Financial Independence

Working allows us to leave our parents and live on our own. It allows us to be independent. I will call this the first independence. If we work hard and invest our savings we can accomplish independence from having to work. This is the second independence. It is often called financial independence. The graph below shows a standard time frame for when we are dependent on parents, independent through work, and independent from work.

path-to-financial-independence

path-to-financial-independence

Financial independence is a worthy goal. If we don't have to work, we can devote our time to developing ourselves and contributing to society. Benjamin Franklin lived to age 84. All of Benjamin Franklin's major achievements were made after he reached financial independence (FI). He reached FI when he was in his early 40s. His path to financial independence looked something like this:

path-to-financial-independence-franklin

path-to-financial-independence-franklin

If you want FI by age 50, you first need a plan that will get you there by 70. It is more difficult to achieve FI at younger ages. Therefore, a retire-at-70 plan must precede a retire-at-50 plan. Increase your chances of an early FI by thinking about these things now and studying people who have achieved early FI.

Savings and lifestyle

The purpose of this post is to show how to maintain one's lifestyle after he/she stops working. Observe the chart below (Source here). It shows the advantage of continuing education past high school. It also shows that in the course of a lifetime one’s salary will tend to rise until about 40, it will rise a bit slower from 40 to 50, then it will plateau and slowly decline.

20120910-Income-by-education

20120910-Income-by-education

For illustration purposes, here is simplified version of the above graph:

20120910-income-by-education-abstracted

20120910-income-by-education-abstracted

Income tends to rise when young people get more experience, education, and skills. Income tends to decline as work skills become obsolete, and as people work less and/or leave the workforce to retire. Many people have negative savings when they are young. That means that they spend more than they earn by taking advantage of school loans. If they had average annual earning and they spent everything they earned on lifestyle and paying back student loans, their lifestyle would look something like this:

20120910-income-and-lifestyle

20120910-income-and-lifestyle

They would borrow when they were young and pay off the loan when they are older. If they spent the rest of their income on lifestyle, then they would be in big trouble when they approach retirement years. They would be forced to decrease their lifestyle and possibly become dependent on others as there annual earnings decreased. To avoid this, they would have to save, by consuming less than they earn as shown in the graph below. For simplicity, let's assume that they didn't have to take out any school loans.

20120910-lifestyle-below-income

20120910-lifestyle-below-income

If people saved as they earned more, they would be able to maintain their lifestyle by living off of their savings. How would savings carry them through retirement? By investing. The graph below shows how this could hypothetically happen:

20120910-income-lifestyle-and-investement

20120910-income-lifestyle-and-investement

If one saved and put their money into investments, he/she could create an income from their investments that would replace their annual earned income that they had to work for. The only way to maintain independence and increase one's lifestyle over time is to consume less than you earn and put your savings into an investment that will grow and provide income without having to work.

Prioritizing Savings

Do you prioritize savings? If you are a millionaire, there is a good chance that you do. According to the author of the book The Millionaire Next Door, people who become millionaires tend to live well below there means by spending only 80% of their income. The other 20% is saved and invested. Many people want to save and intuitively know that they should save more. They might even plan to put whatever is left over at the end of the month into savings. Their monthly flow of money looks something like this:

present-oriented-flow-of-money

present-oriented-flow-of-money

I call this the present-oriented flow of money. This plan rarely works because there usually isn't anything left over to save. The reality often turns out to be more like this:

Actual-present-oriented-flow-of-money

Actual-present-oriented-flow-of-money

The wealthy mentioned above "pay themselves first". Before they pay the grocer, or the bank, or the department store, they pay themselves a set percentage of their income. There flow of money looks like this:

future-oriented-flow-of-money

future-oriented-flow-of-money

Religious people are taught to add one more bucket to their flow of money. That bucket is charity. L. Tom Perry, said:

After paying your tithing of 10 percent to the Lord, you pay yourself a predetermined amount directly into savings. That leaves you a balance of your income to budget for taxes, food, clothing, shelter, transportation, etc. It is amazing to me that so many people work all of their lives for the grocer, the landlord, the power company, the automobile salesman, and the bank and yet think so little of their own efforts that they pay themselves nothing.

 A religious future-oriented flow of money looks like this:

religious-future-oriented-flow-of-money

religious-future-oriented-flow-of-money

There are religious and secular reasons to give to charity. A study done by the economist Arthur Brooks found that after accounting for variables, those who give to charity tend to make more money as a result of their giving. In other words, if you take two people that have the same religion, income, career, and education and track them over time, the one that gives to charity actually makes about $14,000 more on average than the non-giver. I will write more about charity in the future.

In conclusion, it is more difficult to save when expenses take priority over financial goals. Saving only seems to work if you get into the habit of paying yourself before your other expenses. So follow the example of the wealthy and start saving today.

Do Americans save enough?

In my last post I wrote about 3 reasons to save. The first reason is to prepare for rainy days including emergencies or preparing for old age when one cannot work anymore. The second reason is to purchase large items like houses and cars and educations. The third reason is to increase leisure activities like vacations or early retirement. The purpose of this post is to answer the question, "Do Americans save enough?" First, let me define savings. Savings = Income - consumption. If you consume less than you earn, then you have a positive savings rate. If you consume more than you earn then you have a negative savings rate. Negative savings is not categorically bad in every situation. For example, it might make sense for many university students to consume more than they earn by taking advantage of student loans within reasonable limits.

According to some recent studies, Americans say they wish they had saved more for their retirement. According to a survey done by the Consumer Reports magazine's National Research Center, nearly a third of all people at or approaching retirement said their expenses were higher than they had anticipated before retiring. Only 11 percent said expenses were lower than expected.  Also, a survey commissioned by Bankrate and administered by the Princeton Survey Research Associates International asked both retirees and workers questions about retirement realities and expectations. They found that 55% of respondents said they wish they saved more.

survey-of-retirees-and-workers

survey-of-retirees-and-workers

According to another survey done by Putnam Investments70% of people who already retired within the past 2 to 6 years said that they wish they saved more for retirement and 59% said they wish they saved earlier.

survey-of-retirees-within-last-2-to-6-years

survey-of-retirees-within-last-2-to-6-years

So to answer the original question, most Americans say that they wish they saved more and earlier for retirement. Listening to the regrets of the elderly should be a powerful lesson to the young. When you retire, you probably won't be wishing that you saved less.

Coming up: Why don't Americans save more?