The Skinny:
People do not save nearly enough, and it is leading to countless major issues in the U.S., however if everyone embraced the concept of a “savings waterfall”, they would be in much better shape.
Crisis in the USA:
Every time I hear a new statistic about the dismal savings habits of Americans, I gasp nearly every time. Here are some of the most profound that stick in my mind:
More than 2 in 3 Americans worry about having enough emergency savings to cover a month’s worth of living expenses (Bankrate)
Nearly 40% of Americans can’t cover a $400 emergency expense without borrowing money or selling something (Federal Reserve)
Less than half of working-age Americans have any retirement savings at all (U.S. Census)
The personal savings rate in the U.S. as of July 2023 is a 3.5% (BEA)
There are probably another 10 statistics like this, and they all say the same thing, that Americans’ personal finances are not in good shape. Despite being the wealthiest country in the history of the world, many citizens have relatively nothing in their bank accounts. Since money is often cited as the number one cause of stress, this also means that many citizens are constantly stressed out and unable to properly enjoy their lives. It is very sad not only because of how pervasive it is, but also because it essentially makes retirement a mythical goal, which is not how life should be. Everyone should be able to provide for themselves and their family while putting away money to build up a financial cushion.
Instead, many individuals feel they must resort to high-interest credit cards and other forms of debt (looking at your BNPL companies) to meet their basic financial needs. The repercussions of this are extremely damaging. First, if people are borrowing, then there is no way they can save. The interest rates they must pay are often crippling (think about it, if someone needs to use debt to cover day-to-day expenses, they are inherently risky and therefore get charged high interest rates) and interest compounds and snowballs, increasing the amount to pay off. It is a bad, bad situation. Everyone should strive to be on the right side of compounding, not the wrong side.
Second, it ultimately damages the broader economy because people will not be able to spend or invest and will get crushed in a job loss situation. I am not going to get into all the causes of this crisis (living costs outpacing wages, inflation, high housing and education expenses etc.) because they are not really relevant. They are inherent challenges that are unfortunate and will not go away anytime soon. All people can do is to focus on what they can control.
It is my firm belief that this is a solvable crisis because I truly believe everyone can easily shape up their savings habits by implementing a simple but disciplined system. I call it the savings waterfall and it involves rigorously putting aside money before you do literally anything else with it. This concept is far from groundbreaking and many personal finance books echo the same thing:
I found the road to wealth when I decided that a part of all I earned was mine to keep. It should be not less than a tenth, no matter how little you earn. It can be as much more as you can afford. Pay yourself first. – The Richest Man in Babylon (1926)
Most people, when they reach the point where they have a dollar leftover at the end of the month, pay everyone else first and leave nothing for themselves. That’s backwards. Pay yourself first. It’s your money. You worked for it. – Rich Dad, Poor Dad (1997)
The most important principle of all: Pay yourself first. – The Automatic Millionaire (2003)
My spin on this concept is that I think about it terms of the returns waterfalls used in private equity real estate. After all, this is a real estate website not a personal finance one so there of course had to be a tie-in! I also believe that it should be more granular than simply putting aside money first. There should be literal tiers to the savings program to properly account for the allocation of funds.
Comparing Private Equity Waterfalls to Savings Waterfalls:
In private equity, it is commonplace to allocate returns according to a “waterfall”. A waterfall is a seemingly complex and cool-sounding concept that is quite simple. It is just a set of rules to allocate profits to align the incentives of investors and the managers of investors’ money, that’s it.
Visually, a PE waterfall does indeed act like a waterfall does in a natural stream over rocks, except it is more helpful to think of it in terms of buckets / tiers. Water can only flow to a new bucket if the current bucket is filled. Typically, an investor will receive their principal back first followed by a “preferred return” before the manager gets any profit share. This protects the investors’ money while providing an incentive for the manager to do a great job. If the manager does a great job, they get “free” money via an outsized share of the profits (called “carry” or a “promote”). This is very lucrative and is what most real estate managers live for.
For example, let’s say there is a $100 real estate deal that you are the investor in. You agree to terms with the manager that you will invest the entire $100 and offer them an outsized share of the profits if they do a great job. You tell them that before they see a penny, you must receive your $100 back as well as a 10% return. After 10%, they receive 20% of the additional profits despite investing 0% in the deal. Here is what that looks like if the deal returns 20%:
Investment = ($100)
Sale Proceeds = $120
Total Return = 20%
Waterfall Tier 1 = Return of Capital = ($100)
Waterfall Tier 2 = 10% Preferred Return ($10)
Remaining Profits to Distribute = $120 – $100 – $10 = $10
Manager Share of 20% = $2
Investor Share of 80% = $8
Now think about how well the manager does on a $1mm deal ($20k), a $10mm deal ($200k), and a $100mm deal ($2mm) and you see why lots of operators make great money in this field!
