The absence of holidays, social events and physical retail has turned the UK into a nation of forced savers over the last year. Like most, I am eagerly awaiting a time when we can safely visit our friends and families, have a drink in the local pub and even board a plane to somewhere exotic.
But in the meantime, how can we maintain our increased savings most efficiently, without feeling guilty about spending money on the things we are all looking forward to?
Personal savings ratio: The 50/30/20 rule of thumb
For many individuals, particularly those who are employed and receiving a monthly salary, your personal savings ratio will be a key influencing factor on the shape of your future financial security.
One well known approach to budgeting and saving is the 50/30/20 rule. This provides a guideline for allocating your monthly budget, suggesting that 50% of your income should be attributed to ‘needs’ such as housing and food, 30% to ‘wants’ such as holidays and hobbies, and 20% to ‘savings’.
Whilst the 50/30/20 rule provides a sensible guideline for budgeting, the feasibility of this strategy will differ from person to person. A low-income household may view saving 20% of their income as being nigh on impossible, whilst a high-income household might be able to save more than 20% with ease. Similarly, somebody living in the South East may find that a higher cost of living prevents them from limiting their ‘needs’ to 50%.
However, I believe that in general the events of 2020 have proved to many that more of their expenses fall into the discretionary ‘wants’ category than they originally thought, and that they don’t need them quite as much as they imagined. For example, think about those who have realised they don’t need to pay for a monthly gym membership when they can run and exercise from home, or those who have noticed the staggering amount they have saved from making their own coffee and lunch whilst working from home.
So, as we return to more normal life this could be a valuable opportunity to re-evaluate what we think of as our ‘wants’ and ‘needs’ and work out if there is scope for continuing to save more towards our financial future.
Increase and enhance
In addition to budgeting alone, it’s worth knowing that there are other ways that you can make your monthly money work harder for you, whilst continuing to increase your savings ratio.
In between the ‘gross’ and ‘net’ income figures on your payslip are certain deductions, which will include Income Tax and National Insurance contributions. These deductions are what many people tend to ignore, succumbing to the notion that they are unavoidable. However, it is possible to reduce these deductions by contributing to your pension.
Pension contributions made personally benefit from Income Tax relief at your highest marginal rate. In a workplace pension scheme, this generally works by your employer deducting any pension contributions from your monthly salary before they calculate the tax due, meaning that your taxable salary is effectively reduced, as well as the tax you pay on it.
Therefore, as long as you are confident that you won’t need easy access to the funds before retirement and have a suitable emergency fund in place, increasing your pension contributions could be the most effective way to enhance your savings ratio, without cutting back in other areas of your budget. Additionally, if your employer allows you to make pension contributions through a salary sacrifice arrangement, you will also reduce your National Insurance contributions.
Case study
Let’s consider the example of Rachel below, who is earning a salary of £84,000 per year. Rachel requires £3,500 per month to comfortably cover her lifestyle expenses and would like to ensure she is saving as much of her disposable income as possible.
The table below compares the amount that Rachel could afford to save from her net income (option 1) with the amount she could afford to save if she contributed to a pension (option 2):
| 1. Saving from net income | 2. Saving into a pension | |
| Gross Income | £7,000.00 | £7,000.00 |
| Pension Contribution | – | £2,140.16 |
| Taxable Income | £5,952.50 | £3,812.34 |
| Tax | £1,752.66 | £896.60 |
| National Insurance | £463.24 | £463.24 |
| Take Home Pay | £4,784.10 | £3,500.00 |
| Savings from net pay | £1,284.10 | – |
If Rachel chose to follow option 1, she would have the capacity to save £1,284.10 from her take home pay. However, if Rachel chose to take option 2 and contribute to a pension instead, she could increase her savings to £2,140.16 per month, whilst still having sufficient take home pay to meet her lifestyle expenses. By choosing option 2, Rachel has received Income Tax relief of 40% on her pension contribution of £2,140.16. This has reduced that amount of tax payable each month by £856.06.
Moreover, if Rachel was to utilise the salary sacrifice option offered by her employer, she would benefit from an additional National Insurance saving of 2% on the amount contributed to her pension.
Taking advantage of ‘free money’
Some employers encourage their employees to save for their future by agreeing to increase their own contributions to match those made by an employee, usually up to a certain level. Where an employer is willing to match your contributions, you will be rewarded with an additional £1 for every £1 of pension contribution you make. This has the potential to effectively double your contribution at your employer’s expense.
A smarter savings plan
Whilst knowing how much you need to save to meet your goals is clearly important, of equal importance is knowing the most efficient method of saving. Contributing to a pension might not be the most efficient method for everyone, but it can prove to be a powerful wealth building tool when used appropriately.
By taking the time to understand your current position and connecting this with your needs and wants for your future, we can help you to create a suitable savings strategy that gives you confidence in your financial security, without sacrificing your ability to live for today.
