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You probably all know what savings rate are. It is simply the percentage of your income that you are saving. If you do not know your personal savings rate, you should probably start with calculating it.
The basic formula is fairly simple. You need to divide your savings by your income. And this gives you your savings rate. It seems simple, right?
Well… Not really that simple. There are many ways to calculate it. The problem comes from what you count as expenses and income. And because of that, it is extremely difficult to really compare savings rates.
And it seems to me that most people on the internet are trying to inflate their savings rate by using the computation that yields the higher number. So today, we are going to see how to increase your savings rate with math!
In this post, I am going to show how we increased our savings by 26% without doing anything! And so can you!
Savings rate and math
The formula for savings rate is pretty simple: Savings Rate = (Income – Expenses) / Income = Savings / Income.
Based on that formula, there are two ways to increase your savings rate:
- You increase your savings.
- You decrease your income.
The second part is counter-intuitive. But a smaller income makes it easier to have a large savings rate. If two families can each save 5000 CHF each month but one family has an income of 10’000 and the other of 20’000, the first one has a much better savings rate!
Before we play it, let’s think about is really the savings rate. It is how much percentage of your income you are able to save. To optimize it, you will increase your savings either by increasing your income or decreasing your expense.
Put in another way, this represents your capability to save. Therefore, the savings rate should only take into account things that you can control and should ignore the rest.
Now, a lot of people will not agree with me, especially bloggers. Indeed, a lot of people just want the higher number possible, regardless of whether it makes sense or not. Some people do that for their ego and some do that for their audience. In both cases, I think this makes a disservice to everybody!
Use your net income (fair)
The first way is to use your net income instead of your gross income. I am not talking about the taxes you pay each year. I am talking about the direct deductions that are made on your income. For instance, in Switzerland, disability insurance is directly removed from our salary. In the United States, your 401(K) contribution is also directly removed from your salary.
How much of a difference do you think it does? Let’s see!
If you have a gross income of 10’000, a net income of 9000 and expenses of 5000, you will be able to save 4000 per month. If you compute your savings rate based on your gross income, you will get 40% (4000/10000). But if you use your net income, it becomes 44% (4000/9000)!
Congratulations, you just increased your savings rate by 10% with math!
I actually think this is a very fair way of computing your savings. You have no opportunity of reducing this difference between your gross and your net income. So you should not count it as expenses!
Use your post-taxes income (unfair)
Let’s try yet another way to improve our savings rate with math. Some people like to consider their post-taxes income instead of considering taxes as expenses.
For instance, your net income is 9000 and you have 5000 expenses each month. Now, 1000 of these expenses are for taxes. Whether you remove your taxes from your income or add it to your expenses, your savings are the same. Let’s see how we could use this to our advantage:
- Pre-Tax Income Savings rate of 44% (4000/9000)
- Post-Tax Income Savings rate of 50% (4000/8000)
Once again, we are able to increase our savings by 6% with some math!
Now, I do not think this is fair to compute savings rate like this. Some people would argue that taxes are not under our control and so should not be taken into account into savings rate. I would argue exactly the contrary!
Taxes are under your control. By earning more money, you are increasing your taxes. Moreover, there are ways to optimize your taxes. For instance, you can invest in tax-efficient funds. And you could also move to a country with lower taxes. This is all under your control.
Add your contributions as savings (meh)
Another way to increase your saving rate with math is to take into account your retirement contributions as savings. For instance, if you pay 5% of your salary every month to your 401(K) or your second pillar, you can consider this as savings.
Let’s take an example again.
You have a gross income of 10’000, a net income of 9000 and 5000 of expenses. But 5% of your gross salary goes towards your retirement account. If you do not take them into account, you would have a savings rate of 44% (4000/9000). If you take them into account, you get 50% as a result!
Once again congratulations, you just added 6% to your savings rate by doing nothing!
I think this is already borderline unfair. You do not have control of this contribution. As such, you do not have the opportunity to save it, you are forced to save it. For me, this is not a good usage of the savings rate.
On the other hand, if you can choose this contribution, it could make sense to take into account. But for instance, if the minimum is 5% and you are contributing 7%, you should only take 2% into account. Since this is the only thing you control.
Add your employer contributions as savings (unfair)
But, we can do even better! Most employers are matching some contributions to the retirement account. So we could also count it as savings.
You have a gross income of 10’000, a net income of 9000 and 5000 of expenses. Again, 5% of your gross salary goes into your retirement account. And your employer is matching this 5%. Let’s take the three cases:
- Base: 44% savings rate (4000/9000)
- Your contribution into savings: 50% savings rate (4500/9000)
- Your employer contribution into savings: 55% savings rate (5000/9000)
Adding your employer contribution adds again 5% to your savings rate!