With that quick primer out of the way, do you see how the waterfall concept can be implemented in someone’s savings habits? There is a gross amount coming in (income / profits) that should be allocated according to a sensible system. In real estate, from the investor’s perspective, the first tier of the waterfall (return of capital) is a lot more important than the last tier (giving up your share of the profits for “free”). In life, the first tier (i.e., taking care of your true financial needs first) is a lot more important than the last tier (i.e., 10 drinks at a nightclub or a motorized skateboard). The last tier can only exist if you take care of everything ahead of it. This can automatically drive better decision making and it is so easy to do, yet it amazes me how little people think this way (and often think the opposite).
Recommended Savings Waterfall:
I must give a mandatory disclaimer that everyone’s circumstances are different and these recommendations should be tailored for your own needs. This is not financial advice, just super helpful guidelines.
Tier 1 – High-Interest Debt Paydowns
This is the most obvious yet also the most neglected tier for the average person. High-interest debt such as credit cards and car loans are like an anchor that constantly weighs you down. It takes a massive chunk out of your cash flow and can compound and destroy any semblance of a savings plan. To the extent possible, clear out these balances in full monthly (especially credit card loans, which have interest rates of 20%+) before you do anything else. Debt paydown also has mental benefits as you work to “unshackle” yourself and clean up your balance sheet. This will give you a lot more confidence in life while reducing stress considerably.
Tier 2 – 6 Months of Living Expenses / Cash Emergency Fund
It blows my mind when I learn that people do not have a robust amount in cash or cash equivalents to prepare for unexpected life events. Many people think “oh, nothing crazy will happen to me, so I will book this $3k trip to the Dominican Republic instead of replenishing my emergency fund” but every single person I know has had something happen that required a major unexpected cash spend. These are often job losses, medical bills, car accidents, and house repairs. Shit happens in life and the only way you can sleep well is to have this money sitting safely in a dedicated account ready to go. While there are some opportunity costs such as higher investment returns or exciting splurges, you will literally thank yourself for having this when something happens, and something always happens. On an additional positive note, now that we are out of the era of negligible interest rates, you can have this money be liquid while earning a reasonable rate of return in money market accounts, high-yield savings accounts, and CDs.
Tier 3 – Reserves for Large Near-Term Outlays
This is related to the emergency fund but is dedicated to known cash outlays in the next 6-12 months. For example, if you know you are going to buy a house you would not put your $100k down payment on black at the roulette table or buy some exotic stock options. This money should be in short-term treasuries and other instruments that are accessible and stable but offer solid rates of return. I admittedly did not follow this when I knew I had large outlays for my upcoming wedding, I instead left the money in the brokerage account since I was confident they would run up more. Instead, it went down even further (of course) and I had to pull the money out at a loss. Do not make the same mistake!
Tier 4 – Tax-Advantaged Investment Accounts
I can complain a lot about the financial system in this country, but tax-advantaged accounts are one thing that we are doing quite well. Programs like 401ks and IRAs provide very clear mathematical advantages versus traditional brokerage account investing. I would highly recommend you study up on these benefits if you are not already familiar, but the upfront tax deduction, tax-free / tax-deferred compounding, and withdrawal tax treatment (as ordinary income instead of capital gains) combine to make a very material difference in returns over time. If your employer does a 401k match (aka literal free money) these benefits are only multiplied. You should absolutely max out these accounts (if you can) before you touch your traditional brokerage account. If you cannot max them out, then contribute an amount that you are comfortable with as a savings rate, such as 20%. You can then think of this tier as a minimum formula that will take the lower of (i) Gross Income x 20% or (ii) the maximum allowable contributions set by the government. Putting this money away early is analogous to a preferred return in a real estate waterfall. You need to fulfill this obligation before you can use the money for anything else. Note however that these programs are specifically designed for long-term investing and you are essentially “locked out” of accessing this money for a while. This is totally fine and you should embrace that because if you follow this savings waterfall, you are already covered on near-term items in Tiers 1-3 so you can be comfortable putting this money away long term.
