Financial writers and pundits more often than not strive to gain an edge for their stakeholders in an effort to earn positive returns. This is no doubt a good endeavor. But they never seem to take a step back and help individuals decide how much they should be saving. Perhaps that is just assumed to be a dumb question but, as will be confirmed momentarily, there seems to be almost no strategic thought applied to how individuals save money.
As 2011 has finally arrives many people will contemplate all sorts of New Year’s Resolutions. Many folks resolve to drop those extra pounds that they have added during the holidays, as evidenced by fitness centers being so damn crowded for the first month or two. Others might resolve to cut out stressful things in their lives. For many people, I would propose a financial resolution that might just be in order. I propose individuals should employ a savings strategy rooted in Keynesian economic ideas.
In an effort to simplify Keynesian ideas (perhaps even over-simplify), J.M. Keynes argued that during the booming periods of economic expansion, capital should be stowed away for a rainy day that inevitably comes at some point in the future. Keynes, to my knowledge, was speaking specifically about government policy but, I see no reason why individuals should forgo such a strategy in their own lives. This idea seems simple enough, yet, for some reason the general population follows practically anything but this.
Since 1985, the savings rate has never been above 10% of disposable income. While there are several reasons that the savings rate was in decline (until around 2005), none of them seem particularly logical to me–at least enough so to justify such a low savings rate i.e. below 5%.
After the wonderful experience of paying bills (which isn’t likely to change any time soon), an individual has a couple of decisions to make. Should he or she spend the remainder (a.k.a. disposable income) or should it be saved? Whatever the decision, there is a hidden cost that a significant amount of people do not take into account: the opportunity cost of the other choice. An individual can save the money, thereby earning interest on the money that could have been spent. And vice versa, saving money has the implicit cost of forgoing whatever joy the new toy or service would have brought. I would argue that this foregone opportunity has not been taken into account historically. Immediately some may argue “what’s the point of saving when short term interest rates are pretty much zero”. Those people make a valid point which brings me to my proposal for a new year’s resolution. Individuals should adopt a savings strategy in which their proportion of savings is dictated by short term interest rates.
This exercise has a few ground rules. The minimum savings rate allowable in this experiment is 5 percent. In my opinion, there is not much logic behind saving less than 5 percent of your disposable income. I would go so far as to argue that saving less than 5 percent of your disposable income is equivalent to being short a put option with the strike price of “life is about to screw you over hard”. I am not a certified financial planner but I am willing to say that most financial planners would be inclined to argue that a savings rate of 5 percent is far too low. Nonetheless, I have elected 5 percent as the minimum savings rate allowable in this model. The maximum savings rate allowable is set at 15 percent. There isn’t much logic behind this cap and realistically this same savings strategy would only be enhanced with a higher maximum threshold.
So why would someone want short term interest rates to dictate how much they save?
The first thing someone might notice about short term interest rates is that they have been in a downward trend since 1985. This time period has been termed “the great moderation” in which inflation was generally falling thereby allowing the Federal Reserve to maintain ever lower short term interest rates. The next thing someone might notice about the chart is that there is a certain cyclical nature to it. That is in large part, because of the business cycle.
Right around 1990 the economy entered into a recession at which point the Federal Reserve cut interest rates as evidenced by the falling 3 month treasury yield. The same thing happened again in 2000 as well as 2006. The Federal Reserve was, generally speaking, raising interest rates prior to these recessions in an effort to cool the economy down with the intent to control inflation. All of that said; this chart provides a great roadmap for deciding what percentage one should save. Just think about it. When short term rates are the highest the Federal Reserve is pulling the reigns the hardest to slow the economy down. The Federal Reserve is providing an incentive to save more rather than spend. The higher short term interest rates, the greater the opportunity cost of spending. Yet for some silly reason the general population is ignores these signals.
This chart, shown above, portrays the business cycle a bit more clearly. At the very least one might argue that when the line is below the 0 percent mark, the Federal Reserve is promoting “easy” monetary policy to stimulate the economy. When the line is above the 0 percent mark, the Federal Reserve is promoting “tighter” monetary policy. The incentive to save money (a.k.a. the opportunity cost of spending) increases as the line on this chart increases. Thus, for the purposes of this proposal the savings rate should model this chart–increasing as short term interest rates rise.
Yet, take a look at the chart below. The actual savings rate has essentially no relationship whatsoever with the business cycle or the incentives to save. Which is why, I believe my proposal will leave individuals better off from what they seem to be doing historically.
The chart, shown below, is a visual display of the 3 month treasury yield and the targeted savings rate established using a quasi linear regression model of the 3 month treasury yield and a few rules (min/max). The minimum savings allowable (as discussed above) is 5 percent and the maximum is 15%. As can easily be seen the targeted savings rate tracks the 3 month treasury rate rather nicely.
So now a very valid question must be answered: how much better off would an individual be if they implemented this strategy?
Let’s just say a household earnings $50,000 per year after taxes. That is approximately $4,167 per month. I am just going to make this simple and assume that 50 percent of their monthly income is devoted to the cost of living which leaves $2,083 in disposable income per month.
As one can see, the contributions are totally different. The actual savings household total contribution, using the assumed $2,083 monthly disposable income, was $32,183 from 1985 until November 2010. The household that uses the target monthly income with the minimum of 5 percent and maximum of 15 percent is $64,984. But when you factor in compounding and interest that can be earned the picture becomes even more superior for the household using the targeted savings strategy.
Since savings can earn interest on an essentially risk free asset (i.e. 3 month treasuries), it only makes since to incorporate that into this study.
The total accumulated amount of savings for the actual household, incorporating the interest earned at an essentially risk free rate is $57,906. The same figure for the household using this enhanced targeted savings strategy is $105,200. Total interest earned for the actual household is $25,723. The total interest earned for the targeted savings household is $40,216.
As it turns out, the average difference in the targeted savings rate and the actual savings rate from 1985-2010 is a whole whopping 5 percent. For that extra 5 percent, the household that implemented this strategy earned more than 1.5 times the interest over the same period of time.
In reality this model assumes that at no point either household ever has to tap their savings to help offset the cold reality that might be facing them. BUT, surely everyone will agree that at the end 2006, the approximate beginning of the “great recession”, having nearly $90,000 in savings would have been a far superior position to be in vs. a little over $50,000. That buffer might be just enough to bridge the gap between the dismal situation facing the household and the much happier dual income future that awaits them.
I am compelled to acknowledge that taxes have been left out of this study. Incorporating taxes would decrease the compounding of savings but there would still be a sizable gap between the two different household savings strategy.
Godspeed and have a prosperous new year. Thanks for reading.
*Actual savings rate data came from the St. Louis Federal Reserve.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.