You may be saving a fixed amount or a fixed percentage of your monthly income. But is your annual savings rate increasing? In this article, we discuss why you should increase your annual savings rate and how you should go about it.
Why save more?You may be saving to meet “lumpy” expenditure in the future such as your children’s education costs and post-retirement living expenses. But your current savings may not be enough for the following reasons.
One, actual inflation may be higher than what you have assumed. That means actual education costs may turn out to be higher than your initial forecast. You can, of course, bridge the shortfall in your “investment for children’s education account” by taking a loan when your children enter university. But would it not be easier if you save more every year as your income increases?
Two, even if inflation is in line with your expectation, your investment account could earn lower-than-required returns. This means you have to contribute additional capital to bridge the shortfall. You may also decide to send your children to a better university, thereby, requiring more money than what you initially forecast. Saving more every year helps you meet potential shortfall due to poor investment performance or to meet higher costs due to revised objective. And three, your monthly savings may not be enough to fund multiple life goals.
So, you may be contributing less-than-required each month to the investment account set-up to achieve these life goals. For instance, you may require ₹10,000 per month to meet your child’s marriage expenses 15 years hence. But you may be only contributing ₹6,000 per month. It is important that you increase your annual savings rate to bridge the shortfall in these investment accounts.
But why focus on your incremental salary to increase your annual savings rate? For one, you have to otherwise cut your current consumption to increase your savings rate. That would mean giving up some of your present lifestyle to save more for the future. As humans, we suffer from present bias. That is, we value our present consumption much more than saving for the future. And two, your salary increase will happen only next financial year. So, it is easy to give up (or commit to saving) what you do not have today.
How to save?You should set-up the process to increase your savings well before your salary increases. Otherwise, you will be tempted to spend the incremental income.
Typically, your expenditure will increase at a higher rate than your income. So, you should set aside sizable proportion of your incremental income first and only spend the rest. Suppose you are currently saving 15 per cent of your salary and you are due to receive ₹20,000 per month as incremental income. You should save about 25 per cent of ₹20,000 and not just 15 per cent of your incremental income.
How should you set-up the process of investing your incremental savings? If you are between 25 and 45 years of age, you should set-up a forward-start systematic investment plan (SIP) on an equity mutual fund that you already hold in your portfolio. So, if your annual appraisal is in April, you should register for the SIP in March and start the SIP in May when your incremental salary is credited to your savings account.
The reason you should invest incremental salary in equity is because you must increase your equity allocation between the age of 25 and 45. What if you are older than 45? You should set-up recurring deposit with the incremental savings.
This is because you should reduce your equity allocation between 45 and 55. What if you do not receive the expected salary increase? You can choose to cancel the additional SIP.
The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in