2692: Why My 77 Percent Savings Rate Means Nothing by Paula Pant of Afford Anything on FIRE & Early Retirement

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[00:01:10] This is Optimal Finance Daily, episode 2692,

[00:01:14] Why My 77% Savings Rate Means Nothing by Paula Pant of affordanything.com

[00:01:20] and I'm your host and personal finance enthusiast, Diana Mariam.

[00:01:24] This is the show where I serenade you with the sweet sounds of personal finance knowledge

[00:01:29] from some of the best blogs on the planet, with the author's permission, of course.

[00:01:33] So with that, let's get right to today's post as we optimize your life.

[00:01:41] Why My 77% Savings Rate Means Nothing by Paula Pant of affordanything.com

[00:01:49] Finance nerds have strange habits. Here's one of mine.

[00:01:53] Once a year, I lock myself in a room with nothing but a laptop, spreadsheet and boatloads of determination.

[00:01:59] The mission? Decipher my savings rate. Am I saving 30% of my income? 40%? 60%?

[00:02:08] As long time readers might recall, my then partner, now ex and I, saved half of our income in 2012.

[00:02:14] We did this by following one simple rule.

[00:02:18] Pretend that we're a one-income couple, live entirely on one partner's salary and invest 100% of the others after taxes.

[00:02:26] Since we earned roughly the same amount, we ended up investing about 50% of our income in 2012.

[00:02:33] In 2013, we didn't follow any strict rules about spending from one bank account or the other,

[00:02:38] but both of our earnings escalated and I suspected this might translate into a turbocharged savings rate.

[00:02:45] After all, the best way to fast track your savings is by earning more and saving every dime of that extra income.

[00:02:52] I crunched the numbers and made two shocking discoveries.

[00:02:56] We have a 77% savings rate and that statistic is meaningless.

[00:03:03] Here's why that factoid is crook and how to find a metric that really matters.

[00:03:09] Measure the metric that matters.

[00:03:12] I don't want to wax philosophical, at least not too much.

[00:03:16] But before this conversation can continue, we need to discuss an important question.

[00:03:20] How do you define savings?

[00:03:23] Is saving the absence of spending?

[00:03:26] Is it the money remaining at the end of the month?

[00:03:29] Or is it cash that's set aside for a specific goal?

[00:03:33] If so, does the timeline of that goal matter?

[00:03:36] Does it qualify as savings if the goal is 5 years away, 5 months, 5 days?

[00:03:42] What's the cutoff?

[00:03:44] Furthermore, does the content of the goal matter?

[00:03:47] Are certain goals like retirement more worthwhile?

[00:03:50] What about world travel?

[00:03:52] Is this a worthy goal or a frivolous expense?

[00:03:55] You can see where the definition of savings gets hazy.

[00:03:59] Here's the crux of the problem.

[00:04:01] Savings is money that you're setting aside for the future.

[00:04:05] Which means that savings is deferred spending.

[00:04:09] When you save money, you're saying, I'll spend this later.

[00:04:12] But spending later won't get you closer to financial freedom.

[00:04:16] There's a better metric that we can track.

[00:04:19] One that's even more important than savings.

[00:04:21] We'll come back to that metric in a moment.

[00:04:24] But first, back to my meaningless savings rate.

[00:04:27] This issue arose during a conversation with a friend who happens to work as a financial planner.

[00:04:32] We were chatting about income. Yeah, I'm a fun conversationalist.

[00:04:36] And he asked how much I had saved in the past year.

[00:04:39] I took out my laptop, showed him the spreadsheet and drew a blank.

[00:04:42] Because here's what it says.

[00:04:44] HSA 4%

[00:04:46] Cash pay cash for two cars 16%

[00:04:50] Cash account 1 7%

[00:04:52] Cash account 2 1%

[00:04:54] Cash account 3 4%

[00:04:57] Cash account 4 4%

[00:05:00] Roth IRA 7%

[00:05:02] Roth solo 401k prior year 10%

[00:05:05] Roth solo 401k current year 10%

[00:05:08] Extra mortgage payments 14%

[00:05:11] Total savings plus investments is 77%

[00:05:16] Did you hear that second line item?

[00:05:18] Pay cash for two cars.

[00:05:20] Last year, both of us paid cash for our cars.

[00:05:23] I bought a five-year-old Honda Civic.

[00:05:25] He bought a seven-year-old Acura.

[00:05:28] So is this savings because we saved enough money to buy cars and cash?

[00:05:33] Or is this spending because we spent the money on cars?

[00:05:36] It's savings, my financial planner friend remarked.

[00:05:39] Spending is month-to-month.

[00:05:41] I contemplated that remark for a long time.

[00:05:44] I'm not sure if I agree.

[00:05:46] But then it doesn't matter because within those reflections,

[00:05:49] I realized we're discussing the wrong metric.

[00:05:53] Savings won't bring you financial freedom.

