Understanding the importance of savings rate on your path to financial independence

This one small ratio has an enormous impact on your time to financial independence

One small ratio, with an enormous impact on your time to financial independence. Your savings rate gives you an estimation of the time it will take you to reach financial independence, based on your current circumstances, so no matter your age you can still reach financial independence. 

The importance of your savings rate and how it impacts your time to financial independence is important to note, to increase your financial IQ. The higher your savings rate means less time to reach financial independence. For people who use the stock market as their way to reach financial independence, your savings rate is the only part of the process that you can directly control, meaning you are in control of your time to financial independence, so understanding the importance and how to calculate your savings rate is crucial.

What is savings rate 

Your savings rate tells you how much you are saving from your income and is calculated by taking the amount you invest and save monthly divided by your after-tax income. This formula can include more technicalities but we will cover them below.

We will start by showing the savings rate graph for Family X: To simplify the illustration we assume Family X earns a household income of R80 000 per month with an R60 000 monthly expense. On the Y-Axis (left-hand column) you will see the savings rate and on the x-axis (top row) expected market returns or return on investments.

If family X has a savings rate of 25% with a return on investment of 12% it will take them 16 years to reach their financial independence goals. If they increase their savings rate to 40%, assuming the same returns, their time to financial independence will be 13.3 years.

The most referred to percentage when referring to savings rates by brokers or financial planners is 15% to 20%.  Real financial independence enthusiasts can push this number up to 80%. Like all things in life, a balance must be found. At Finsesh we believe those serious about financial independence should aim for a savings rate of 50% and higher. You might not start here, but as your journey progresses, income increases and your assets grow, saving all the excess income will lead to a 50% or more savings rate. At a 50% savings rate Family X has a maximum time to financial independence of 14,7 years and a minimum of 10 years given your returns.

Savings rate formula: Below is the standard formula for savings rate calculations. From this standard formula, you can add complexities as necessary.

         Savings  

Income after-tax 

Most popular savings rate: As most people employed in the formal sector have a pension fund scheme, the below formula should apply to most people. From here you can make adjustments to your scenario. 

Pension fund contributions (pre-tax) + Savings (income-spending)  

Income after-tax + Pension fund contributions (pre-tax)

For most people, the standard saving rate would be applicable, providing you with information to give you an idea of how long it will take you to reach financial independence. If you have other sources of income, and making mortgage debt repayments you might have a more complex situation. As your savings rate might contain many variables, if you have a more complex situation, ensure you calculate your formula entries for a full year and read further to understand how to apply various examples to your savings rate, to build in the necessary complexities.

Let's define each section of the formula and look at how they can be amended

For each of these sections of the formula, ensure that you add up your amounts for a 1 year period, to reflect an accurate savings rate. 

Starting with the top part (numerator):

Pension fund contributions pre-tax: If you form part of a pension fund scheme at your employer, you should be adding these contributions to your savings account. You will also have to add it below the line (denominator) to create a more accurate reflection of your savings rate, if it's not included in the denominator, your saving rate will be artificially high.

Savings after-tax: Income after-tax minus all expenses would be what you have available for savings. Under savings, you want to add up all your savings and contributions to all investment accounts, such as retirement annuities(RA), pension funds, tax-free savings accounts (TFSA), emergency funds, etc. All savings should preferably be invested in income-generating assets, to fund your lifestyle when you reach financial independence. 

Savings can include various other entries that will be discussed below:

• If your employer matches or partially matches your pension fund contribution. Add this amount under savings but make sure you add this amount below (denominator too) if not added below your savings rate will be artificially high.
• Bond repayments: Monthly bond repayments are made up of two parts, principal repayments and interest. Only add principal repayments as interest is paid to the bank. You can use your bond repayments made to your house but we recommend using this section for rental properties only, as only they are seen as an income-generating asset. 

Below the line (numerator):

Income after-tax: If you have only one source of income, then you only use your salary after-tax. 

Additional sources of income that could be added as income:

• Rental property income after tax. Do not enter your gross rental here, only the amount you receive i.e net rental income after tax.
• Investment income: This could be interest- or dividends payments from your investment portfolio 
• Business income: Any business income earned that you're either directly or indirectly involved with.

Side hustle income: Any secondary sources of income that you earn.

Here's a simple example: 

Ms. X earns an R20 000 salary and pays R4000 tax per month. She has monthly expenses of R11000, contributes R3000 to her employer pension fund, and still saves R2000pm in her Tax-Free savings account. What is her savings rate? 

         Pension fund contributions + Savings (R3000+R2000)                 

   Pension fund contributions + Income after-tax   (R3000+R20000 - R4000) 

= 0.2632 * 100

= 26.32%

Entering all of Ms. X's figures into our Finsesh Savings rate tool shows that if she generates an 11% annual return, at this savings rate she will reach Financial Independence in 15.6 years. 

How to increase your savings rate

It all comes down to a simple strategy to increase your savings rate. It is to save more. When you earn more, save and invest the extra earnings. Spending below your ego and raising your humility while knowing you don't have to show off will increase your savings rate. You don't have to give a damn care less about what people think and save more! Your future self will thank you. 

Onward to Financial Independence 

If you found this blog post helpful please follow us on Facebook and Twitter @finsesh for more tips on Financial independence.