How much you save for retirement goes a long way to determining how much you can spend in retirement. The more you save while you’re working, all else equal, the more you can spend in retirement. It sounds straight forward, but it seems to be something that many people forget, or at the very least, seem to take for granted. Everyone’s talking about the details – how much risk you should take in your portfolio, how to maximize your portfolio’s tax efficiency, or how to set up a bond ladder. Now, these are important (we wouldn’t have written articles about them if they weren’t), but they all pale in comparison to your savings rate. Put simply, this is the most important number in financial planning.
It’s easy to say that how much you save is important, but, as researchers, we want to put some numbers around this. How big of an impact does your savings rate have on your portfolio compared to your asset allocation? The answer is your savings rate has an enormous effect.
To show just how big the effect is, let’s make a couple of assumptions. Let’s say that we assume that stock returns will be 6% per year going forward, bond returns will be 3% per year(1), and you’re comfortable with a portfolio that is 60% stocks, and 40% bonds. We’ll also assume that you’re going to save $20,000 per year for the next 25 years. Well, at the end of the 25 years, you would have a little less than $975,000. That’s all well and good, but what we care about is how that changes as you play around with the different variables.
The two variables we’ll start with are your asset allocation and your savings rate. To avoid having to account for the exact savings amount, we’ll look at things in terms of how they are different from our base case, which uses a 60/40 asset allocation.
40/60 | 45/55 | 50/50 | 55/45 | 60/40 | 65/35 | 70/30 | 75/25 | 80/20 | |
Base -20% | -27% | -25% | -23% | -22% | -20% | -18% | -16% | -15% | -13% |
Base – 15% | -22% | -20% | -19% | -17% | -15% | -13% | -11% | -9% | -7% |
Base -10% | -18% | -16% | -14% | -12% | -10% | -8% | -6% | -4% | -2% |
Base -5% | -13% | -11% | -9% | -7% | -5% | -3% | -1% | 2% | 4% |
Base Savings | -8% | -6% | -4% | -2% | Base | 2% | 5% | 7% | 9% |
Base + 5% | -4% | -2% | 0% | 3% | 5% | 7% | 10% | 12% | 15% |
Base + 10% | 1% | 3% | 5% | 8% | 10% | 12% | 15% | 18% | 20% |
Base +15% | 5% | 8% | 10% | 12% | 15% | 18% | 20% | 23% | 26% |
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.
As you would expect, decreasing either your savings rate or your asset allocation reduces the amount of money that you will have available at retirement. Now let’s look at how the changes are happening.
For instance, if you were to increase your savings amount by 5% per year, that would have roughly the same effect as moving from a 60/40 portfolio to a 70/30 portfolio. If you were to increase your savings by 10% relative to your base amount, you’re literally off the chart – that corresponds to having slightly more than 80% of your portfolio in stocks.
This works on the other side, as well. If you decrease your savings rate by five percent per year, that would be roughly equivalent to moving down to slightly less than a 50/50 portfolio.
But some interesting things happen when you start playing around with how long you plan on saving before retirement. When you have less time to prepare for retirement your savings rate becomes even more important compared to your asset allocation (and vice versa). If you stop and think about it, this makes sense. With a shorter investment period you have less time for your investments to do their work – they have less time to compound. Essentially, the money that you are saving represents a bigger part of the total ending value of your portfolio. And if you have more time to prepare for retirement, your investments have more time to compound, and the amount that you are saving is relatively less important.
But to be clear, the effect isn’t that pronounced. Even if we use a 30 year savings period(2), the difference isn’t all that significant.
40/60 | 45/55 | 50/50 | 55/45 | 60/40 | 65/35 | 70/30 | 75/25 | 80/20 | |
Base -20% | -28% | -26% | -24% | -22% | -20% | -18% | -16% | -13% | -11% |
Base – 15% | -24% | -22% | -19% | -17% | -15% | -13% | -10% | -8% | -5% |
Base -10% | -19% | -17% | -15% | -12% | -10% | -8% | -5% | -2% | 0% |
Base -5% | -15% | -12% | -10% | -8% | -5% | -2% | 0% | 3% | 6% |
Base Savings | -10% | -8% | -5% | -3% | Base | 3% | 6% | 9% | 12% |
Base + 5% | -6% | -3% | -1% | 2% | 5% | 8% | 11% | 14% | 17% |
Base + 10% | -1% | 1% | 4% | 7% | 10% | 13% | 16% | 19% | 23% |
Base +15% | 3% | 6% | 9% | 12% | 15% | 18% | 21% | 25% | 28% |
Base + 20% | 8% | 11% | 14% | 17% | 20% | 23% | 27% | 30% | 34% |
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 30 year savings period.
The driving factor is still going to be how much you put away for retirement. The more you save, the less risk you need to take to reach your ideal retirement.
It’s also worth considering that in this analysis we’ve been using straight line returns. We assumed that you would get a 6% return on your stocks every year, and that you would get a 3% return on your bonds every year. This assumption is… suspect, to say the least. Your investments will be all over the place, but you can think of your savings as guaranteed increases in your portfolio value, at least to the extent that you stick to your savings plan.
To find out how to what you should do with those savings once you’ve got them into your portfolio, take a look at the 9 Principles of Intelligent Investors.