Personal finance rules of thumb can be useful for pointing us in the right general direction. But if we apply rules of thumb blindly, for every person in every situation, they can lead us down the wrong path.
Many of us want to know how much to save for our retirement. A simple rule of thumb is to set aside 10% of your income. But is this the best way to save for retirement? A new book by retirement expert and former Morneau Shepell chief actuary, Frederick Vettese, suggests not.
The problem, according to Vettese, is that young people have many competing financial priorities, such as rent or a mortgage, student loans, vehicle payments, and childcare expenses. These come at a time when young workers have not reached their peak earning years and may indeed still be in early-career or even entry-level positions. These competing forces make it difficult and impractical to save 10% of their income for retirement.
That’s okay. I repeat, that’s okay. In The Rule of 30, Vettese offers a road map for young people to save for retirement throughout their lifetime, while acknowledging the reality of competing financial priorities in the early, child-rearing years.
What is the Rule of 30?
The Rule of 30 says that you should aim to save 30% of your gross income, minus mortgage or rent payments, and minus extraordinary short-term expenses, like childcare costs. The result is a variable approach to saving, rather than a fixed percentage each year.
The underlying goal behind the rule of 30 is to smooth out your consumption (i.e. your spending) throughout your lifetime so that you’re never decreasing your standard of living at any stage of your life.
This makes all kinds of sense when you consider that a couple in their 30s with a new mortgage and two children don’t have much disposable income to begin with, let alone an extra 10% to save for retirement.
As you get closer to retirement, with childcare expenses and mortgage payments in the rear-view mirror, your ability to save for retirement dramatically increases. But by sticking to the rule of 30 and only saving up to 30% of your gross income you can continue to spend 70% of your gross income and maintain your standard of living.
“Saving is not more important than paying for the roof over your heads or for someone to take care of your kids while you work. Moreover, varying your savings percentage ensures you’ll have more spendable income when you really need it, like in your 30s and 40s.” – Fred Vettese.
How does the Rule of 30 work?
The rule of 30 works for couples, singles, people with children, and even those without kids. The ultimate goal is to have spendable income in retirement that matches your spendable income just before retirement. The rule of 30 solves this issue.
What does the rule of 30 look like throughout your lifetime?
|Ages||Mortgage payments*||Childcare costs*||Sum of expenses||Retirement savings|
|33 to 37||20%||7%||27%||3%|
|38 to 42||13%||2%||15%||15%|
|43 to 47||22%||0%||22%||8%|
|48 to 52||22%||0%||22%||8%|
|53 to 57||15%||0%||15%||15%|
|58 to 62||0%||0%||0%||30%|
In this scenario, the couple has two children and a mortgage, plus childcare expenses for the first 5-7 years. Their salaries are also much lower, mixing in parental leave along with their more entry-level roles.
By age 38 to 42 years, the salaries increase and the childcare costs are eventually eliminated as their kids enter school full time. Their mortgage payments remain a constant dollar amount, but because of their increased income, it takes up less of a percentage of their gross pay. This gives them the ability to ramp up their savings to 15% of gross income while still abiding by the rule of 30.
The scenario also assumes the couple trades up to a larger house in their 40s. The bigger home leads to larger mortgage payments, which is why the percentage increases to 22% of their gross income from ages 43 to 52. The couple also aims to pay off this home in 15 years. In these years, the couple can only save 8% of their gross income for retirement.
Now in their mid-fifties, the couple pays off the mortgage and starts increasing their retirement savings contributions once again – now saving 15% of their gross income. Finally, in the last five years leading up to retirement, and with the mortgage fully paid off, the couple can save all 30% of their gross income for retirement. Furthermore, the couple’s spendable income is also much higher than at any other point in their lives – even with saving 30% of their pre-tax income.
Why is the Rule of 30 a better retirement saving strategy?
The Rule of 30 is a better retirement savings strategy than saving a fixed percentage of your income every single year. The main reason is that it acknowledges the fact that young people have competing financial priorities, namely expensive housing and childcare costs, and so it gives them a break on retirement savings in those years. In fact, retirement savings might only be in the 1% to 5% range.
Meanwhile, as temporary childcare costs ease, and incomes rise, people have a greater ability to save for retirement without significantly impacting their spendable income.
Indeed, the real point is that under the rule of 30, spendable income is higher when you really need it to be higher.
Let’s say we have a couple with a combined gross income of $145,000 (one spouse earns $90,000 and the other earns $55,000). The Rule of 30 says that $43,500 (30%) should go towards mortgage payments, childcare costs, and then retirement savings.
Their mortgage payment is $2,350 per month, or $28,200 for the year. They spend $1,100 per month, or $13,200 per year on childcare costs. Their combined mortgage and childcare costs come to $41,400, leaving the couple with $2,100 per year to save for retirement. That’s just 1.4% of their gross income.
The couple lives in Ontario and would pay about $28,850 in income tax. That leaves them with $72,650 in spendable income after taxes, mortgage payments, childcare costs, and retirement savings.
Now let’s compare that to the same couple saving a fixed 10% of their gross income. The couple in this scenario saves $14,500 (10%) for retirement, leaving them with spendable income of just $60,250. That’s a $12,400 decrease in annual spending.
Astute readers might think, what’s so bad about that? After all, isn’t it a good thing to save more?
Fast forward five years and the couple now earns a combined $168,000 before taxes. Childcare expenses are gone, and the mortgage payment is still $2,350 per month ($28,200 per year). Income taxes now total about $37,000.
In the variable saving scenario, the couple can now afford to save $22,200 per year using the Rule of 30. Their spendable income also increases to $80,600 per year.
Compare that to the fixed savings scenario. Here, the couple saves $16,800 and has spendable income of $86,000 per year.
When the couple trades up to a new home, their mortgage payments jump back up to 22% of their gross income, which is now $194,000. In the variable savings scenario, the couple can save 8% of their gross income, or $15,520 per year. They pay income taxes of about $47,000 and have spendable income of $88,800.
In the fixed savings scenario, the couple would save $19,400 and have spendable income of $84,920.
Scenario 1: Variable savings rate
|33 to 37||$145,000||$2,100||$72,650|
|38 to 42||$168,000||$22,200||$80,600|
|43 to 47||$194,000||$15,520||$88,800|
Scenario 2: Fixed savings rate
|33 to 37||$145,000||$14,500||$60,250|
|38 to 42||$168,000||$16,800||$86,000|
|43 to 47||$194,000||$19,400||$84,920|
Yes, in the fixed savings scenario the couple saves more money in total. But at what cost? The spendable income is unpalatably low during the couple’s child-rearing years. It then increases dramatically once childcare costs subside, but the savings rate only ticks up slightly. Then, over the next five years, they must decrease their spendable income even though their income has grown.
In contrast, the couple that chose the variable savings path has more spendable income during their childrearing years and then significantly increases their savings rate once those temporary costs come to an end. They do this while also increasing their spendable income at a reasonable rate.
The point is: by following the Rule of 30, we can get to the same retirement outcome without impacting our standard of living – without depriving ourselves of the ability to spend at any point in our lives.
The last word
The Rule of 30 allows us to smooth out our consumption throughout our lifetime by adjusting the percentage of income we save each year. That’s easier for people to swallow than following a fixed savings percentage every single year and having to adjust their spendable income up and down.
The bottom line? The Rule of 30 is a wonderful retirement savings strategy and a way for young Canadians to meet their retirement goals without impacting their standard of living.