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Should We Sweat Our Savings Rate?

With Social Security steadily shrinking, Foolish investors are right to be concerned about saving for retirement. As a nation, our financial preparedness seems especially worrisome, with the U.S. personal savings rate dropping to a negative 1.2% in last year's third quarter. Do the savings statistics accurately portray an overspending American consumer, or is it just another financial illusion? Let's find out!

Savings rate defined
The common economic definition of savings is "current income minus spending." When it's given in percentage terms, a negative number means that people are spending more money than they're earning. But this definition of savings excludes the rising values of stocks in a brokerage account, or any sort of investment activities, as income -- at least, not until the gains from these assets are realized and sold.

It makes sense that statisticians don't count assets like stocks as income before they are sold. Still, numerous studies have shown that as assets increase in value, consumer spending will rise as well, even before the asset is sold. Therefore, in periods of rapidly appreciating asset prices -- like, say, right now -- savings is bound to decline.

So when the news comes out that the average U.S. citizen has a negative savings rate, everyone tends to bemoan consumers' overspending, undersaving ways. Yet in reality, people in the United States do a great job of saving for the future -- if you measure by the more appropriate metric of economic wealth, which accounts for rising asset values even before they are sold.

Wealth defined
A person's net worth, and their level of wealth, are most often defined as the total value of their physical and financial assets, minus their debts. Physical assets are things like your car or house, and financial assets include the stocks or bonds that you may own. Defining wealth this way captures the value of a person's vacation home and investments even before they are sold, for example.

When economists want to measure individuals' preparedness for retirement, wealth is a better metric to use than savings, because it encompasses all the various ways that people attempt to finance those golden years before they resort to selling their assets for cash. While a negative savings rate may show that you spent more cash than you brought in for the year, your wealth measure will show whether your assets are worth more than they were last year.

Suppose you bought shares of Apple (Nasdaq: AAPL  ) last year, subsequently enjoyed the stock's roughly 80% gains, and then splurged on a Porsche, since you knew your retirement accounts were in good standing. You won't have those gains counted as income, but the Porsche purchase will reduce your savings rate. In scenarios like that, it's better to judge people's retirement readiness by their wealth, because financial assets like stocks can be sold any time, and they're easily turned into cash.

Are we ready for retirement?
If net wealth is a better measure of one's ability to fund retirement, how does the United States stack up? Despite the declining savings rate, our individual net worth is on the rise. In the most recent report from the Federal Reserve, using data from the Survey of Consumer Finances, average net wealth grew 29% from 1998-2001, and more than 6% from 2001 to 2004. Even though savings may not be appreciably growing, the physical and financial assets we can convert to cash are increasing in value. Even more importantly, looking at households containing 55- to 64-year-olds shows that from 1995 to 2004, net wealth rose nearly 80% on average!

More evidence that U.S. consumers might not be in such bad financial shape -- or perhaps that the rest of the world is in even more trouble -- can be found in a paper comparing people's net worth around the world. Wealth in the U.S. was by far the highest for large countries, averaging $144,000 per person. (Remember, this statistic counts children as well.) Japan was a distant second, with an average net worth of $125,000 per person.

One criticism of using wealth as a metric for retirement preparedness is that some assets, such as homes, aren't always liquid enough to finance a retirement. Obviously, you can't sell your home off room by room to fund your golden years. However, the data shows that as people get older and begin to stop working, they do draw down on these assets to fund their retirement quite easily. For instance, in 2004, the average net wealth of families containing 55- to 64-year-olds was $840,000 in the U.S. That figure drops to $640,000 in the 65-to-74 age group, as couples downsize their housing, sell off vacation homes, and use that money for their daily retirement needs.

Why the savings rate matters
In addition to measuring financial preparedness, there are obviously some good economic reasons why it's important to keep an eye on the savings rate. For one thing, it's a crucial way to gauge business investment. In addition, if people are putting too much of their retirement nest egg in one basket, like the stock market or their home, they could be just one hurricane or Enron away from financial ruin if they aren't saving as much as possible.

The United States' current saving situation certainly looks bad; personal savings rates have been negative since 2005. But even as savings have stagnated, wealth has grown at an incredible rate in the past 15 years. Given the choice, I'd rather hold 20 years worth of unrealized capital gains on Microsoft (Nasdaq: MSFT  ) stock (more than a 150-bagger in the past two decades) and zero savings, than have a high savings rate but very little wealth.

Need help getting your finances ready for retirement? Just want to learn how to invest more intelligently? Try out our personal finance newsletter, Motley Fool Green Light, free for 30 days.

Fool contributor Brian Lawler does not own shares of any company mentioned in this article. Microsoft is an Inside Value pick. The Fool has a disclosure policy.


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