Saving Rate vs Spending

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In personal finance, we obsess about investment portfolios and income. Are they big enough? Can they get bigger? How can we improve returns? Can we ask for a raise, promotion, or new/second job? What about the dreaded side hustle? 

The one thing we never spend much time thinking about is how lifestyle and spending play into retirement planning. It’s probably more important than any other single factor, yet gets by far the least attention. Here’s an example:

Imagine two identical 21 year old college graduates with exactly identical starting jobs. Both earn $50,000 to start, increased by 3% each year. Both earn 10% each year on their savings and investments. Both believe in the “4% rule,” which states that you are close to financial independence when in a given year, your spending equals 4% or less of your investment portfolio- in other words, you might be able to retire if you have saved 25x your annual spending. 

The only difference in these two cases is how much they save each year. In the first case, the investor decides to fund their Roth IRA with $6,000 each year for as long as they work. This is probably more saving than average early in their career, but not ideal later on. With these hypothetical facts, they will achieve retirement/financial independence after 46 years at age 67—conveniently the current “full retirement age” according to Social Security.

In the second case, let’s say the investor is a very aggressive saver. Maybe they live at home after graduation, don’t need a car, and stay on their parent’s insurance. They manage to save 50% of their income. Even if they leave the nest after a few years and a few raises, they are accustomed to spending less, so they manage to maintain that goal of saving 50% of their income as long as they work. Not surprisingly, their timeline is very different. They only have to work for about 15 years to age 36 before reaching financial independence.

What drives the difference in their timelines? The obvious answer is that the 50% saver has a much larger investment portfolio which allows them to retire early. The thing that most people miss, however, is that the only reason it works out in 15 years is that in creating that portfolio, their spending had to be much lower than the $6k saver, so there’s less spending that the portfolio has to cover. After 15 years, when the 50% saver is financially independent, it’s because they are only spending $37k each year. The $6k saver is spending almost $70k a year at this point, which would take a much larger portfolio to replace. Even the 50% saver would have years more to work if they had a higher income such that they could save the same amount as before but spend as much as the $6k saver. 

If $37,000 seems like not much money to live on, keep in mind that the median income in America today is about $36,000. More than half of American workers make less than $37k, which makes it seem very doable- especially if our hypothetical person is doing what they want with their time rather than reporting to a job five days a week! You can scale these dollars up or down or even add a zero- what matters is the savings rate, not the total dollar amount of income. It’s easier to save more when you earn more- at least in theory.

This is a dramatically oversimplified case, ignoring taxes, social security, and many other factors, but it demonstrates one of the most profound truths of financial planning. We don’t know what will happen with the stock market, especially in the short term. The one thing we absolutely control is spending- and if there’s any way to spend less and still be happy, it can dramatically accelerate your trajectory towards financial freedom, both because you’ll be saving more and have less income to replace in the future. In short, money not saved is spent, so a lower savings rate is a double whammy when it comes to planning for financial independence.


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