The #1 Factor of Financial Independence Success

Let’s start by talking about pensions!  It may sound boring but this is an important place to start the conversation about savings since the type of pension you have have (if you have a pension at all) has a huge impact on your future savings plan.

Years ago, people relied on Defined Benefit Pension plans and government benefits to fund their retirement.  With Defined Benefit plans,

  • Contributions are generally made by both the employer and the employee during the employee’s career
  • The employer pools the funds of all employees and manages them together as one
  • The employer is responsible for providing employees with a monthly payment upon retirement (generally until death) that is calculated based on various factors (e.g. years of service, salary, etc.).
  • Given the employer’s obligation to pay the employee monthly payments set by a calculation, the employer bears the risk associated with investing the funds (the performance of the investments do not impact the outcome for the employee).  

Nowadays, many employers have shifted to Defined Contribution Pension plans since they are less expensive to administer, create certainty on how much the employer is required to pay in (usually a percentage of employee salaries), and allow investment risk to be shifted to employees.  With Defined Contribution Pension Plans,

  • Contributions are generally made by both the employer and the employee during the employee’s career
  • The employee is assigned an individual account and is responsible for selecting his/her preferred investments within the account
  • Given uncertainty of future investment performance, the actual amount that the employee can withdraw in the future is not known (the employee bears the risk associated with investing the funds).

For those without any employer pension plan (e.g. entrepreneurs, self-employed, or employees of companies that do not offer pension plans), they have to responsibly save money outside a pension plan to ensure they have enough money for retirement.

As the responsibility of investing shifted from employers to employees over the years, many were not ready and equipped with the knowledge to manage their pension. In 2011, the ASPPA Journal published a paper named “Retirement Success: A Surprising Look into the Factors that Drive Positive Outcomes” by David M. Blanchett and Jason E. Grantz.  In that study, the authors ranked four drivers of retirement success, in order of importance:

  1. Savings Rate
  2. Asset Allocation (the mix of the assets that you invest in – e.g. stocks, bonds, GICs, etc.)
  3. Asset Quality (selecting and monitoring individual investments) 
  4. Actuarial Assessment (making strategic changes to the allocation as situations warrant)

Ironically though, people spend most of their time on the less important activities (e.g. picking individual investments) and very little time figuring out how they can SAVE MORE (the most important activity). In fact, it should be obvious that savings is the #1 factor of retirement success since you need savings to start the wealth accumulation journey.  Investment selection is a moot point if you don’t have enough money going into the account in the first place!

Let me show you how much of a difference savings rate can have on the time you need to work to reach financial independence.  See the chart below (assumptions stated at the bottom of this post).

  • On the horizontal axis – different levels of savings rate (expressed as percentage of after tax income) 
  • On the vertical axis (or blue numbers at the top of each bar) – working years to Financial Independence (“FI”)

First let’s speak through the extremes:

  • If your savings rate is zero or negative, you will never accumulate money and will technically have to keep working forever or fully rely on government benefits in your older years (in Canada, Canada Pension Plan, Old Age Security, Guaranteed Income Supplement)
  • If you only save 1% of your salary, of course it is going to take you forever to reach financial independence – it would take a whopping 37 working years to save just 1 year of expenses, and 99 working years to save 25 years of expenses
  • If you save 100% of your salary, you are already financially independent.

What about the average?

  • The average savings in Canada in 2019 was between 3 and 4% – at that rate it would take you between 71 and 77 years to reach financial independence!  This means that the average Canadian is drastically under saving and will likely have to significantly rely on government benefits during retirement.

But what if you can save more?

Where this really becomes interesting is when you progress towards a higher savings rate.  You will see that small changes in your savings rate can create a massive impact on your time to financial independence.  

  • Let’s say you make a few minor tweaks to your monthly budget (whether that be earning a bit more, or spending a bit less through conscious value-based spending), and are able to go from the average savings rate of 3-4% up to 10%.  At the 10% level, the math says that you reach financial independence in 52 years. THIS MEANS THAT YOU CAN WORK 19-25 YEARS LESS JUST BY SAVING 6-7% MORE!
  • I personally think we all should go further – who really wants to trade their time for money for 50+ years!
    • Many people in the financial independence community target saving 40-70% of their net incomes (that puts their working years down to 9-22 years).  That is certainly not for everyone, and like most other topics in personal finance this is a very personal decision where you have to find what is right for you. Those who enjoy their jobs and value spending a higher percentage of their income may be more than happy to have a longer working career. Others who find their jobs less fulfilling or stressful may want to try to save more so that they can expedite their journey to financial independence – eventually shifting their time and energy to other things that they value.

Anyone can do this – sure it is easier to have a higher savings rate with a higher income (assuming you are able to avoid the lifestyle creep / rising expenses associated with a higher income), but there are many examples of people in the financial independence community who are able to reach high levels of savings on a low income.

I have a strong opinion that the basic concept of “saving” is too often overlooked.  Most people spend too much time with their financial advisor thinking about what stocks to buy and not enough time thinking about how they can increase their savings rate in the first place.

So what should you do? Track your finances, spend less and/or earn more to increase your savings rate to decrease the number of years to financial independence!  If you would like help, visit my financial coaching page.

And for those who’re interested in the assumptions and math behind the bar chart above:

  • Networth starting from zero today looking forward
  • Constant expenses 
  • Investment return of 5%
  • Withdrawal rate of 4% during financial independence
  • Financial independence definition – the point where your investment portfolio is 25x your annual expenses  
  • Income: these numbers work for every level of income since we are talking about relative savings rate (annual savings divided by after-tax income)
  • These numbers ignore government benefits.

2 thoughts on “The #1 Factor of Financial Independence Success

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