Tier 5 – Taxable Investment Accounts
I view taxable investment accounts simply as a “plug” number to reach a targeted savings rate. We set the targeted savings rate in the prior tier at 20% of gross income. The formula for this tier then is simply Gross Income x 20% – Amounts Contributed to Tax-Advantaged Investment Accounts in Tier 4. If the tax-advantaged accounts hit the savings rate already, then this tier will be $0. Note that this tier will only be greater than $0 if the gross income is high enough that the maximum allowable contributions are less than 20% (or whatever savings target) of the total gross income. We will cover this in the examples.
Tier 6 – Living Expenses
We have arrived at what is the most controversial tier to the uninitiated. Why are living expenses so far down the list, below investments and just above the YOLO tier? If housing and food are non-discretionary then shouldn’t these be first on the list? I fervently had this view before I really took the time to think about it. The fact is that due to our own psychology and human nature, the only way to consistently save a desired amount of money is to treat that amount as completely unavailable for day-to-day spending. This in turn forces you to work only with what is left, by being more creative and judicious with your spending. For lack of a better analogy, think of it like taxes. In your job, you earn $100 but 20% or whatever is immediately taken out and given to Uncle Sam. You are now forced to live off $80. Well, you need to dock yourself again after putting away your targeted savings amount, say another $10 and then live off of $70. It needs to be viewed that strictly. That is table stakes for good savings habits. Many individuals and families who earn a lot less than you have found ways to save and provide. We see this all the time and that is because they are able to work through their constraints by being resourceful and judicious.
Tier 7 – YOLO and Other
Life is not meant to be lived without any excitement and it is certainly not meant to be excessively stingy. While the first 6 tiers will provide you with financial security in your day-to-day life, you should regularly “treat yourself” as the youngins say. In fact, while it may seem counterintuitive, the point of this savings framework is to allow you to splurge without any guilt or financial stress.
I take this tier quite seriously because my personal longtime definition of success was to get to a point where I never have to say no to a desired spend because of the money alone. There are not many better feelings than being able to get something you want and not have to think twice about whether you can really afford it. No credit card interest or installment plans. Just the feeling knowing that you have already hit the thresholds for your savings and investment plan and that the remainder can be used for whatever you damn well please. At risk of sounding like a corny guru, this level is super achievable with just some basic discipline and planning.
Bonus Tier – Valuable Life Experiences
I could not find out where exactly to put this one because it is a bit subjective and does not flow neatly into the savings waterfall, so I just added it here as a bonus. However, I would try and add priority to this tier because I think it is a very, very underappreciated part of life. I do not have direct data proving this, but many of the people I know who are struggling financially are ones that have never really experienced the world or left their own bubbles in a real way. We all have that hometown friend who never left and is content to be the king or queen of the local watering hole, still hooked on the glory days. These types of people are not the ones who typically have lofty ambitions or strong balance sheets. Real life experiences like traveling to historical or special destinations almost always leads to a broader appreciation of life and a fervent desire to do more of it. I do not know anyone in my life who is both worldly and unsuccessful. My belief is that because travel and experiences are expensive, the only option you have is to be more disciplined to earn and save more. To be clear, this bucket is not for benders in Cancun. These are for studying / living abroad or a weeklong trip to a distant land that you have always wanted to go to. This can have a much higher ROI than an S+P index fund. This tier will not be used every month or even every year, but it should be one that is consciously thought about.
How to Keep Score and Track Your Progress:
My favorite part about this system is that it is very easy to track and keep score without doing anything fancy or downloading a bunch of fintech apps. Your scoreboard is simply the balance in your checking account.
In the first phase of keeping score via Tiers 1-2 of the savings waterfall, you want your checking account to equal 6 months of living expenses. Therefore if that number is $30,000 ($5k / month) and you are only at $20,000, you keep score by noting how close you are to hitting that critical amount.
In the second phase of keeping score, when your high-interest debt is $0 and your checking account equals 6 months of living expenses, your sole goal is then to keep your checking account equal to the 6 months of living expenses. So if that number is $30,000 then that is what your checking account should always show. In this phase, what you will be doing is setting up automatic sweeps into your tax-advantaged and potentially also your taxable investment accounts. Every bank or brokerage account nowadays has a toggle to turn on these automatic sweeps in recurring intervals. The amount of these sweeps should be your savings % target. If the goal is 10% of your gross income, then that should be automatically swept from your checking account into the appropriate investment account. This way, you can simply set a reminder at the same time each month to see whether you at, above, or below $30,000.
If you are consistently above $30,000 each month, you have proven that you can increase your savings rate %. If you are consistently below, you need to make sure you are being as efficient as you can with your living expenses. If that cannot be reasonably improved, you may need to reduce your savings rate.
