More often than not, retirement advice focuses on some variation of needing to save and invest a percentage of your income on an ongoing basis. What if you were told to throw those “target savings rates” out the window? Stay with us on this …

At Sequoia we define financial independence as "the ability to earn an income from your investment accounts and other retirement resources sufficient to maintain your current standard of living throughout your life.” Given this definition, it’s reasonable to ask, “How is savings not the primary driver of achieving financial independence?” The answer: it is, and it isn’t.

In a perfect world, households spend less than they earn, which in turn allows the household to save and invest the difference. It’s not the savings rate that drives financial independence; it’s actually the spending rate.

By framing retirement advice in the context of a household’s spending rate, spending and income are positioned as the primary factors driving financial independence. The lower the spending rate, the higher the likelihood of success.

There are only two ways to improve household spending rate: spend less or earn more.

When it comes to reducing expenses, it’s helpful to place spending habits in context. In April 2018 the Bureau of Labor Statistics (BLS) released its 2016 Consumer Expenditure Survey, which looks at the median spending by category for U.S. households.

The two areas where people may have the greatest ability to reduce their expenses are housing and transportation, which make up approximately 33% and 16% of median household expenditures, respectively. Armed with this information consumers should consider what the long-term effect of purchasing the largest home or the nicest car might be.

According to the BLS survey, discretionary expenses (restaurants, entertainment, apparel, etc.) make up less than 20% of household spending. When comparing this to housing and transportation costs, which together make up nearly 50% of household spending, it becomes clear that nickel-and-diming the small stuff won’t make up for overspending on the big stuff. The ubiquitous recommendations to cut back on Starbucks lattes may help lower your healthcare expenses, but it’s unlikely to make or break your financial independence.

Situations where essential expenses make up a high percentage of household income present a unique challenge. A two-bedroom apartment in San Francisco currently rents for approximately $4,650, while the median household income over the previous 12 months in San Francisco was approximately $9,200/month. When housing costs make up 50% of a household’s gross income, reducing expenses enough to move the needle may be impossible. When you consider the fact that real estate inflation has far outstripped income growth, it becomes clear that spending less is not always the answer.

When cutting expenses won’t work, earning more by retraining for a new career, pushing for a promotion or starting a side-hustle (Uber started in San Francisco) may prove to be the most viable option for reducing the household spending rate.

In the end, savings is critical to your ability to achieve financial independence. However, it’s important to recognize that the ability to save is predicated on your decision and ability to spend less than you make. By setting reasonable spending guidelines you not only increase the amount you’re able to save, but you also reduce the amount needed to fund a more modest retirement lifestyle.

 

Contact Michael Baker to learn more about this topic.
330.255.4326 | mbaker@sequoia-financial.com

 

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