Since I started up a savings and retirement blog, with a focus on early retirement and financial independence I have calculated my savings rate the same way. Like The Rock lining up for a bare knuckle brawl with Danny DeVeto, I never gave it a second thought. That was until, crying while cutting onions one evening, my mind drifted to the calculation of your saving rate and whether I was doing it right.
Googling “how to calculate your savings rate” or “how to calculate your personal savings rate” comes up with a lot of hits from Banks and other companies offering savings products, advice on tax calculations or methods to calculate it from an economic stand point.
Up to now I have simply been calculating my savings rate as;
(Total saved) / (Net Salary)
Where the Net Salary wasn’t just my take home pay, but my take home plus my pension contributions plus Share Option payments. I guess you could use something like Salary Calculator to work out your Net Salary if your payslip is a whirlwind of complexity.
But here is the sneaky bit. I was taking the amount saved as;
Total saved = (Total pension contribution + Share Options + Cash Saving)
So am I inflating the amount saved by my employers contribution towards my pension?
Let’s have a look at some examples. We will take Miguel as an example.
- Gross Salary per month: £2,167
- Employees Pension Contribution : 5% (£108)
- Net Salary (before pension contribution): £1,720
- Employeers Contribution : 5% (£108)
- Other monthly Savings: £300
The Simple Method
No mucking about with this fella. It is simply;
(Total amount saved) / (Gross Pay)
Take your total saving in the month (or year) and divide it by your gross salary, where to total amount saved includes the employers contribution to a company pension.
But this doesn’t seem entirely fair as you will incur tax on your gross pay, and we don’t want to encourage tax avoidance in order to impress people on PF blogs with our nice savings rate, now do we?
So for Miguel – (£300 + £108*2) / (£2,167) = 24%
The Flattering Cheating Finance Zombie Method
Want to make your savings percentage look better? Then use this one;
(Total amount saved) / (Net Pay)
Where total amount saved includes the employers contribution to your company pension (if you have one) but your Net Pay doesn’t include this. Buuuuuuuuuuuuut, if we were lucky enough to have no outgoings and we saved every penny, then we could have a savings rate in excess of 100%. Mighty impressive…
But for Miguel – (£300 + £108*2) / (£1,720) = 30%
This gives a higher rate than the gross method, by some way.
The Fairer Method
Let’s make things a bit fairer by including an adjustment for the employers contribution to a company pension.
(Total amount saved) / (Net pay + Employers contribution)
This seems a bit more reflective of reality now.
So for Miguel – (£300 + £108*2) / (£1,720 + £108) = 28%
So a bit lower but perhaps a little fairer.
The Free Cash Method
There is an argument that certain expenses are unavoidable and so shouldn’t come into this calculation. They are sunk cost, for example rent, food, toiletries, bills, petrol, whisky etc, (after all we have had a similar argument for tax). You could define your savings rate on an adjusted take home, e.g. your net pay less any essential expenditure. This would then be your free (or discretionary) cash.
Our savings rate would then be;
(Total amount saved) / (Free cash)
Lets say that Miguel has payments for rent, food, toiletries, bills, petrol etc that total £1,000. This would set his free cash in the month at £1,720 (his net pay before pension) less £1,000. So £720 being the maximum that he could save after tax and essential spending.
So for Miguel – (£300 + £108*2) / (£1,720 – £1,000) = 72%
This gives us the best rate, let’s stick with this one… Actually no. I’m not so sure that this is a great measure. For one it doesn’t make us challenge certain expenditure, for example our spending on food. You could also have the same problem as earlier, where the savings rate is in excess of 100% (if you saved all your free cash plus employers contribution to your pension).
Also, how do we define what should be included in the non-discretionary expenditure? Bills and food are essential but we can still look to reduce them. What if Miguel wants to argue that his Audi is an essential expenditure? Or his expensive whisky habit.
You could also arrive in the situation where you class everything as essential expenditure and have £1 in free cash. Saving 80p of this would give you a savings rate of 80% and make you feel like a right FI hero. When you would just be a mug.
It’s easy to see that tweaking the formula for our savings rate can have some pretty big impact on the numbers;
But Mr Zombie, does it really matter? Probably not. As long as you are consistent from month to month and you are making improvements. The Free Cash Method may give you the most inspiring numbers, but that doesn’t mean much if in reality we are only saving 2% of our actual take home.
The difference between the Flattering Method and the Fair Method one isn’t as much as I thought it would be, although it would obviously change depending on your circumstances.
I’m going to stick with the flattering method for this year, as that’s what my savings rate goal for 2015 has been set on. So after all that, I’ll change nothing. It’s fun making simple things complicated, isn’t it?
Any thoughts on how you calculate your savings rate or percentage?
EDIT: after all this I found this post by TFS. Which is much more eloquent and actually comes to a conclusion unlike my sporadic chirping above.
Spend less, save more and escape the Horde