This may require frequent rebalancing as you home in on the right balance of spending vs. saving, but the key goal is to essentially to keep your checking account at the same level while your investment accounts consistently grow. Let’s look at some examples to hammer this home and to show how this simple scorekeeping method is also a feedback mechanism.
Savings Waterfall Example #1 – The Beginning Saver:
Assumptions
Income: $60,000 ($5,000 / month)
High Interest Debt: $2,000
Monthly Living Costs: $3,000
Target Emergency Fund: $18,000 ($3,000 x 6)
Near-Term Outlays: $0
Tax-Advantaged Limit: $25,000
Target Savings Rate: 10%
Starting Checking Account Balance: $0
Starting Investment Account Balance: $0
Tier 1 – High-Interest Debt Paydowns
Available Cash: $5,000 (from paycheck)
High Interest Debt Paydown: $2,000
Remaining Cash: $3,000
Tier 2 – 6 Months of Living Expenses / Cash Emergency Fund
Available Cash: $3,000
Emergency Fund Outstanding: $18,000
Emergency Fund Contribution: $3,000
Remaining Cash: $0
Tier 3 – Reserves for Large Near-Term Outlays
Available Cash: $0
Near-Term Outlays Outstanding: $0
Near-Term Outlays Contribution: $0
Remaining Cash: $0
Tier 4 – Tax-Advantaged Investment Accounts
Available Cash: $0
Contributions Outstanding: $25,000
Contributions Made: $0
Remaining Cash: $0
Tier 5 – Taxable Investment Accounts
Available Cash: $0
Contributions Outstanding: $0 (the 10% savings rate is easily covered via tax-advantaged investments)
Contributions Made: $0
Remaining Cash: $0
Tier 6 – Living Expenses
Available Cash: $0
Living Expenses: $3,000
Emergency Fund Offset: $3,000
Remaining Cash: $0
Note that this example is specifically designed to illustrate the importance of emergency funds. Since you put this cash away first, it is available to use later when you must pay your living expenses or other unavoidable costs. It is a little funky to the overall flow of the waterfall and should hopefully be very rare but I hope it is clear why you should prioritize in this manner.
Tier 7 – YOLO and Other
Available Cash: $0
YOLO Spending: $0
Remaining Cash: $0
Ending Checking Account Balance: $0
Ending Investment Account Balance: $0
After 1 month in this hypothetical example, you still have $0 in your checking and investment accounts, but you have now paid off your high-interest debt and learned to prioritize your personal finances.
Now let’s fast forward to this individual who has followed this savings waterfall for the rest of the year. Due to space constraints I cannot easily show the flow over such a long period of time, but I highly suggest you build this out for yourself and follow the money each month to see where you shake out after month 12.
Email me at [email protected] if you want the savings waterfall in excel to check your work or to use as a reference.
If you follow the money, you will find that after 12 months this person will have $18,000 in their checking account and $4,000 in their tax-advantaged investment accounts. Aka they will have “filled” waterfall tiers 1-3 (high-interest debt, emergency fund, and near-term outlays) and have started filling up tier 4. While it might not seem like much, this is a big accomplishment for someone who literally started at $0.
Savings Waterfall Example #2 – The HENRY (High Earner Not Rich Yet):
Assumptions
Income: $150,000 ($12,500 / month)
High Interest Debt: $0
Monthly Living Costs: $8,000
Target Emergency Fund: $48,000 ($8,000 x 6)
Near-Term Outlays: $30,000 (wedding)
Tax-Advantaged Limit: $25,000
Target Savings Rate: 20%
Starting Checking Account Balance: $40,000
Starting Investment Account Balance: $50,000
Tier 1 – High-Interest Debt Paydowns
Available Cash: $12,500 (from paycheck)
High Interest Debt Paydown: $0
Remaining Cash: $12,500
Tier 2 – 6 Months of Living Expenses / Cash Emergency Fund
Available Cash: $12,500
Emergency Fund Outstanding: $8,000 ($48,000 – $40,000)
Emergency Fund Contribution: $8,000
Remaining Cash: $4,500
Tier 3 – Reserves for Large Near-Term Outlays
Available Cash: $4,500
Near-Term Outlays Outstanding: $30,000
Near-Term Outlays Contribution: $4,500
Remaining Cash: $0
Tier 4 – Tax-Advantaged Investment Accounts
Available Cash: $0
Contributions Outstanding: $25,000
Contributions Made: $0
Remaining Cash: $0
Tier 5 – Taxable Investment Accounts
Available Cash: $0
Contributions Outstanding: $5,000 ($150,000 income x 20% target savings rate less the $25,000 tax-advantaged cap)
Contributions Made: $0
Remaining Cash: $0
Tier 6 – Living Expenses
Available Cash: $0
Living Expenses: $8,000
Emergency Fund Offset: $8,000
Remaining Cash: $0
Tier 7 – YOLO and Other
Available Cash: $0
YOLO Spending: $0
If you follow the money for one year, this individual will have handily filled up tiers 1-3 and just like the first example, will be working on Tier 4. You will note that the $78,000 in the checking account equals the 6M emergency fund of $48,000 plus the $30,000 set aside for the wedding. The balance flows to the tax-advantaged investment accounts.
