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Why Your Savings Rate is the Keystone of Retirement Planning

As we’re preparing for retirement, there are a whole bunch of moving pieces. And they can all feel pretty daunting.

What should your asset allocation look like?

How can you maximize your portfolio’s tax efficiency?

Should you get out of the market before it drops? (I’ll give you a hint on this one – no.)

And a lot of them (except for that last one) are important questions. But, like a lot of life, the most important thing to pay attention to is one of the simplest and most overlooked.

And that’s your savings rate.

Your savings rate will, to a very large degree, determine how much you can spend in retirement. If you save enough, then – so long as you don’t go completely off the rails – most things will sort themselves out. And if you don’t save enough, then all of the fancy portfolio optimizations in the world will have a hard time saving your retirement.

It’s not an exaggeration to say that when you are working your savings rate is the most important number in retirement planning.

Why Your Savings Rate is So Important

It’s easy to say that how much you save is important, but to understand why it matters so much, it helps to put some numbers around it. So let’s look at the impact of your savings rate compared to what you are saving that money into.

What we want to be focusing on here is not necessarily the amount of money that we have in the portfolio, but rather the change in that number as we tweak your asset allocation through time.

Because the effects are pretty impressive.

Our Base Case

To start off with, let’s create a base case that we can compare everything else to. Let’s say that you’ve got 25 years left to go until retirement – but you haven’t saved anything for retirement. So you’re going to commit to putting away $20,000 per year until retirement (normally this will go up through time, but keeping this constant makes the example more clear).

And we also have a moderate risk tolerance, so we’ll assume that our portfolio will be 60% stocks and 40% bonds (often called a 60/40 portfolio). And to keep things simple, we’ll assume a constant return of 6% per year for our stocks, and 3% per your for our bonds.

So let’s run the numbers. At the end of the 25 years, we would have a portfolio worth a little bit more than $973,000.

That’s great, but how would the numbers change if we start adjusting the portfolio?

Changing Your Asset Allocation

There are a lot of fancy things that you can do with your portfolio in the hunt for either increasing your returns or reducing your risk. A lot of the things that people try (like timing the market, or active management, or focusing on your portfolio’s income yield) don’t work. But we do have a really powerful (and easy to use) lever – the ratio of stocks to bonds in our portfolio.

So let’s use that in our analysis.

As we either increase or decrease our return (by changing the amount of stocks and bonds in our portfolio), how much does our ending portfolio value change from our base case?

Difference from Base Case-8%-4%N/A+5%+9%
For illustration purposes only. Percentage represents the difference from the ending portfolio value portfolio using the base savings amount and a 60/40 asset allocation over a 25 year savings period. 

Well, it can have a really big impact – if you were more conservative, and went with a 40% stock portfolio, you would have ended up with about 8% less money (or about $82,000 less). Alternatively, if you decided to be more aggressive and use an 80% stock portfolio, you would have about 9% more money (or about $90,000 more).

And these are meaningful numbers. Having that “extra” $90k (which you paid for by taking on more risk) would likely have a real impact on your retirement.

But what if we bring changes to our savings rate into play?

Changing our Asset Allocation AND Savings Rate

Here, we’ll look at both adjusting our asset allocation, but also changing our savings rate. And, well, I’ll let you be the judge.

 40/6045/5550/5055/4560/4065/35 70/3075/25 80/20
 Base -20%-27%-25%-23%-22%-20%-18%-16%-15%-13%
 Base -10%-18%-16%-14%-12%-10%-8%-6%-4%-2%
 Base Savings-8%-6%-4%-2%Base2%5%7%9%
 Base + 10%1%3%5%8%10%12%15%18%20%
 Base + 20%10%12%15%17%20%23%25%28%31%
For illustration purposes only. Percentage represents the difference from the ending portfolio value portfolio using the base savings amount and a 60/40 asset allocation over a 25 year savings period. 

The impact of your savings rate dwarfs the impact of your asset allocation.

And we can see this just by looking at the corners. If you were to increase your savings by 20% (which is only an extra $4,000 per year), but also reduce the amount of your stocks in your portfolio by 20%, you still increase your ending portfolio value by nearly $100,000 dollars – in fact, this is more than if you had kept your base savings are and used the 80% stock portfolio.

If we go over to the top right of the table – where we dropped our savings rate by 20% (so only saving $16,000 per year), but upped the amount of stock in our portfolio to 80% – our ending portfolio value dropped by nearly $123,000.

How much you save makes a much bigger difference than where you are putting those savings.

What Does This Mean?

So much of what hear about retirement planning is about the details – whether you should do a Roth conversion, or which specific fund you should use in your portfolio, or exactly how often you should rebalance your portfolio.

And all (ok, most) of this stuff is important.

But they’re details.

Your savings rate matters more.

If you put away enough money, all of the other stuff just sort of works itself out.

This doesn’t mean that you should save everything for retirement, but it does mean that you want to take a good look at your overall situation, and think about what you can (comfortably) save today, and what that will mean for you in the future.

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