Banking 101: Understanding the 10% Savings Rule

When it comes to financial planning, one of the most famous pieces of advice out there is that you should save 10% of your income to reach your retirement goals. It’s so common that even the Consumer Financial Protection Bureau describes it as a rule of thumb.

But while the 10% savings target is a decent place to start, these days it may not be enough. Let’s take a closer look at where this advice came from and why it might not be enough to reach your financial goals. Also, we’ll help you set your own personal savings target, based on your own earnings and needs.

George Clason and The Richest Man in Babylon

The 10% savings rule became famous from a book called The Richest Man in Babylon, written by George Clason in 1926. Clason wrote a series of financial guides, and The Richest Man was far and away his biggest hit.

The book is fictional, set in Ancient Babylon. The Babylonian ruler reaches out to the richest man in the kingdom, Arkad, for advice on how he became successful so that others in Babylon could succeed as well.

Arkad shares a series of lessons for financial prosperity, rendered in charmingly archaic phrases:

• “Control thy expenditures”: Readers should spend less than they earn to achieve financial freedom.
• “Make thy gold multiply”: Rather than keeping your money in cash, you should invest so your wealth grows. This way you benefit from compound interest, where your money makes more money.
• “Increase thy ability to earn”: Beyond investing, you should be learning new skills to become more valuable and receive a higher income.

Another lesson, arguably the most important in the book, is to “start thy purse to fattening” — in other words, saving and building wealth should be your number one priority. Every paycheck, you should set some money aside for your long-term financial goals.

In this chapter, Clason brings up the 10% savings rule. Regular, consistent savings is the foundation of any financial plan, because if you aren’t regularly saving money, you won’t have the resources to follow any of the other advice.

Is the 10% savings rule enough?

When Clason wrote his book nearly 100 years ago, the world was a very different place. The average person only had a life expectancy of about 60 years, versus 78 today, so retirements were much shorter. In addition, before 1980, it was much more common for workers to have a pension to replace part of their income at retirement. These are much rarer now, especially for workers in the private sector.

We spoke with Ken Tumin, founder of DepositAccounts, about the 10% savings rule. “The 10% savings rule should still be considered a basic rule of thumb for retirement saving. However, a higher rate of savings is more important these days now that defined pension plans are a thing of the past,” he said.

Between longer retirements and less money coming in from pensions, chances are you’ll need more of your own savings to manage everything. The best way is to get there is by increasing the amount you put aside each year.

So how much should you save?

Vanguard offers a free online calculator where you can predict how much you’d have at retirement based on your savings rate. Here’s one scenario to show you how it works.

Steve is 30 years old and earns $50,000 a year after-tax, with no savings just yet. Steve expects to earn 8% a year from his investments and his goal is to replace 70% of his income when he retires at 65 — that would be just under $3,000 a month. He doesn’t need to replace 100% of his income because some money will come in from Social Security.

If Steve saves $5,000 per year, 10% of his salary, Vanguard calculates his savings will pay out about $1,500 per month in retirement income — not bad, but it’s well short of his goal of $3,000 a month. If Steve saves 15%, he’ll have $2,300 a month — closer, but still a little short. For Steve to reach his goal of $3,000 of monthly income, he should be saving about 19% of his earnings today.

When it comes to your own goal, Tumin advises that each person should customize a savings rate that’s based on their own personal situation. If you already have some savings, you expect a higher investment return and/or you think you can get by with a lower income in retirement, then perhaps you can still get by with a savings rate around 10%.

But for typical Americans, you can see why a 10% savings rate will leave some people surprisingly short of their retirement goals.

Make your own savings rule

When the government measures how much people are saving, they look at a statistic called the personal savings rate. Over the last couple years, U.S. households had an average personal savings rate of 6.7%, according to Bloomberg. This is better than in years past, but it doesn’t even reach the 10% savings rule, not to mention the more ambitious savings targets we calculated earlier.

How to calculate your personal savings rate

• Step 1: Add up all your savings for the year. This includes contributions in both your retirement and non-retirement accounts. If your employer pays out a matching contribution for your 401k, count this as well since it builds your savings. However, don’t count the earnings from your investments.
• Step 2: Find your total income. For total income, add your deductible contributions into a retirement plan to your after-tax income. Your take-home pay would have been higher if you hadn’t put money in your retirement plan, which is why you add these contributions back to find your total income for the year. You should also include any matching contributions given to you by your employer.
• Step 3: Divide your savings by after after-tax income. This calculates your personal savings rate.

Personal savings rate example

Let’s say your after-tax salary is $50,000 per year. Before you get paid, you put $5,000 into a 401k. Your employer gives you another $1,000 for a match. After you receive your paycheck, you add another $2,000 to your personal savingsthrough a certificate of deposit.

• Your total savings will be $8,000: Counting $5,000 from the 401k + $1,000 from the employer match + $2,000 into personal savings.
• Your total income will be $56,000: Includes $50,000 from after-tax salary + $5,000 that went into your 401k instead + $1,000 from the employer match.
• Your personal savings rate is 14.2%: $8,000 in savings divided by $56,000 in income

Set your own personal savings rate

To figure out the precise amount you need to be saving per year, set a personal savings rate target and work backwards through the formula, using your after-tax income.

Let’s say you want a personal savings rate of 15% and your after-tax total income is $60,000, with nothing going into savings just yet. You’ll need to put aside roughly $9,000 throughout your 401k, IRA, personal savings and matching contributions from your employer to hit your goal ($60,000 x 15% = $9,000).

To make this goal easier to imagine, break it down by month and weeks. A total of $9,000 per year means saving $750 a month or $173 a week.

The final word on your personal savings rule

The right personal savings rule for you ultimately depends on your current situations and goals for your financial plan. It could be the 10% savings rule, or more (or even less) depending on your situation. The key point is that you pick a savings rate and stick to it throughout the year.

The Consumer Financial Protection Bureau has put together a pledge form, “My savings rule to live by.” We encourage you to read through their document, figure out your ideal personal savings rate and work to hit that goal each and every week.