Ending Checking Account Balance: $78,000
Ending Investment Account Balance: $66,000
Savings Waterfall Example #3 – The Rainmaker:
Assumptions
Income: $300,000 ($25,000 / month)
High Interest Debt: $0
Monthly Living Costs: $12,000
Target Emergency Fund: $72,000 ($12,000 x 6)
Near-Term Outlays: $0
Tax-Advantaged Limit: $25,000
Target Savings Rate: 30%
Starting Checking Account Balance: $100,000
Starting Investment Account Balance: $1,000,000
Tier 1 – High-Interest Debt Paydowns
Available Cash: $25,000 (from paycheck)
High Interest Debt Paydown: $0
Remaining Cash: $25,000
Tier 2 – 6 Months of Living Expenses / Cash Emergency Fund
Available Cash: $25,000
Emergency Fund Outstanding: $0 (already met the criteria)
Emergency Fund Contribution: $0
Remaining Cash: $25,000
Tier 3 – Reserves for Large Near-Term Outlays
Available Cash: $0
Near-Term Outlays Outstanding: $0
Near-Term Outlays Contribution: $0
Remaining Cash: $25,000
Tier 4 – Tax-Advantaged Investment Accounts
Available Cash: $0
Contributions Outstanding: $25,000
Contributions Made: $25,000
Remaining Cash: $0
Tier 5 – Taxable Investment Accounts
Available Cash: $0
Contributions Outstanding: $65,000 ($300,000 income x 30% target savings rate less the $25,000 tax-advantage cap)
Contributions Made: $0
Remaining Cash: $0
Tier 6 – Living Expenses
Available Cash: $0
Living Expenses: $12,000
Emergency Fund Offset: $0
Remaining Cash: $0
Tier 7 – YOLO and Other
Available Cash: $0
YOLO Spending: $0
After one year, this individual will have the following in their accounts:
Ending Checking Account Balance: $166,000
Ending Investment Account Balance: $1,090,000
Total gain of $156,000
Pretty awesome right? With a high savings target of 30% and low lifestyle creep, assets are accumulated very fast, which in turn leads to very powerful compounding.
If you remember the “scoreboard”, you will note that because the checking accounting balance has increased meaningfully, this means this person can increase their savings rate from 30%. Remember, the goal is for the checking account to remain constant once you hit a number that is at least 6M of your living expenses. In this case $100k (which is more than 6M of living expenses).
Can you figure out the savings rate to keep the checking account at the $100k level?
With a little algebra you will arrive at 52%! What an incredible savings rate! This in a nutshell is why the rich will always get richer.
This should be the goal of everyone. To be at a point where you can handily cover your living expenses while saving plenty of money. You will be confident, happy, and stress-free financially. To be clear, you do not need to make $300k, you just need to reach a savings rate that allows for this type of discipline.
Scarcity vs. Abundant Mindsets:
A lot of people scoff at such a disciplined savings regime, claiming that “no one ever got rich by budgeting” or some similar line. Their argument is usually that budgeting is a “scarcity mindset” and that everyone should instead strive to have an “abundance mindset”. In other words, you should focus on expanding your income and assets instead of reducing your expenses, since expenses can only be shrunk a certain amount while income is technically infinite. While I agree with this concept, I think that they are two sides of the same coin and that the scarcity mindset gets a bad rap.
When you have a disciplined savings regime, you have more money left over to grow and compound. Similarly, when you have more money in the bank, you will feel more comfortable and confident taking more risks that in turn might earn you more income and assets (i.e. a business venture or large investment). While scarcity and abundance are technically polar opposites, they are actually complementary when it comes to personal financial habits.
Summary:
There is a savings crisis in this country but it is very solvable. One way to tackle it is to create your own “savings” waterfall” that prioritizes your cash flow into buckets. Sticking with this framework will instill discipline and will ultimately lead to a strong checking account, large investment accounts, and financially stress-free living that will invariably improve other parts of your life as well.
