How much do I need to 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 is based on setting 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 can be viewed as a means to an end. The end goal of my financial plan is a financially secure retirement.
But how comfortable? Ideally, I’d like my standard of living to be high now and remain broadly similar 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 it becomes important to monitor 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 remainder, I could instead set a spending target and save the remainder. The change of focus makes a huge difference for my financial plan.
If I were setting a savings target, I might treat a cash windfall, such as an annual bonus, as an opportunity for a spending spree. For example. I might use it to take an extra holiday.
With a spending target, I might instead treat a windfall as a top‑up to my retirement fund. With a larger retirement fund, I would increase my discretionary spending, but not blow it all right away.
Which approach leads to different outcomes? In other words, which approach leads to the most sustainable level of discretionary spending? Put this way, it’s clear that spending a bonus all in one go can increase the chance of a drop in living standards after retirement, once bonuses stop.
The attempt to keep one’s standard of living constant is known as “consumption smoothing”. The strategies that our own calculator generates incorporate the idea of consumption smoothing. The financial plan assumes that whatever we don’t spend we save. In other words, the focus becomes spending rather than saving.