Now, I really think this one is totally unfair to count as savings rate, for two reasons. First of all, you do not have the choice to save this money! You did not do anything for it and you just increased your savings rate. It feels like cheating to me.
And the second reason, using this, you could actually have a savings rate higher than 100%! This would mean you save more money than you earn. This is plain stupid and this shows that this does not make sense!
Remove Expense X from your income (stupid)
Let’s go all the way into savings rate optimization! Some people remove some expenses, other than taxes, from their income instead of adding it to their expenses. This has the same effect as taking the post-tax income.
Let’s take our example again, a net income of 9000 and expenses of 5000. Let’s say you want to remove your health insurance from your income instead of adding it your expenses:
- Net-Savings Rate: 44% (4000/9000)
- Net-Savings Rate without expense: 47% (4000/8500)
Congratulations, you are saving 3% more per month!
This last one just does not make sense. I have seen this done several times on the internet and it makes my skin crawl. I have seen one example where people did that for a so-called mandatory expense, such as health insurance in Switzerland.
For me, this is a just way some people use to inflate their savings rate for showing off. There is no good reason to remove any expense from your income. Even for taxes, it made little sense, but for any other expense, it is just stupid.
Once again some people would say that they have no control over that, but they do! Even if the health insurance in Switzerland is mandatory, you still have some control over how much you pay.
Putting it all together
Let’s put everything together. Once again, the gross income is 10’000 and the net income is 9’000. Your contribution is 5% and your employer contribution is 5% as well. 1000 of your 5000 monthly expenses is for taxes. Each month you spend 500 for your health insurance.
Let’s see all the levels of savings rate:
- Gross Savings Rate: 40% (4000/10000)
- Net Savings Rate: 44% (4000/9000)
- Post-Tax Savings Rate: 50% (4000/8000)
- Post-Tax Savings Rate with Employee Contribution: 56.25% (4500/8000)
- Post-Tax Savings Rate with Employee/Employer Contribution: 62.5% (5000/8000)
- Post-Tax Savings Rate with Employee/Employer Contribution Without Health Insurance: 66.6% (5000/7500)
Congratulations, your savings rate went from 40% to 66.6%! You are now in the elite savers! And you did not need to save any extra money to increase your savings rate!
I hope this goes to show that this way of counting your savings does not make sense!
We increased our savings rate by 26%!
Finally, let’s see how we can increase our own savings rate with some math!
Our gross income is about 10’400 CHF and our net income is about 9’400 CHF. 4% of our gross income goes towards our second pillar and my employer matches this 4%. Generally, we spend around 5000 CHF expenses. Out of this, about 900 CHF goes to taxes and 800 CHF goes to our health insurances.
- Gross Savings Rate: 42.3% (4400/10400)
- Net Savings Rate: 46.8% (4400/9400)
- Post-Tax Savings Rate: 51.7% (4400/8500)
- Post-Tax Savings Rate with Employee Contribution: 56.6% (4816/8500)
- Post-Tax Savings Rate with Employee/Employer Contribution: 61.5 (5232 / 8500)
- Post-Tax Savings Rate with Employee/Employer Contribution Without Health Insurance: 67.9% (5232/7700)
Wow! Our savings rate increased from 42% to 68%! This should mean 50% more savings, no? No! We are not saving anything more. We just inflated our savings rate with math!
This does not make sense!
I think that is enough math and manipulation for one post! As you can see, there are many ways to manipulate an important metric such as the savings rate. It is important to know these tricks so that you can realize what a savings rate may means.
I hope that all this shows that you should not always trust savings rate online. By default, you should not compare savings rates. They may have been computed differently. Unless you know exactly how someone computes his savings rate, you cannot compare it. By default, you should only consider your own savings rate and not consider other’s results.
Also, I am not trying to encourage you to cheat with your savings rate! On the contrary! I think everybody should use the same formula. The net savings rate is the best way to compute this important metric!
Removing things from your expenses just does not make sense. It increases your savings rate, nothing more. And it makes you complacent since you think, wrongly, that you are saving more!
I really wish bloggers would use a fair way to compute their savings rate instead of just trying to aim for the biggest number for no reason. Or at the very least, they should indicate exactly how they compute it before publishing it. This shows once again that we are having a transparency issue on the personal finance community.
What do you think? How do you compute your savings rate? What do you think is the fairest way to compute it?