FOOL'S EYE VIEW
How Much Should You Be Saving?

By James Carlisle
March 25, 2002

When it comes to saving and investing, people are obsessed with the returns they're going to get on their money. Whether it's debating the merits of a particular investment strategy, discussing the pros and cons of pensions and ISAs or simply searching for the best interest rate on cash savings, it's the returns that dominate people's thinking.

It stands to reason because, all things being equal, the better the returns you get, the more money you'll end up with. But all things aren't always equal. There are a further two factors that determine how much money we end up with - the amount we put into our savings and investments in the first place and the amount of time we have it there. These two factors will have a far greater impact on how much money you end up with than mundane things like investment returns. You can see this by playing with the Motley Fool's handy compound interest calculators.

For instance, let's suppose that you need to cobble together £400,000 over 30 years and you reckon on getting an investment return of 5% per year (we'll come back to these figures in a moment). If you pop the numbers in to the relevant calculator, you'll see that you have to save a tricky looking £489 per month.

Now imagine that you spend an extra ten years of your life on fast forward and you find yourself with just 20 years to get your £400,000 together. At the same 5% per year investment return, you'll now have to save an unfeasible £982. More than twice the monthly amount, although we've only taken a third off our time period.

What if we did fancy ourselves to get that higher investment return, that would surely get us to our £400,000 over 20 years. Wouldn't it? Well, of course anything's possible, but to make up for the missed ten years, you'd have to more than double your investment returns. In fact, you'd need to get a return of 11% per year to turn £489 into £400,000 over 20 years.

Putting in your own numbers

Have a play on the calculators with your own numbers. The trick to keeping the sums relatively simple is to think of everything in terms of today's money. We can allow for inflation by just excluding it from both sides of the equation. In other words, we can ignore inflation for the amount of money we're trying to get together, but also remove it from the investment return that we're expecting to get.

In fact, you should probably take this a step further since the 'wealth of the nation', as measured by average wages, has tended to outstrip inflation by about 2% per year. So, if you want to keep up with the Jones', as it were, then you'd want to start with a real (that is, post-inflation) investment return and then knock off another 2% for the increases in average earnings.

Finally, you'd need to account for your investing costs. If you're investing in the stock market via an index tracker, then that might amount to 0.5% per year. If you're investing via an actively-managed investment fund, then you're charges might be more like 2%.

The long-term returns, after inflation, from the stock market tend to be quoted at anywhere from about 5.5% to 8% depending on time period and a few other things. So, for an efficient, tracker-based investment strategy, you'd want to be using a figure of 3% to 5.5%. So that 5% I was using is, if anything, fairly ambitious. It would certainly be easier to argue for a figure of 4% per year than 6% per year.

The long-term returns, after inflation, from gilts and cash are generally quoted as a little below 2% so, if you take away that 2% for average earnings growth you're left with not very much. As an illustration, to cobble together £400,000 over 30 years with an investment return of 0%, you'd need to be saving £1,111. You get the same effect if your investing costs are too high.

With so little to play with, it's no accident that shares are considered better long-term investments than cash and gilts and it's no accident that low-cost approaches tend to work best.

How big a pot do you need?

The size of the pot you'll need depends on how much retirement income you need. For the sake of argument, I'm going to target an income of £20,000. If we reckon that we can get a return of 5% from our money, while both the income and capital grow to keep pace with inflation and average earnings growth, then we'd need a pot of £400,000 to generate the £20,000 income. You can work it out by dividing the income you want by the return you expect to get. Remember that 5% is the same as 0.05, so you get 20,000 divided by 0.05, which comes to £400,000.

So, plug everything in...

So, you should now have a investment return to aim for, an amount of money that you need to reach. All you need to do now is have a realistic guess at how many years you have until retirement, plug in the numbers and hey presto, it'll tell you how much you need to save.

...and repeat the process regularly

It's important to recognise that these calculations only tell you what to do, given certain assumptions. Those assumptions are guesses at best and they'll change regularly. The investment return you get might be different from predicted and the date of your retirement might get closer or further away. Most importantly, since we're saving money in today's money, we'll have to keep increasing the amount we save to take account of inflation and average earnings growth.

Let's go back to the original example in this article where we were expecting a return of 5% per annum and aiming to cobble together £400,000 over 30 years. To do that we set about saving £489 pm. Now let's fast-forward to 2012 and look at two possible scenarios - one good and one not so good.

Scenario 1 - Things go swimmingly

In the first scenario, we've actually managed an excellent investment return of 16% per year. That gives us a pot of investments worth £135,712 (you can work it out with this calculator). The investment return is all the more impressive because we've only had inflation and increases in average earnings amounting to 4% between them. Because of that, in the money of 2012, we would now be targeting an income of £30,000 to keep ourselves in the manner to which we've become accustomed (that is, an increase of 4% per year on the £20,000 income that we were targeting back in 2002). So we now need a pot of £600,000 (£30,000 divided by 0.05).

Plugging the numbers in (a final pot value of £600,000, 20 years to get there, £135,712 already saved and a 5% annual return), we find we need to save £589 per month to get us there. That's an increase of 20% on what we worked out we had to save back in 2002, but our task has actually got a lot easier because, assuming our salary has increased along with everyone else's, we should now be earning 50% more.

Scenario 2 - Things go, er, not so swimmingly

In the second scenario, we've actually managed an investment return of 6% per year. That gives us a pot of investments worth £79,836. Again, inflation and earnings growth have amounted to 4%, so we're now targeting an income of £30,000 and a pot value of £600,000.

Plugging in the numbers for this scenario (a final pot value of £660,000, 20 years to get there, £79,836 already saved and a 5% annual return), we find that we need to put by £953, almost double the amount we were saving before and we're only earning 50% more than before. Things have got harder for us because of the poor investment return that we managed.

Either way, it's better than doing nothing

So, by repeating the sums on a regular basis, you can adjust your rate of saving to account for changing circumstances and how well your investments have actually done. Ideally, you should probably refresh the rate at which you're adding to your savings and investments on about a once yearly basis.

Anyway, what you can see from both the above scenarios is the importance of getting started early. Where things had worked well for the first ten years, you'd be left looking to save £589 per month. Where things had gone badly, you'd be left saving £953. If you hadn't started saving at all, though, you'd be left needing to save an unlikely looking £1,473 per month.

So get saving now, Fool!

More: ISA Centre; Pension Centre.