It is very difficult to set out any general rules to act as a guide in determining an appropriate level of family saving. Apart from the fact that most families should save more than they do and more than they think they should, only some rather vague rules of thumb can be given. Many financial experts suggest a regular savings program of from 5 per cent to 10 percent of total income with a primary objective of an emergency cash reserve of one to two months' salary and a secondary objective of a retirement savings plan. The actual amount you should save depends upon the variety of factors discussed below, and also on what you consider savings to be.
The most important factor affecting the size of your savings program is the pension you expect to get on retirement. If you are fairly certain that you will receive a pension that will support both you and your spouse in old age, saving for retirement is obviously not a major issue with you. The RCMP and the armed services both have very attractive pension plans, where the amount of pension paid is based on the standard 2 per cent of salary per year for every year of service. These plans offer a pension after as little as twenty to twenty-five years of service. On the other hand, individuals who work for a relatively small retailer, without a pension plan or with a very poor one, should plan to save substantial amounts to help support themselves during retirement.
Another important factor which should influence your savings program is the security of your employment. If you work for almost any civil service, your job is fairly secure. If on the other
hand you are a professional entertainer or sportsman, or even if you work for a small industry or enterprise of any kind, your job is not so secure. Clearly your savings program should be at a higher level if your earnings are likely to be cut off through loss of your job.
Your skills or knowledge should also influence your level of savings. A doctor or lawyer should never have much trouble getting some type of job paying reasonably well. The general clerk,
the lower level administrator, or the supervisor might have difficulty, however, particularly as he gets older. While the clerk, administrator or supervisor may have done an excellent job for his previous employer, he sometimes has difficulty convincing a prospective employer that he can do as good a job for him.
The trend you anticipate your salary will follow should also influence your savings program. If your salary is likely to remain level or to fall, you will clearly need to save more than if
you expect it to rise. The lawyer's income together with the general insurance broker's income usually rise continually until retirement. The doctor's income often starts to fall in his mid fifties, the dentist's usually falls even sooner. The unskilled or semi-skilled worker often experiences a similar sharp drop in income when he has passed his early fifties, unless he has a permanent employment.
While it is a very easy matter to exhort the young to save, there are many good reasons why they cannot. Age clearly has an effect on the amount that can be saved: the young couple will be buying items for their homes, meeting the many initial expenses in setting up a home, and dealing with the frequent hospital bills and moving fees that are encountered. While the young should save, as anyone should, the middle aged should save more. They are closer to retirement, they have a shorter time to save for it, and their flexibility in adjusting to new economic situations is often limited.
Finally, the number of dependents a man has must obviously influence the amount he saves. The single man should be able to save up to 50 per cent of his salary, the married man with two or three small dependent children will struggle to save 10 percent, even when his 4 per cent to 6 per cent pension contributions is included in the 10 per cent figure. Obviously, the man who has several dependents should save a great deal, but it is usually impossible for him to do this. He has to spend most of his savings dollar on insurance protection and can build up only a modest cash reserve. It is important to stress again that your appropriate savings level does not depend on the income you happen to be receiving. The six factors just mentioned are the crucial things to bear in mind.
Compounding In this chapter and the following one, compounding will be mentioned frequently. Compound interest means simply that as each amount of interest is paid, it automatically and immediately becomes part of the principal amount and earns further interest along with the principal sum invested. Simple interest means that the principal alone is used as the base for interest payments.
For example, in an account paying 4 percent simple interest, a deposit of $100 would earn $4 interest in the first year. The $4 interest would then be set aside and the original deposit of $100 would earn another $4 interest in the second year; this $4 interest would be again set aside, and so on. By the end of ten years the original deposit would have earned a total of $40 interest. Under compound interest, the original deposit of $100 would still earn $4 interest in the first year. However, that $4 interest would not be set aside but would be added to the original deposit of $100, so that the $4 interest would itself earn interest during the second year. Larger amounts of interest would be added to the original deposit each year until, at the end of the tenth year, the original deposit would be worth $148.02. This difference of $8.02 may seem hardly worth worrying about, but for higher rates of interest and longer periods of time, the effect of compounding has a remarkable effect on the account balance.
For example, $100 invested at simple interest of 7 per cent for ten years would amount to $170; if invested for twenty years it would amount to $240, and if invested for thirty years it would rise to $310. If the interest had been compounded, the $100 investment after ten years would amount to $196.72, after twenty years it would amount to $386.97, and after thirty years, to $761.26 much more than the $310 figure obtained through simple interest.
If Adam had invested one penny at 5 percent simple interest in 3034 B.C., the investment would now have grown to $2.49. Had he invested the penny at 5 percent compound interest, it would now amount to a figure difficult to comprehend, $1,329,212 followed by ninety-six zeros. Coming closer to home, it delights some history teachers to point out quite properly that had the Indians who took $24 for Manhattan Island invested the sum at 7 percent compound interest, it would by now have grown so large that they could purchase every piece of real estate on the island. While these two examples may not seem relevant to your study of personal finance and savings generally, they should indicate that there is a certain magic in the phrase "compound interest".
Effective rates of interest Stated rates of interest are not always what they seem, and the effective rate of two apparently identical interest rates may be quite different. The important variable to watch out for is the length of time between interest rate calculations. For chartered banks, this time lapse is three months, but for the post office savings bank it is equivalent to about a month. For an average pattern of deposit and withdrawal, an account calculating interest on the average, or even minimum, balance daily would have an effective rate of interest of about 100 percent of the stated rate. If interest were calculated on a minimum monthly balance, the effective rate might be from 90 to 95 per cent of the stated rate. When interest is calculated on a minimum quarterly balance, as is the case with commercial banks, the effective rate is only about 75 per cent or less than the stated rate. These percentages are only approximations and depend to a large extent on the deposit and withdrawal pattern.
