I know a lot of those who have posted know and understand it, but I just want everyone reading the thread to understand where this idea of a savings rate, and the 20% number, comes from. The “20% savings rate” is intended to be the following:

- a rule-of-thumb

- broadly generalizable

- understood by financial novices

Therefore its limitations are fairly obvious in that it isn’t universally applicable and can be rendered semantically irrelevant if an individual breaks it down into nuts and bolts.

The entire purpose is to estimate your retirement income in relation to your current income. Clearly, if you are not yet at maximal income for your career, then it will not be appropriately representative. Therefore, the only things that should count toward your saving rate are things that are being saved/investedfor the purpose of generating retirement income, and your retirement income is likewise only being representedin terms of your current income.If those aren’t commensurate with your current situation, then it’s going to be a garbage number. If that’s the case, then you’d need to figure out what you think your future retirement income would need to be, divide that by your planned withdrawal rate (4% is commonly thrown out, so you’d divide by 0.04, or multiply by 25), and shoot for that number; for example, if you want $100,000/year, you’d want $2,500,000 specifically for retirement income.

Also, there is often a question as to whether to use gross or net to figure it. I posit that gross should be used since you can factor in the reduction of your tax bracket into the retirement income side of the equation. It’s arguable that net is what matters since some of your investment will be tax-free on withdrawal (Roth, LTCGs if in 15% bracket), but again that adds a bit of complication to it. For people who will be able to plan their future finances to that degree of detail, this whole thing is a moot point anyway.

While it’s true that X dollars here can still equal X dollars there (i.e. “money is fungible”), the following things should NOT be included in your saving rate, since while they do go toward your net worth, they are not used to generate retirement income and therefore won’t fit the equation on which the “savings rate” is based:

- 529 college savings accounts

- Student loan or other debt payments

- Mortgage payments

- Any investment holding not planned for being used as retirement income

Also, things like HSAs could go either way. Lots of us here plan to use the HSA as another retirement account, so I’d include it. Also the oft-mentioned profit-sharing contribution for employees counts both for savings and income, hence the “numerator and denominator” argument previously mentioned. If you plan on investing in real estate solely for the purpose of creating retirement income, that’s a slightly tougher one to figure, and you’d have to assume future income and expenses, or at least sale value to add to the rest of your nest egg if you so choose.

If you’re planning for when you’re out of debt, then you can fudge your numbers to count them since you’ll get to it eventually, but that moves the time goalposts (which I’ll get to in a bit) and just be aware that you’re still fudging your numbers to make them look better.

Now to get to the 20% figure. This is basic financial math using the future value concept, expressed in Excel as =FV(rate,nper,-pmt,pv,type). To reverse-engineer this, you’re basically trying to figure out the payment portion using the annuity formula in Excel =-PMT(rate,nper,pv,fv,type) to achieve a specific percentage of pre-retirement income. To simplify, we’ll just infer the following:

- you’ll save
20%of gross income annually, specifically for retirement income (p = -0.2; it’s saving, so it’s a “negative payment” in Excel)

- you’ll save that amount for
30 years(n = 30)

- you’ll
gain 5%on those investments annually (r = 0.05)

- you don’t have anything now (PV = 0)

- you’ll have a safe
withdrawal rate of 4%(w = 0.04)

So, sigma p([1+r]^n) when n = {1,2,3…30}, or =FV(0.05,30,-0.2,0,1), is 13.95, meaning you’ll have in retirement savings nearly 14x your income. Multiplied by your SWR of 4%, that comes out to 0.56, or56% of your pre-retirement incomein retirement. Why is 56% of pre-retirement income OK? That’s a huge pay cut, right? Well…

- You won’t need retirement savings anymore (-20%)

- You’ll be in a lower tax bracket, and some of your retirement income (e.g. Roth) will be tax free (-10-15% or so)

- You [ideally] won’t have a mortgage payment anymore

- You won’t need life or disability insurance anymore since you won’t have any earned income to replace

- You’ll [hopefully] have social security

- You can still earn little bits of money every now and then if you really feel like it and you get bored

So based on that math alone, 56% of pre-retirement income *should* be all you’d need to continue living the exact same life you’ve been living.

Now, obviously, this is based on you working for 30 years, having compound annual growth of 5%, and withdrawing 4% a year. All those variables are, well…variable. You might want to work for fewer years and hence need to save more, but then you’ll be retired for longer, and might need a lower withdrawal rate. You might really kill it in the market and have better gains, or inflation might eat away your gains (none of this is really indexed for inflation, other than if it’s reflected in your holdings’ gains and in the amount you saved each year with your inflation-adjusted income) and you need to re-adjust. That’s lots of moving targets.

So if I want to have that same percentage of income (56%) of my current income in retirement but only work for 20 years, and as such need a lower safe withdrawal rate (3%), but think I’ll earn 6% CAGR over time, then I’d need to save =-PMT(6%,20,0,0.56/0.03,1) = 0.48, or 48%. This is commensurate with PoF’s “live on half” mantra, probably not for this exact reason, but it sure does fit nicely with it.

So I hope this both answers some questions and creates more, because that’s what understanding is really about…why your “savings rate” matters, and why it doesn’t. Yes, you should try to save 20% of your gross income each because it’s a very easy rule of thumb to follow and *should* put you on the right track, but like all broadly generalized rules-of-thumb, it has its limitations.

Thanks for taking the time to write the detailed post. I agree that rules of thumb can be helpful. Rules of thumb are generally designed to keep the general population out of trouble, and that's a good thing. This particular rule of thumb is championed by Elizabeth Warren, so I am skeptical about it being optimal or even applicable to a high earner. The justification you provided for the 20% rule is reasonable, although seemingly reverse engineered. I think the true origins are a bit more simplistic (i.e. 20% sounds good, 80/20 rule, etc.) and typically includes all savings (emergency account, debt pay down, etc.).

In my view a savings rate based on income runs counter to how I think about my own retirement need. I am not trying to replace an income, I am trying to replace a spending level. Therefore looking at a savings rate using my current income does not provide any quantitative insight into how I am performing relative to my savings goal. For example, how bad is it if I save 18% of income rather than 20%? I don't really know. If I know i need to save $30k per year and I save 80% of that number, or 120% of that number, I know what that means. Starting at a savings rate of income also requires a number of squishy assumptions to convert that savings rate into a spending level per year.

I would look at it this way, you need to save 36 cents/year for every dollar/year you want to spend in retirement using the 4% rule and a 5% investment return over 30 years. If you want to spend $100k per year in retirement, you need to save $36k per year. If you make $200k per year, that's an 18% savings rate if you want to look at it that way. The $36k per year would include only retirement savings and include matches. You can include retirement matches in the denominator or not, but you just have to be consistent. You can then compare your actual annual retirement savings to $36k and you know how you are doing every year without further thought.

## Leave a comment: