Savings, Returns and Time
To generate long-term wealth, there are three key components. However, it’s important to note that investors tend to focus more on one component, which is investment returns. This component is also the one that is least in the investor’s control, as it relies on external factors such as market performance and macroeconomic conditions. The other two components, savings and time, are more directly correlated to long-term wealth generation and are within the investor’s control. We will focus on Savings Ratio here.
Background
The savings ratio is the percentage of income that is saved instead of spent. This simple yet powerful concept determines our future financial position. It is a critical element of financial planning that helps us achieve our financial goals. Our previous write-up covered the Savings Ratio, and in this article, we will delve deeper into its impact on accumulating wealth over time, regardless of investment returns.
Base Case Scenario
Let’s imagine a scenario where the real investment returns, adjusted for inflation, are zero. In this situation, we will examine how different savings ratios can impact the amount of money accumulated over a period of 25 years. We will make an important assumption of a constant annual lifestyle expense that matches the expenses during accumulation.
Savings Ratio -Base Case
Let’s start with base case example of Savings Ratio of 50%.
Suppose we earn Rs 100/- and save 50% of it, which is Rs 50/-, every year for 25 years. In this case, we would have saved a total of Rs 1250/-. Assuming our annual lifestyle expense remains constant at Rs 50/- per year, we can use the accumulated corpus for our retirement spending. With an accumulated corpus of Rs 1250/-, we can cover our annual expenses of Rs 50/- for 25 years.
Decreased Savings Ratio
Let’s say we reduce the savings rate to 40%. This means we save Rs 40/- per year out of our income, which adds up to Rs 1000/- over 25 years. However, our annual lifestyle expense is now Rs 60/-, which is higher than before. This means our corpus would need to support an annual expense of Rs 60/-. With the accumulated corpus of Rs 1000/-, we can only support this expense for approximately 17 years. But if we aim for a 25-year retirement goal, we will need to save Rs 60/- per year for 25 years, which translates to a corpus of Rs 1500/-. This is Rs 250/- more than the base case scenario where the savings rate was 50%. Also, it would take 37.5 years to accumulate this amount if we save Rs 40/- per year, 12.5 years more than base case scenario.
Increased Savings Ratio
Let’s increase the savings rate to 60%. This means we would save Rs 60/- per year out of our income, totalling Rs 1500/- over 25 years. With an annual lifestyle expense of Rs 40/-, our corpus would need to support an expense of the same amount. The accumulated corpus of Rs 1500/- would last for 37.5 years, which is 12.5 years more than the base case scenario. To achieve a 25-year retirement goal with an annual expense of Rs 40/-, we would need a corpus of Rs 1000/-. This is Rs 250/- less than the base case scenario’s corpus of Rs 1250/- due to the lower lifestyle expense. To accumulate this corpus at Rs 40/- savings, it would take 17 years instead of 25 years base case scenario.
Impact of Savings Ratio
The main message is that the savings ratio has a significant impact on the accumulation of wealth over time. With a lower savings ratio, it takes more time to save the same corpus, and a higher corpus is needed to achieve financial goals to accounting for higher lifestyle expenses. Conversely, with a higher savings ratio, it takes less time to save the same corpus, and a lower corpus is needed to achieve financial goals due to lower lifestyle expenses. Therefore, a higher savings ratio is preferable as it allows for a shorter time frame to achieve financial goals and requires a relatively lower corpus compared to income. This concept is simple but is backed up by some basic mathematics here.
Summary
To summarize, the scenario of zero returns on investment was used to analyse the impact of savings ratio on achieving financial goals. With a savings ratio of 50% and a 25-year retirement goal, the target can be achieved in 25 years. If the savings ratio is reduced to 40%, the goal will take 37.5 years to achieve. On the other hand, a savings ratio of 60% will achieve the goal in 17 years (16.7 years). The fundamental directionality of the results in terms of impact of higher/lower savings rate remains the same even with positive investment returns. So focusing on savings ratio is a high leverage action for individual investors.
