Financial success often revolves around savings. This week, we will look at the savings factor four different ways:
Saving Versus Returns
Initial growth for investment accounts comes mostly from savings, not returns. To illustrate, we will use two investors, Sarah and John. We will assume both have market returns of five per cent.
Sarah has $50,000 on January 1. Sarah has committed to contributing $500 a month in savings through a pre-authorized contribution (commonly referred to as a PAC). At the end of the year she has $58,650. The $8,650 increase is broken up between $6,000 in her own contributions and $2,650 in investment returns. Of the increase in the value of her account, 69 per cent was the result of savings. As the investment account grows, the percentage declines. If Sarah had $120,000 on January 1, and contributed $500 per month, then her investment returns (assuming 5 per cent) would be approximately equal to her savings. If the market value of Sarah’s investment account exceeds $120,000 then at that point she would expect that the annual investment returns would begin exceeding her monthly savings given a five per cent rate of return.
John has $50,000 on January 1 but does not contribute to his account. By the end of the year, John has $52,500. Even if we assume that John invests the account with higher risk investments, he will not achieve the same outcome as Sarah. Let’s say John earns ten per cent on his investments for the year. At the end of the year he has $55,000 and has taken considerably more risk than Sarah. The main reason John has less than Sarah is that he has not focused on saving.
Saving Early Versus Late
Living all for today may come with some sacrifices down the road. Saving too much today may also come with some immediate sacrifices of not enjoying life to the fullest. The challenge that everyone has is to balance current life style with future needs.
Our role as financial advisors is to assess individual incomes and map out a reasonable savings factor. We find that some people save too much, and others save very little given the income they have earned.
It is easy to illustrate the concept of compound growth – income on income. The earlier you save the more time the income has the ability to grow, especially if it is tax deferred within a registered account. If most of your savings are done in the final years before retirement then you will not have as much of a benefit of compound growth.
By savings we are not saying that part of your pay cheque has to go into the bank or an investment account. Paying down debt is savings. If you are doing extra mortgage payments, or applying lump sums then you are essentially saving. If you are doing neither, then you’re not saving. Whether you pay your mortgage off earlier, or begin investing, there are some distinct advantages.
Saving Versus Spending
It is not how much money you make, but rather how much you spend. This is easily illustrated when you hear about celebrities filing for bankruptcy. Spending is a huge component to financial success. We would expect that as incomes increase, people would buy nicer cars or homes. This is different than living beyond your means. One of the benefits of a financial plan is that it allows you to map out how much you should be saving to reach your retirement goals. Savings are a key component to being able to retire comfortably. Savings may also help you weather any difficult economic periods.
Savings Based On Income
The more we make, the more we spend. If your income is low then your primary needs are food, shelter, clothing and transportation. If you have a family then savings become even more difficult with a low income.
As your income rises, so does your ability to consider savings. You could say that until your income exceeds a certain dollar threshold that your savings factor is zero. If you exceed certain dollar thresholds then your savings factor should increase. This savings factor really fluctuates based on where you live, whether you have a family, and what your primary needs are. If your income does not exceed the cost of your primary needs then you have no savings decision to make. As your income rises above the cost of your primary needs you have to make a choice between savings or buying the things you want.
Differentiating between the things you need versus the things you want helps in determining your planned savings.