Saving

Why Your Savings Rate Matters More Than You Think

A question I get asked all the time: “What funds should I choose for my 401(k) or IRA?”

A question I almost never get asked: “How much should I save per month?”

For most people, the second question is, oh, ten times as important as the first one. I’m going to explain why in words and then in pictures.

In words, here’s the answer. Every month, some money is added to (or subtracted from) your account due to factors beyond your control. Your stocks go up or down. A bond fund pays a dividend. In short, market stuff happens. Also every month, you add some money to your account.

If the amount of money you add is bigger than the effect of the market stuff, then your savings rate is more important than your investment performance. If the market drops and you lose $200, but your monthly contribution is $1000, then your balance at the end of the month is still $800 higher than it had been.

At some point in life, if you’re lucky and diligent, you get to the point where the monthly fluctuations in your investments dwarf the new money coming in. But it takes surprisingly long for this to happen, as demonstrated by a beautifully simple graph created by Chartered Financial Analyst, Rick Ferri of Portfolio Solutions.

This graph, as explained by Ferri on his blog, represents two people who work at the same steady job with exactly the same pay. One saves 5% and earns 10% annual returns. The other saves 10% and earns 5% annual returns. It takes over 25 years for the one with the awesome 10% return to come out ahead.

There are two key lessons here, says Ferri. One is: on your first day of work, save 10% of your gross pay and keep doing so forever. “Mathematically, if you work for 45 years starting at age 20 and you save 10%, then it gives you the number that you need to retire on comfortably,” he says.

The second lesson: if you hit the middle of your career and are still making stupid investment mistakes like market timing, day trading, and performance chasing, cut it out. “Some time in your early 40s, you need to have gotten all the bad stuff out of your system,” says Ferri. “You need to have learned how to diversify, how to keep your costs low.”

We’re all Generation Y now

But how many people do you know who started saving for retirement at age 20 and haven’t been unemployed, or taken a 401(k) loan, or gone off to India in search of themselves, before they hit age 45? In their 2011 retirement confidence survey, the Employee Benefit Research Institute found that 70 percent of Americans believe they are “a little” or “a lot” behind schedule.

In other words, regardless of our age, most of us are more like the 20-year-old on Ferri’s chart than the 45-year-old. The best thing we can do to increase our retirement nest egg is to (snooze alert) save more and spend less.

That’s what Carl Richards told me as well. Richards is a certified financial planner and author of the forthcoming book The Behavior Gap. I asked for his take, and rather than respond in prose, he sent me this original sketch:

(My sister-in-law thought it was hysterical. I don’t see why.)

Don’t get me wrong. Investment choices are important, especially once you’ve accumulated a sizable chunk of savings. I like helping people choose their investments, and I enjoy checking my own spreadsheet to see how close I am to my goals and whether I need to rebalance. Investing is fun, scary, and mysterious; saving more money, well, that’s boring at best, and painful at worst.

And that’s exactly why it’s so important—for me as much as anyone—to listen to what Ferri and Richards are saying.

The silver lining of saving more

Last question: is it better for your 401(k) balance to go up because you’re saving more or because your investments are performing well? Or does it matter?

It matters. Improving your balance by saving more is better. Once you retire, you’ll be using your savings to pay expenses. The lower your expenses before retirement, the easier it will be to cover them from your nest egg. And when your savings rate goes up, your expenses (as a percentage of your pay) have to go down, right?

Maybe the secret of a comfortable retirement isn’t about savings rate or investment performance: it’s about redefining “comfortable.” Oh, and ignoring your brother-in-law.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.