How do I determine an appropriate savings rate?
The word “de-leveraging” came and went in about 2 months during the credit crisis. An initial upswing in the household savings rate seemed to be a blimp and not a pattern. After a short period of frugality, Canada’s savings rate fell to 4.6% in Q1 2010 according to Statistics Canada (it was in the 6% during the late 90′s) and the American personal savings rate has seen a downward trend from over 5% in early 2009 to slightly over 3% in Q1, 2010 (back to the approximate range of 2004 rates).
There has been a lot of focus on stock allocations and risk in the last few weeks arising from Greece and the larger sovereign debt issues but the fundamental issue continues to be the same.
People are not saving enough. Household debt levels continue to rise while personal savings rates continue to fall (although household debt levels include both mortgage and non-mortgage debt which raises the question of whether real estate valuations can support our debt- a subject of another post).
But what exactly is enough savings? The figure of 10% of take-home pay has been often used as a nice round number as an ideal savings rate. The only issue with the 10% rule is that it lacks context. Studies have shown that household savings rates are influenced by factors such as interest rates, inflation, the government’s fiscal position and ratio of household net worth to personal disposable income.
When all these factors are aligned positively for the average household, the savings rate can fall and is generally seem as acceptable. Whereas when these factors are affecting households negatively, household savings by necessity must rise.
For example, during the 1960′s, a low inflation/high growth period, the savings rate for Canadians was 6.7%. In the 1970′s and early 1980′s, a high inflation/stagnant growth period, the savings rate for Canadians was in the teens and peaking at 20% in 1982 when mortgage rates were regularly between 15%-20%.
The particular issue facing all of us is that we live such economically anomalous times. Typically, savings rate tend to shot up in down times as a defense mechanism (this is why government in the past could safely increase debt- there was enough domestic personal savings to purchase the debt but if the government and its citizen are broke…). This does not seem to be happening based on recent data. Only one factor- low interest rates- seems to be aligned for consumers which would mean household saving rates should be going up but its not.
Thus, looking at savings rates today and using it as a peg, may not be very helpful and given no one knows what will happen when government turns off the taps, it is hard to predict what exactly an appropriate savings rate should be.
In such uncertainty, the only safe rule seems to be: (i) save; (ii) make it automatic; (iii) save more than you think you need since it is easier to go backwards than forwards.
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