[00:05:56] Investing will.

[00:05:58] That's the metric we should track.

[00:06:00] Saving is awesome, but investing creates freedom.

[00:06:05] Savings are great.

[00:06:06] They help you pay for big-ticket items like cars,

[00:06:08] graduate school, medical bills,

[00:06:10] world travel and a wedding.

[00:06:12] But savings alone won't help you achieve

[00:06:15] financial independence.

[00:06:17] Savings is a feel-good word.

[00:06:19] That means I'll spend this money later.

[00:06:21] While that's great for buying big-ticket stuff,

[00:06:24] it won't move the needle on creating your life's freedom.

[00:06:27] It won't help you reach the retire early.

[00:06:30] Investing, on the other hand,

[00:06:32] allows you to supercharge your net worth.

[00:06:34] So I need to throw away my so-called savings rate

[00:06:37] and focus on my investing rate.

[00:06:39] I tighten those line items into a more condensed version.

[00:06:43] Here's the breakdown.

[00:06:45] Cash, 32%.

[00:06:47] Retirement, 28%.

[00:06:49] Health savings, 4%.

[00:06:51] Extra mortgage payments, 14%.

[00:06:54] Let's attack this.

[00:06:56] Cash represents money that will morph into refrigerators,

[00:06:59] washing machines and other junk that doesn't command a return.

[00:07:02] Sure, these purchases are important.

[00:07:04] I need a fridge to keep my food cold,

[00:07:06] but it won't move the needle.

[00:07:08] Let's throw it out.

[00:07:09] Next, let's go back to health savings.

[00:07:12] Prior to a few months ago,

[00:07:14] I would have thrown out that line for the same reason.

[00:07:16] This money will get spent on wisdom,

[00:07:18] tooth extractions and blood tests.

[00:07:20] Those are important expenses for sure,

[00:07:22] but our mission is to track financial freedom.

[00:07:25] But then I learned how to hack your HSA,

[00:07:28] leave money inside the account so it can grow tax-deferred,

[00:07:31] pay out of pocket for medical costs,

[00:07:33] conceptualize the HSA as a bonus retirement account.

[00:07:37] Brilliant idea.

[00:07:38] I can't believe I didn't think of that.

[00:07:40] So my total retirement investing rate is

[00:07:43] retirement, 28%, health savings, 4%,

[00:07:46] total retirement, 32%.

[00:07:49] Next come the extra mortgage payments.

[00:07:52] I'm paying down my rental properties

[00:07:54] so they'll produce even stronger passive income.

[00:07:57] Extra principal payments comprised 14% of my income last year.

[00:08:01] Extra mortgage payments, 14%.

[00:08:04] What happens when we add these figures?

[00:08:06] Retirement, 28%, health savings, 4%,

[00:08:09] extra mortgage payments, 14%,

[00:08:12] investing rate, 45%.

[00:08:15] Now we're hearing the metric that matters.

[00:08:17] We're focused on investing, not savings.

[00:08:20] And that moves the needle.

[00:08:26] You just listened to the post titled

[00:08:28] Why My 77% Savings Rate Means Nothing

[00:08:32] by Paula Pant of AffordAnything.com.

[00:08:35] And I'll be right back with my commentary.

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[00:10:45] Wow, I absolutely loved this article.

[00:10:49] I've never heard anyone describe savings as deferred spending,

[00:10:53] but it makes so much sense.

[00:10:55] And I think at the crux of this issue

[00:10:58] is that many of us use the words

[00:11:00] saving and investing interchangeably.

[00:11:03] Many people will say that they're saving for retirement

[00:11:06] when they're actually investing through a 401k.

[00:11:09] We can dismiss it as semantics,

[00:11:11] but I agree with Paula that the distinction is important.

[00:11:14] Saving for big-ticket items is a valuable skill set

[00:11:18] that will allow you to buy the things you want

[00:11:20] while avoiding debt,

[00:11:22] but it won't make you wealthy.

[00:11:24] The key to building wealth

[00:11:26] is to buy assets and let your money work harder

[00:11:29] than you ever could by growing through

[00:11:31] the power of compound interest.

[00:11:33] Cash sitting in a bank account

[00:11:35] provides security in the form of an emergency fund, for example,

[00:11:38] but money growing in an investment account

[00:11:41] is where your financial freedom lives.

[00:11:44] Reading this article reminds me of something

[00:11:46] that I've come to learn about money.

[00:11:48] It's only as valuable as your clarity on how you're going to use it

[00:11:51] and your comfort level of how much is enough.

[00:11:54] The money you are saving for deferred spending

[00:11:57] benefits from having clarity,

[00:11:59] and the money you're investing

[00:12:01] can lead to financial freedom

[00:12:03] as long as it eventually feels like enough.

[00:12:06] And that will do it for today.

[00:12:08] Thank you for listening,

[00:12:09] and I'll be back here tomorrow where your Optimal Life awaits.