of your own income and expenses.
An interesting point revolving around calculating IR will be the manner in which salary sacrificed additionals are managed beyond pensions, whereby the individual is paying for something (such as vehicles, child care vouchers or cycle to work schemes).
Initially I think that these should be included in the total IC value, as you could choose to do without them and save the difference. Special attention should be brought to the fact that these obviously are “worth more” as a salary sacrifice benefit opposed to cash in your bank, due to the reduced tax and national insurance burden.
I welcome any and all additional thoughts, particularly on this aspect.