How much should I save towards my retirement? That’s the question that most people confront at some point in their lives. But is it the right question? It implies that my financial plan should be to set myself a savings target. Then as long as my savings are on target I can happily spend the remainder.
But what should my retirement savings target be and why? Should I save just enough to avoid or minimise higher rate income tax? Or should I save a fixed percentage of my salary? Or should I save a specific amount? There are all sorts of approaches to targeting saving. The reality is that saving should be viewed as a means to an end. The end goal of my financial plan is a comfortable retirement.
But how comfortable? The ideal is that my standard of living should be high right now, and stay roughly the same after retirement after allowing for inflation. I don’t want to experience a sudden drop in my standard of living when I retire. But I also don’t want to give up too much enjoyment before I retire. After all, I don’t know how long I’m going to live.
Look At It The Other Way Round
It’s my discretionary spending that determines my standard of living. So clearly I need to keep a close eye on discretionary spending while saving for retirement. So let’s flip the conventional approach to saving on its head. Instead of setting a savings target and spending the rest, I’ll set a spending target and save the rest! The change of focus makes a huge difference for my financial plan.
If I were setting a savings target, I’d treat a cash windfall, such as an annual bonus, as an excuse to spend more than I’d planned. For example. I might use it to take an extra holiday.
With a spending target, I’d treat a windfall as a top-up to my retirement fund. Having a larger retirement fund, I would increase my discretionary spending, but not blow it all right away.
Which approach is better? This is not meant to be a moral question. It’s meant to ask which approach leads to the most sustainable level of discretionary spending. Put this way, it’s obvious that spending one’s bonus all in one go is much more likely to result in a drop in living standards after retirement, once there are no more bonuses.
The attempt to keep one’s standard of living constant is known as “consumption smoothing”. The strategies that our own calculator generates are designed with consumption smoothing in mind. The financial plan assumes that whatever we don’t spend we save. In other words, the focus is on spending rather than saving.